Tuesday, September 27, 2011


One question that has been in the minds of most of us: Why are gas prices so high? There is also another thing that has puzzled me quite often: Why are they so different? Yesterday evening we were almost out of gas (me and my car) when I started from office. I checked the gas station nearby and it read $3.89 per gallon. I remembered seeing $3.79 somewhere near my house, so I kept driving. I was about to fill my gas at that station when my iPhone informed me that 4 miles away, gas was $3.72. I live in Chicago suburbs and Gas Buddy tells me that fuel costs $4.09 in downtown. So within a radius of about 15 miles I was able to see 4 different prices for fuel. And we are just getting started here. If you look at US national averages: Gas costs around $3.9 on average in the West Coast, Mid West comes close with $3.7, Utah/Colarado being in the center come in at about $3.5  whereas if you go down South to Texas, gas is relatively cheap at $3.1. Now that is a $1 differential for just 1 gallon and it is fairly significant. And within regions too the prices fluctuate as much or more over the year. I wanted to make sense of all this and was going crazy. So I decided to catch Professor Eisenkleiftovich again and pick his brain on this topic.

Me: Professor. Why are you looking so dejected?

Prof: Err… Did you hear that a few neutrinos have outpaced the speed of light by 60-billionth of a second? I never imagined Einstein could be proved wrong.

Me: But Prof: That could just be a false alarm. There have been quite a few of them before.

Prof: Hmm.. you are right. And I hope so too. Otherwise I will have to revisit and redo all my research again as they all have the theory of relativity as the foundation stone. Either way, an interesting space to follow! You tell me kiddo. What are you upto?

Me: These fuel prices have been intriguing me for a while now. I have always thought that they are based mostly on the price of crude oil but I don’t believe that theory supports the fact that different regions in a country have different gas prices. Could you shed some light on this?

Prof: Sure. You have the common misconception that most people have. To be precise, today you are just 65% correct when you say fuel prices swing exactly with prices of crude oil. There is more to it.  Gas is just like any other consumer product and there is a supply chain that sets the price of the product. Here is the entire pie which tells you where each dollar you spend on gas goes:
    Crude oil                      :    68 cents
  Taxes                            :    14 cents
  Refining                        :    10 cents
  Distribution/Marketing  :    8 cents

Me: Hmm…. That is interesting to know. But still it doesn’t solve my confusion about global price fluctuations and regional differences in fuel costs.

Prof: Patience, my boy. Let me take up your global confusion (err..fluctuation) first. As you see the biggest slice is still crude oil and its price is controlled by the classic supply and demand principle. Demand here is straightforward: World Economic Growth. It is driven by the increase in the number of people who drive! Developing nations like China and India have an expanding middle class who are likely to use more gasoline over time. And don’t forget the US which has a whopping 86,000 miles of interstate highways and consumes 178 million gallons of gasoline each day. Which is precisely why you will be surprised to note that US imports around 11 million barrels of oil and petroleum products per week and still happens to be the 3rd largest producer of crude oil!

Me: Whoaa… I didn’t know that. No wonder the Strategic Petroleum reserve is a big thing. But my heart goes out for the Arctic National Wildlife Refuge. Anyways, what is the supply side story?

Prof: Hmm… ever heard of OPEC. It is the single largest entity impacting the world's oil supplies: The Organization of the Petroleum Exporting Countries (OPEC), a consortium of 13 countries: Algeria, Angola, Ecuador, Indonesia, Iran, Iraq, Kuwait, Libya, Nigeria, Qatar, Saudi Arabia, UAE and Venezuela. Together, these 13 nations are responsible for 40 percent of the world's oil production and hold the majority of the world's oil reserves. They have the switch to control crude oil prices. When OPEC wants to raise the price of crude oil, it simply reduces production. This causes gasoline prices to jump because of the short supply as well as the possibility of future reductions. When oil production dips, gas companies get nervous. The mere threat of oil reductions can raise gas prices.

And apart from that, world events like military conflicts in oil zones, weather calamities like hurricanes in offshore drilling patterns and seasonality (summer for example where people drive more) can also cause fuel prices to shoot up.

Me: Now I get this completely. But what about the local piece? Why do gas prices vary from state to state?

Prof: There a few reasons, but taxes probably are the biggest factor. Distance from oil refineries can affect prices too. That is why places that are closer to the Gulf of Mexico enjoy lower prices due to low transportation costs. Hence the $3 in Texas compared to a $4 in San Diego.  And then there is regulation that differs across different states. California has stricter cleaner burning fuel requirements while Mid West has the use of ethanol requirement. That explains the higher fuel prices in these regions relative to the rest of US. And last but not least, local competition among gas stations can also drive price down within a region.

And to bust the last myth: most people think that gas stations make a good cut due to fuel price fluctuations. Remember that 8% of the pie is split between distribution, marketing and the gas station. And then there is competition. So now you can see that they typically just add a few cents per gallon (max a dime)!

Me: Wow… that was good stuff. I feel a lot more educated and oil-savvy. Thank you for enlightening me in such an entertaining way. Good luck on your Einstein bet though. You think he will once again stand the test of time (and light)?

Prof: Of course I do. I would go ALL-IN on that one! I don’t want to rewrite all my theories, for Christ sake!



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