It’s the Infrastructure, Stupid: Why is Gasoline So Expensive?

I will start from a vantage point of gasoline costs rising to $4 a gallon. But how do we get to that number? The numbers on the gas station sign hide a complex set of transactions. Before gas can power your car, it must be discovered as crude oil, navigate three markets, and be refined from crude into gas.

The Three Markets: Contract, Spot and Futures

Both oil and gas are traded on three markets: the contract market, the spot market, and the futures market. Each is influenced by different factors and impacts the price of gas at different stages of production. Unlike the futures market, the contract and spot markets are not the kind of markets found on Wall Street; they are informal networks of businesspeople.

The Contract Market

Refiners plan their purchasing and refining activity to ensure that these contracts are fulfilled. In exchanged for this privileged standing, refiners charge contract customers a premium.

The Spot Market

The best deals are often found on the spot market. Since neither the buyer nor seller is locked into a prearranged deal, the laws of supply, demand, and free market are mostly in effect.

The Futures Market

The people buying and selling futures rarely, if ever, collect on their contracts; if we look at the most recent seven year period, you could note that 5 billion barrels traded, of which only 31,000 were ever delivered.

Refineries

In the early 80's, there were over 350 refineries, mostly owned by the oil companies. Today there are less than 150 refineries, and most of them no longer controlled by the oil companies. Refineries are now held privately and independently, and as with any independent businesses, profit is king. It is in the refiner's interests to supply only as much gas as is absolutely needed to stay on the profitable side of the supply and demand curve.

Fixing the Price of Oil

Heard of OPEC? Well, on the world market, the price of oil is really established by these countries first. Then follows the trickle down I have described above. And if you think that this above is complex, stay tuned for another write up about OPEC at a later date…

Taxes

State and federal taxes account for about 18% of the price of gas. The cost is a constant and is factored into the baseline price of gas.

Eliminating those taxes would reduce the price of gas by a few cents, but would do nothing to otherwise address the underlying factors involved in pricing gas.

So why is gas so expensive?

Now that we have a primer on the process, let’s get to the heart of the matter.

When conflict arises in the Saudi desert, causing the State Department to release a warning of increased terrorist activity, the futures market reacts, sending the price of crude soaring.

The higher price on the futures market makes it more expensive for refiners to acquire crude to refine into gas. When the refiner's work is done, the emerging gas will be priced accordingly higher. This raises the rack price and the prices on the spot markets. Oil companies and independents with long-term contracts might be insulated from the higher price, depending on their contracts. Because refining oil into gas isn't instantaneous, there can be a lag before the higher price of the oil is reflected in higher gas prices.

Anything that can “scare” markets will always be significant at the pump. Since the oil companies all move in lockstep, that “scare” can cause the price of gas to rise for several days as one oil company sees another raising prices and adjusts accordingly.

Eventually the markets will calm and the price will begin to fall.

Since the next natural question is “isn’t this price gouging?”

Sure, if the price is artificially bumped for an unreasonable amount of time – but how would we define that? The hard part is proving that it is gouging. So far, millions have been spent on this topic and nothing has ever really been proven. Not a good path to go down in my opinion.

Bottom Line

The best signal to the market will be people driving less. That will bump the supply and drop the price. If this happens, DOE would then (at its next opportunity) report that “due to price increases, US drivers traveled less this summer, resulting in an unexpected supply increase in summer – a period which usually sees a supply draw.” If DOE said this in a report, prices would fall off – not dramatically, but it would have an impact.

But in my opinion, the best way to have a lasting effect is to move to the 35-45 MPG sooner rather than later. How long do the auto makers really need to reconfigure MPG? I would argue that it depends on the current inventory in the market --- but if you told them today to move sooner on the MPG and that those that get there faster will be awarded certain incentives (tax incentives?), then we can all be happy. Labor will keep its workforce on the line, Detroit will be rescued, and the nation will be consuming less gasoline – so we can thumb our nose to OPEC. Lest we forget – OPEC still prices the oil and that means that without the relaxing of price fixing there, nothing changes.

As is always the case, there will be no silver bullets to solving this problem. I always come back to the simple realities. Infrastructure. We need to identify more supply – this means drilling domestically, but at the same time we need to be creative about how we improve MPG and or how we fundamentally change our approach to this problem. If we need to drive less – why not institute or require major employers to institute telecommuting? Offer incentives – maybe in the form of carbon credits to those companies? See what I mean? We need creativity and so far we have seen none.

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Labor will keep its workforce on the line, Detroit will be rescued, and the nation will be consuming less gasoline – so we can thumb our nose to OPEC.

Posted by: ClubPenguinCheats | April 20, 2010 at 06:59 PM