Why Are Gasoline Prices High (And What Can Be Done About It)?

By Kenneth P. Green

Policymakers often blame high gasoline prices on oil company profits, collusion, or speculators, but understanding what really goes into the cost of gasoline is key to understanding what the government could do to lower prices.

Once again, high gasoline prices are in the news. As of this writing, the national average gasoline price per gallon is hovering around $3.79. The public is unhappy with the high gas prices, and politicians are scrambling to find ways to either claim they’ve done all they could; to disclaim responsibility; to distract the conversation; or, as is often the case in a presidential campaign, to blame the other guy.

In addition to triggering off a gusher of newspaper editorials, the price pinch at the pump is sparking serious consumer discomfort. SymphonyIRI reports that “57 percent of consumers are feeling increased financial strain when gas prices increase, and more than four in ten say high gas prices make it difficult to meet monthly expenses,” based on polls conducted in the second quarter of 2011. Furthermore, 49 percent of consumers plan to reduce grocery spending if gas prices climb another 50 cents.
The table below shows how consumers respond to higher gasoline prices.

Gallup polls show similar results. The most recent poll on the subject, conducted May 12-15, 2011, shows that increased gasoline prices caused severe financial hardship for 21 percent of respondents and moderate hardship for 46 percent, a total of 67 percent.
Moody’s Analytics data shows that the “average American household spends $3,348 of its after tax income on gasoline and diesel.” A 10 cent increase in gas prices translates to an extra $93.25 in gasoline and diesel expenditures per year for the average household, and deducts $11 billion from consumers in one year.
An Associated Press-Gfk survey conducted February 16-20, 2012, found that 58 percent of respondents disapproved of how President Obama has handled gas prices. Since December 2011, the average cost of a gallon of gasoline increased by 30 cents, during which time the percentage of people who called gas prices deeply important grew 6 percent to seven out of ten, and the percentage that views gas prices as extremely important went up 9 percent, to 39 percent. On March 6, 2012, or “Super Tuesday,” seven out of ten primary voters said gas prices were an “important” factor in their decision making.
So what’s behind gas prices?

Real gasoline prices, 1976–2012, in February 2012 dollars. Data from http://www.eia.gov/emeu/steo/realprices/.
Oil Supply and Demand
Setting aside conspiracy theories about oil company collusion—a perennial favorite of politicians of all stripes—the primary reason for high gasoline prices, as any economist will tell you, is very simple: world demand for oil (from which gasoline is made) is high, and the available supply is limited. The cost of crude oil as a share of the retail price of gasoline varies over time, but in January 2012, it was 76 percent.
And what drives the price of oil? Many factors, according to the Energy Information Association:

Supply and demand in the world oil market are balanced through responses to price movements, and the factors underlying expectations for supply and demand are both numerous and complex. The key factors determining long-term expectations for oil supply, demand, and prices can be summarized in four broad categories: the economics of non-OPEC conventional liquids supply; OPEC investment and production decisions; the economics of unconventional liquids (such as oil from oil-sand or shale) supply; and world demand for liquids.

Back in 2006, the EIA observed that prices have risen since 2000 as a result of strong demand growth in developing economies (such as China), supply disruptions, and “inadequate investment to meet demand growth.”
Unrest in the Middle East is a perennial cause of worry over world oil supplies, and the recent explicit threats by Iran to close the Straits of Hormuz can’t be promoting confidence in oil consumer markets.

Another source of supply uncertainty is the moratorium that the Obama administration placed on U.S. development of domestic oil production in the last two years. Since the Deepwater Horizon oil rig disaster in 2010, U.S. domestic oil production has slowed significantly, especially in the Gulf of Mexico. The permitting slowdown as a result of the spill is estimated to have cost the United States $4.4 billion in output costs, 19,000 jobs, $1.1 billion in wages, and over $500 million in federal, state, and local government lost tax revenues. The Gulf Oil spill also caused a slowdown in the allotment of shallow-water drilling permits. A study by Bernard L. Weinstein at the Southern Methodist University looked at the effects of this slowdown in shallow-water permitting, and found that it will cost 50,000 jobs and U.S. income losses could exceed $12.5 billion.
But if 76 percent of the cost of gasoline is due to fluctuations in the price of crude, then 24 percent is due to something else, or a bunch of something elses. The Federal Trade Commission suggests that the other 24 percent of the cost of gasoline is influenced by a variety of supply and public policy factors. Some of the more significant factors follow.
Taxes
As the figure below shows, a significant share of the price people pay at the pump consists of federal and state taxes, and an array of fees associated with the production, processing, and transportation of oil and gas. Taxes, in fact, are nearly equal to the costs of refining, distribution, and marketing of gasoline. That fluctuates, of course, because most gas taxes are percentage based. Hence, they shrink as a proportion of cost when oil prices rise, but they remain significant. At $3.79/gallon, taxes account for about 53 cents.

Source: http://www.eia.gov/energyexplained/index.cfm?page=gasoline_factors_affecting_prices.
A Fractured Market
In order to fulfill air pollution reduction plans in states and localities across the country, gasoline sold in the United States has been fractionated into about 17 different boutique fuels sold in dozens of discrete markets. With three grades of gasoline per fuel, refiners are producing over 50 separate blends. Such boutique fuel requirements increase both price volatility and the height of price spikes as a function of the distance-to-market of boutique fuel producers and consumers, according to the Energy Information Administration. Boutique fuel requirements also increase the absolute price of gasoline sold in boutique markets, according to the U.S. Government Accountability Office.
Escalating Refinery Costs
Another factor that may have contributed to the increased price of gasoline is the reduction in the number of operating refineries in the United States over the last 30 years. The number and capacity of U.S. refineries peaked in 1981, and, since then, 171 plants have closed, although the remaining plants have increased output to offset a loss of production. Though most of this reduction has been caused by the low profit potential of refineries, others see a significant cause in “extremely tight environmental restrictions, not-in-my-backyard community opposition, and the high cost of new construction.” Refinery profit margins have played a role in recent gasoline price hikes. The EIA suggests that “The sizable jump in retail prices this year reflects not only the higher average cost of crude oil compared to previous years, but also an increase in U.S. refining margins on gasoline (the difference between refinery wholesale gasoline prices and the average cost of crude oil) from an average of $0.34 per gallon in 2010 to $0.45 per gallon in 2011 and $0.42 per gallon in 2012.”
A Weak Dollar
In recent congressional testimony, Robert Murphy, of the Institute for Energy Research, observed:

Crude oil is traded in a world market. If the dollar falls against another currency, such as the euro, then either the euro-price of oil has to fall, or the dollar-price of oil has to rise, to eliminate arbitrage profits. From its peak in March 2009, the dollar has fallen 17 percent against other major currencies. Therefore, holding everything else constant, the dollar depreciation alone from early 2009 can explain a 20.5 percent increase in oil prices (quoted in dollars). Put differently, the oil price quoted in (say) Japanese yen has not risen as much since early 2009 as it has in U.S. dollars.

It is on the basis of such calculations that a recent Joint Economic Committee report estimated that Federal Reserve policies have added almost 57 cents to the price of a gallon of gasoline for American motorists.

As (former AEI) economist Vincent Reinhart put it:

Indeed, both the net rise and the volatility of oil prices over the past nine months are partly a predictable byproduct of the Fed’s expansion of its balance sheet in its policy known as quantitative easing (QE).

Reinhart elaborates:

Since the Fed firmly signaled in August its intent to launch the latest round of QE, oil prices have risen from $76 to around $100 per barrel.

Why does the Fed’s balance sheet matter for oil prices? The producers of oil as well as other commodities typically sell their output in a worldwide market priced in U.S. dollars. Thus, they care about the current and expected future purchasing power of the dollar and how that will translate into goods and services back home. But QE has been associated with higher inflation and dollar depreciation, which combines to erode the purchasing power of the foreign producers of commodities. Thus, some of the rise in the nominal price of oil has been to catch up with that erosion.

Much more important in shaping near-term oil-price dynamics has been the nudge to investors from QE to move from safe to riskier investments. The commodity market has been one outlet for that reinvigorated search for yield. Investment flows into commodity-related vehicles has stepped up noticeably. This has been reinforced by the Fed’s policy of keeping short-term nominal interest rates near zero, which keeps it cheap to do some of that trading on borrowed funds. Such speculation neither produces nor consumes the commodity, so it should have no long lasting effect on prices. However, over short periods, it can fuel spasms of enthusiasm or angst that trigger wide swings in prices.

Some analysts believe that the Fed’s role is still more important:

Weakness in the U.S. currency feeds upward pressure on commodities, which are priced in dollars and thus come at a discount on the foreign markets. One result has been a surge higher in gasoline prices to nearly $4 a gallon before the summer driving season even starts, a trend that economists say will be aggravated as demand increases and the summer storm season threatens to disrupt oil supplies ... Using a model that combines "subtle rates of change" with movements in the dollar index and commodity prices, Hastings figures the low dollar is responsible for about one-third, or $1.31, of the total gas-at-the-pump cost.

Speculators
When explaining gasoline price hikes, policymakers point first to things like oil company profits, but lately, more attention has been paid to so-called “speculators:” people who buy oil futures as an investment, never intending to actually take possession of the oil that they have contracted for. In a Forbes article entitled “Oil Speculators Are Your Friends,” Jerry Taylor and Peter Van Doren show that, while speculation has been shown capable of causing short-term price spikes in the past, there is little evidence that speculation is a cause of oil price hikes since 2005. First, they observe that no evidence has emerged linking the real prices of oil to the prices being set in futures markets. Second, they point out that a sharp increase in the number of speculators also fails to show a correlation with real prices. Third, they find that rather than increasing price volatility, it turns out that speculation increases after price volatility manifests, and tends to damp it down: only two out of 26 studies of speculation showed increased price volatility after the onset of futures trading in commodity markets, while 14 out of 26 studies showed a decrease in commodity price volatility after trading markets were introduced.
Conclusion
The gas price consumers pay at the pump reflects the world price of oil, state and federal taxes, and other factors such as escalating refining costs, environmental regulations, and the Federal Reserve’s monetary policy.
Understanding what goes into the cost of gasoline is key to understanding what the government could do to lower gasoline prices. While U.S. policy cannot affect the world price of oil much in either the short or long term (though policies aimed at reducing instability in oil-producing regions couldn’t hurt), policymakers do have other options that might reduce the cost of gasoline, including: tax holidays at the state and federal level; strong-dollar and inflation-control policies at the Federal Reserve; and relaxation, suspension, or simplification of environmental regulations that fragment markets, increase market fragility, and boost refining costs.
Kenneth Green is a resident scholar at the American Enterprise Institute.