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You Should Know: Why Does Gas Cost So Much?

That pain you feel at the pump comes from more factors than you may think.
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"Why does my gas cost so much?"

It's a valid question, especially when gas prices fluctuate overnight for no apparent reason and TV news talking heads focus on it with the same energy as the health care debate. Some might say there's a good reason to be concerned, especially in light of a recent study by the U.S. Joint Forces Command that pointed to an oil shortage in 2015. A reasonable person has a right to wonder what's going on.

The genesis for this story was the simple fact that I didn't have a clear idea of why we pay what we pay for a gallon of 87 octane . After reading this story, you'll have a much better understanding of how and why gas prices change, and what the future holds.

The billion-dollar equation
Many factors contribute to the price of a gallon of gas. The good news is that, in general terms, the equation is simple. These are the four main components that determine the gas prices you and I pay:
Crude Oil + Refining Process + Retail Sales/Distribution + Taxes = Gas Price.

These components, however, don't contribute equally to the gas prices at the pump. Here's a look at each component and its role in the retail pump price:

  • Crude oil: 69 percent
    o Finding the crude oil
    o Getting the crude oil out of the ground
    o Transporting the crude oil to the refinery
    o Maintaining a reserve capacity of crude oil
    o Profit
  • Refining the crude oil into gasoline: 6 percent
    o Producing special blends of gasoline to meet local clean air government regulations
    o Transporting the gasoline to the gas station
    o Profit
  • Selling the gasoline at a station: 10 percent
    o Operational costs
    o Marketing costs
    o Profit
  • Taxes, federal and state: 15 percent

Source: U.S. Energy Information Adminstration

Understanding gas price swings
Knowing the basic components of gas prices is a good start that makes understanding price swings easier. The two largest components of oil production are the most volatile. Many variables can interrupt the flow of crude oil and the refining process. Most gas price hikes happen in the wake of some kind of disruption in these two areas.

Hurricane Katrina provided a textbook example of this. It wiped out major drilling operations and refineries on the Gulf Coast. Gas prices shot up because the balance between supply and demand changed. Katrina's wrath caused a significant drop in gasoline production, but demand stayed constant, resulting in higher gas prices in the U.S. and across the globe.

In the months after Katrina, as the wells in the Gulf of Mexico and the huge refineries along the Gulf Coast came back on line, gas prices came down because supply increased to meet demand. Gas prices then moderated globally.

While Katrina was an obvious reason for a gas price swing, other factors are harder to identify. If you live in a major metropolitan area affected by the Clean Act, you've likely already seen mild gas price swings. Why? Refineries serving your geographic area have to change their fuel blending process to produce the government-mandated "boutique" gasolines that help reduce vehicle emissions over the colder winter months . These changeovers temporarily reduce supplies, causing modest and short-lived price increases. As soon as the refineries are back up to capacity after the blend shift, prices edge back down. Maintenance at refineries and on oil pipelines can also temporarily reduce supplies, causing localized price jumps.

What's happening now with gas prices
Obviously, gas prices are generally higher than they used to be. If you were driving back in the 1960s, you were used to gas prices of about 25 cents a gallon. Adjusted for inflation, that works out to be about $1.63 per gallon today. However, adjusted for inflation, gas prices between 1984-2001 were even lower. Today, we're definitely paying more than we used to, with the national average around $2.86 per gallon. So what other factors are causing gas prices to rise?

According to a report by BP Oil, worldwide demand for crude grew by 0.7 percent from 2005 to 2006, a rate that equates to almost 253 million barrels per year. Of some 60 countries surveyed by BP, demand was up in nearly 40 countries, while demand was flat or down in the other 20. For the record, United States oil consumption decreased in 2006 to below the levels of 2004.

Against this reality of increased demand, especially from developing countries with huge populations such as China (demand up 6.7 percent in 2006), oil production has been fairly flat. Between the jump in demand and flat production, gas prices have risen.

Several less obvious reasons are also behind jacked-up gas prices:

  • The crude oil that has been "the easiest to get" has already been pumped from the ground. Oil companies have to work harder to obtain oil they pump out today, and that costs more.
  • The quality of crude oil available now is generally lower, making it more expensive to refine than the more desirable "light sweet" crude that was more widely available in years past.
  • Supply uncertainty due to political issues in countries such as Nigeria, Iran, Iraq, and Venezuela, which in turn creates market nervousness. This tends to drive up prices from other oil producing countries because these suppliers can guarantee an uninterrupted supply. Some place the premium at $10 per barrel, but it's nearly impossible to quantify.

Taxes drive gas prices up further
As noted above, state and federal gasoline taxes account for about 15 percent of the cost at the pump. This figure equates to a national average of about 57 cents per gallon. As you can understand, states with percentage-based sales tax make considerably more on each gallon as gas prices rise.

While paying nearly 60 cents per gallon in taxes is not great news, compared to many countries, we get off easy. The country of Turkey levies nearly a $5 per gallon tax on each gallon of fuel (this really seems like a "fine"). Norway, even with its oil industry, taxes its gasoline buyers about $4 per gallon. However, some countries enjoy little if any taxation. Most of these same countries also enjoy huge oil reserves and refining capabilities that have been "nationalized" by their governments. In Iran, gas is only 33 cents per gallon, while Venezuelans do even better, with gas as little as 17 cents per gallon. The trade-off, of course, is living under a totalitarian government.

Is raising fuel taxes further the right thing to do to encourage alternative energy sources?
No. Raising taxes will cause a non-market driven decrease in oil consumption. This decrease in demand will drive down the world price of oil, making it tougher for alternative energy sources to gain market share. Until alternative sources of energy are profitable to produce on an even playing field compared to gasoline, they won't get to market on a large scale. Many energy experts do not support raising taxes because of this economic reality.

What about higher mandated fuel economy standards?
Bob Lutz, GM's outgoing vice chairman, believes "if fuel efficiency is the goal, making it impossible for consumers to buy full-size trucks and SUVs because of mandated fuel economy standards won't help. This will hurt the economy and decrease the demand for fuel, causing lower prices, thereby increasing demand (for fuel)."

Bob gets it. His point is that Americans should drive what they want until they decide the price of fuel is so important that it makes them choose a more efficient vehicle. If one assumes that gas prices will remain high, these elevated gas prices will encourage alternate energy development. Legislating larger vehicles out of existence isn't the answer. Hey Washington, are you listening?

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