The Constitutional Convention of 1787 was held in strict secrecy. Consequently, anxious citizens gathered outside Independence Hall when the proceedings ended in order to learn what had been produced behind closed doors. The answer was provided immediately. A Mrs. Powel of Philadelphia asked Benjamin Franklin, "Well, Doctor, what have we got, a republic or a monarchy?" With no hesitation whatsoever, Franklin responded, "A republic, if you can keep it." ~ BENJAMIN FRANKLIN 1787
What am I paying for in the price of a gallon of gasoline?
I’m asked this question a lot. And I know a lot of drivers ask themselves this question when they pull up to the pump.
The answer is based on the economics of supply and demand and how products are manufactured and sold – along with what the government takes in taxes. Let’s take a look, based on the U.S. Energy Information Administration’s breakdown of the estimated average price of a gallon of gas in December 2011, which was $3.27. Raw materials = $2.62
The cost of the raw materials used to make a product has a major impact on the final product price. The raw material for gasoline is crude oil. The price of crude oil is set by global markets, where buyers and sellers constantly react to supply and demand factors. Oil is just one of many commodities traded every day in the global market. Others are the corn that affects the price of food and the cotton that affects the price of clothing.
Crude oil is by far the largest factor in the price of a gallon of gasoline – accounting for 80 percent of the $3.27 average retail price per gallon in December, according to the EIA.
To put that in another way – about $2.62 of the average gallon of gas in this example is set before a refiner even touches the raw material.
Where I find many people get confused is that they assume oil companies are producing all the oil that goes into their own refineries – and therefore can control gas prices by controlling the supply chain. That’s not the case.
U.S. crude oil production in 2010 was 5.5 million barrels per day. But U.S. refineries processed 15.2 million barrels of oil per day – almost three times more oil than was produced in the U.S. That means U.S. refiners, like ExxonMobil, have to purchase millions of barrels of crude oil – at market prices – to produce gasoline and other products for American consumers. For example, in 2010, ExxonMobil spent $198 billion purchasing oil around the world for its refining operations.
Manufacturing the product
Like any product, there are costs to manufacture it – so the manufacturer tries to recover those costs, plus make a profit, when it goes to sell the product.
The refining portion of a gallon of gasoline has, on average, accounted for about 11 percent of the price in 2011, according to theEIA data through December. That means a little less than 40 cents per gallon would be due to refiners’ costs – wages, equipment, financing and others – plus their profits.
As the EIA figures show, however, refining doesn’t always produce a profit. In December, the data indicate that the U.S. market price for gasoline coming out of refineries was on average about 7 cents per gallon (-2 percent) below the refiners’ cost of crude oil alone, and before accounting for their costs of upgrading the crude into gasoline. In other words, refineries faced a market where domestic gasoline prices were very weak relative to global crude prices.
How does that happen? Refiners are “price takers” that operate on relatively low profit margins that are highly dependent on the market demand for petroleum products. That means at times, the value of a petroleum product coming out of the refinery isn’t enough to cover the costs of obtaining and refining the crude oil.
Distributing and marketing the product = $0.33
Products then have to get from the manufacturing site to the retail site. When gasoline leaves the refinery, it is shipped largely via pipelines to local terminals. There, distributors load their trucks and transport the gasoline to a service station. Naturally, each step in the distribution chain includes labor, capital equipment and other expenses that must be recovered by operators. Of course, these operators must also compete to sustain their profitability while also paying taxes.
Retailers then set the price at the pump, based on recovering these costs of getting gasoline to the service station and the costs of marketing it to consumers. They also have to generate enough money to pay their taxes and make a profit to keep their business running. And on top of that, they have to collect mandatory state and federal gasoline taxes from the consumer (which we’ll break down in the next section).
So who are the retailers setting the prices? When consumers pull into an Exxon or Mobil station, they assume it’s ExxonMobil. But we own only about 5 percent of the stations with our name on them. About 95 percent of the stations carrying the Exxon or Mobil brand are actually owned by network retailers or local business owners – not ExxonMobil.
Taxes = $0.39
So how much does the government make on a gallon of gas?
How does this compare to what a company like ExxonMobil makes on a gallon of gasoline? As we saw earlier, sometimes a company or an operation may lose money. Other times, it may make money. A competitive market just provides an opportunity, not a guaranteed profit. In the first two quarters of 2011, for example, ExxonMobil made 7 cents and 8 cents a gallon , respectively, on the gasoline, diesel and other petroleum products it refined and sold in the United States.
What actions could help lower gas prices?
Again, let’s go back to the economics of supply and demand that govern the crude oil market, since it’s the largest determinant of the price at the pump.
There are many global factors that affect the crude oil market. But adding more supplies of crude oil to the global marketplace can help put downward pressure on the price of a barrel of oil. The United States has abundant supplies of oil, from the deep-water regions of the Gulf of Mexico to the tight oil resources throughout North Dakota and Montana. Combined with Canada’s oil resources (one of the largest in the world), North America has enormous potential to add new reliable supplies to the market. And, the U.S. has one of the largest and most advanced refinery systems in the world.
But first, the oil needs to get to market. There, we’ve often seen economics trumped by politics – even as the U.S. economy remains weak. The recent moratorium in the Gulf of Mexico, as well as the decision to deny the permit for the Keystone XL pipeline from Canada to U.S. refineries, are just two examples of U.S. political decisions that serve to keep supplies out of the market.
The economics behind a gallon of gas are pretty straightforward. It’s the policies behind access to U.S. energy resources that are less certain – but critical to our energy future.