Q. Why are gasoline prices so high?

Answer:

I could begin by saying that gasoline prices are not all that high by historical standards. In the 1950s a gallon cost the equivalent of $3 in today’s dollars. The price in 1980 was almost as high. But everyone loathes the guy who says, “You think you have it bad. Why, when I was a kid….” So I’ll move on.

In point of fact, the increase in gasoline prices in the last 6 months is unprecedented. Why has it soared so high so quickly?

We can dispose of two popular explanations right away. The recent surge is not caused by as shortage of crude oil. The world will run out of oil. But as of now everyone agrees that supplies are plentiful. There is no shortage of crude oil production capacity. We can also dismiss the theory that OPEC (Organization of Petroleum Exporting Countries) is to blame.[1] OPEC, which controls 35-50 percent of the world’s oil exports, did announce in March that it was going to cut output by about 1 million barrels per day. But that hasn’t occurred. Indeed, as of mid May the OPEC countries were producing 2 million barrels per day above their official quota. In any event, US gasoline prices have soared by over 40 percent this year, double the rate of crude oil increases.

So why has the price of gasoline gone up by more than 60 cents per gallon in the last year?

A combination of circumstances is to blame.

First, prices normally rise significantly in the spring and early summer as people drive more and gasoline demand increases. In the past ten years gas prices rise from December to August by an average of 15 cents per gallon. In 2000 and again in 2002 gas prices rose by more than 30 cents per gallon.[2]

Second, energy demand is growing far more rapidly than expected.

The United States, which consumes 45 percent of the world’s gasoline, increased its consumption by 4.5 percent in the last 12 months. Asian economies are booming. China’s continues to grow at the astonishing rate of 8-10 percent a year. The recent impact of this fast-industrializing nation of 1.3 billion people on world commodity prices has been remarkable. Stockpiles of all minerals, from copper to coal to recycled metals are disappearing into the maw of the Chinese economy. This year China displaced Japan as the world’s number one oil importer. One fifth of the world’s ocean freight now delivers to Chinese ports, causing the cost of moving bulk freight to more than double.

Third, this increased demand is coming when gasoline inventories are low and refineries are operating at almost full capacity. There’s less and less slack in the system.

An extra long and cold winter, especially in the eastern United States, forced oil refineries to continue making heating oil longer than expected. Which led to reduced inventories of gasoline as the peak summer driving season began. U.S. oil companies began importing large quantities of gasoline from abroad, taxing the capacity of Asian refineries.

The real bottleneck in world gasoline supply is in refinery capacity. The International Energy Agency (IEA) estimates that world refining capacity is about 82.1 million barrels a day (bpd), about 2 million bpd above consumption estimates for the first quarter of this year. But it is below estimates for global oil consumption of 82.4 bpd expected in the fourth quarter of this year.[3]

In the United States refineries are operating at 96 percent capacity as of mid May. In California operating capacity is nearer to 98 percent. There are far fewer refineries today than there were 20 years ago. In 1981 according to the National Petrochemical and Refiners Association, 321 refineries pumped out 18.6 million barrels a day of gasoline in the U.S. Today 149 refineries, run by 60 companies in 33 different states, pump out 16.8 million barrels.[4] In 1983, California had 37 refineries. Today it has 13 and Shell recently announced it would close a refinery in Bakersfield in the next few months further straining capacity.

Today when a refinery goes down or a pipeline breaks, the price of a gallon of gasoline in that area can rise by 25-50 cents. A coker problem in the ChevronTexaco’s El Segundo refinery outside Los Angeles in early February reduced the amount of gasoline available to California, which almost immediately led to a 30 cent a gallon increase.

Contributing to the lack of resilience in the system is that 18 different types of gasoline are sold in this country. These are tailored to the specific requirements of various states and climates. California, for example, requires a different type of gasoline than does the rest of the country. Thus unlike in the old days (pre 1970) an oil supplier cannot, in an emergency simply divert gasoline from Arizona across the border to California because the gasolines are different.

M.J. Ervin & Associates, a Calgary based petroleum industry analysis group estimates that 90 percent of the fuel price hike in Canada since January has been a result of a sharp climb in refiner’s margins, from about 44 cents (Canadian) to about 88 cents per gallon.[5] In the U.S. the refiner’s margin has increased from about 32 cents per gallon to about 48 cents per gallon.

Fourth, the weakness in the U.S. dollar has led oil producers to raise prices.

Almost all of the world’s oil is sold in dollars. And the dollar has fallen against other currencies like the euro by 25 percent in the last year. Thus OPEC is in effect getting 25 percent less for its oil than a year ago. Which is what prompted oil producing countries to raise their target price range above the $22-28 per barrel in the first place. We might recall that Saddam Hussein threatened to require that Iraq be paid in euros for its oil just before we ousted him from power. The European Union’s outgoing energy commissioner Loyola de Palacio made the suggestion about the same time and recently renewed his call that oil trade be priced in a basket of currencies to promote greater price stability.

And last but by no means least, is the impact of speculation.

Many industries, like airlines, buy oil futures to hedge against the possibility of steep price hikes. But in the last six months non-commercial, financial hedging has occurred. Richard Schaeffer, of ABN Amro, a Dutch Bank with a big presence on the New York Mercantile Exchange (Merc) reports that the amount of speculation in oil is “more than I’ve seen in a very long time”.[6] Speculative funds once operated on the edges of the commodities arena. But they now make up about 20 percent of the crude oil and gasoline markets on the Merc.

This artificially raises the cost of oil. Bill O’Grady, director of futures research at the brokerage firm of A.G. Edwards in St. Louis told Reuters, “it is hard to justify $38.00 (oil prices)”. “I see the fair value at $30 to $31.”[7] On June 3^rd the price reached $42.

Some are calling this the terrorism or risk premium. Political troubles in Venezuela, Nigeria and Iraq have fueled speculation. The late May terrorist attack in Saudi Arabia caused the greatest one-day increase in the price of oil ever. There is a fear of terrorists targeting oil pipelines and refineries. This fear is reinforced by the specter of the American(and other governments) buying oil for strategic petroleum reserves even with the price so high. As the Economist magazine reported in March, “The administration’s persistence, coupled with increased strategic purchases by other governments, has fuelled suspicions that officials might have some intelligence about terrorist threats to oil infrastructure”. [8]

Who’s winning and who’s losing from the oil price run up?

The typical motorist is paying about $30 per month more for gasoline. The nation is paying a price penalty of about $3 billion a month. Your local gasoline station owner is also losing. Retail margins have been cut in half in the last 6 months and in some cases the margin is as small as a penny a gallon.[9] As expected, oil companies are doing very well. ExxonMobil announced profits of $21 billion last year and it could be even higher in the coming months. Refinery companies like Valero Oil are raking in the dough.

When will it end?

Ordinarily gasoline prices rise after Memorial Day as the summer driving season begins. On the other hand, the laws of supply and demand are at the present dwarfed by the impact of global financial speculation in oil futures. Speculators can move into or out of that market in seconds. So it is possible for oil prices to fall by as much as $10 per barrel quickly if speculators decide to cash out their winnings.