Crude oil prices have dropped dramatically since last summer. Strangely, over the same time period the price at gasoline pumps fell much less. If a barrel of oil today costs less than half what it did last summer, why hasn’t the price people pay at the pump decreased a similar amount?
It’s tough to say exactly how much the price of crude oil has fallen because there are many types of crude oil. Crude prices vary widely based on the oil’s location and quality. Crude oil is named for where it was pumped out of the ground. U.S. news reports focus on West Texas oil, not because it is currently plentiful, but because the market for this type of oil has existed for many decades. European news often reports the price of Brent oil, from the North Sea, for the same reason. From mid-June 2014 to mid-March 2015 West Texas Intermediate fell from $107 to below $44, a fall of almost 60%, while Brent oil fell from $114 to $52, a reduction of over 50%.
It’s also tough to say exactly how much the price of gasoline has fallen because there are many formulations, types and grades of gasoline and petrol. In the middle of this past June the average gas station in the U.S. was selling a gallon of regular unleaded gasoline for about $3.65, while now in mid-March the average price is $2.45, a drop of 33%. In the United Kingdom the price of super 95 petrol went from £1.30 a litre in mid-June to £1.11 in mid-March, a drop of only 15%. In both countries gasoline prices have fallen far less than crude prices.
I have heard numerous callers on radio talk shows state the reason prices are not falling is because oil company executives are greedy and are profiting at regular people’s expense. There is some evidence for both the U.S. and Europe that retail gasoline prices go up much faster than they go down, but not all researchers agree. The U.S. evidence suggests three-quarters of a crude oil price increase is passed along to customers within four weeks, but it takes eight weeks for three-quarters of price decreases to show up at the pump. So it appears there is some greed involved. However, since crude oil prices began dropping eight months ago, even if decreases take longer to occur than increases, enough time has passed that pricing lags cannot be the explanation.
The real reason is much less sinister. Crude oil only comprises a portion of the cost that goes into making a gallon or litre of gasoline. In the U.S. slightly more than half of the pump price is impacted by crude prices. Federal, state, local and city taxes make up about twenty percent of the price of gasoline. Distribution, which is moving the gasoline from the refiner to your local station, plus marketing, which are the ads that convince you to buy brand name gasoline instead of generic, comprise another twenty percent of the price. Finally, refining, which turns the crude into gasoline, makes up about six percent of the price of gasoline. Taxes, distribution, marketing and refining are all components of gasoline’s price that do not depend on the current price of crude oil, and together add up to almost half of the price.
Outside the U.S. taxes comprise an even larger percentage of gasoline’s selling price. Canadian drivers see almost 40% of their gasoline spending go toward taxes. Japanese drivers pay about half; French, German and Italian drivers pay about two-thirds; and British drivers pay over seventy percent of total petrol cost on taxes. How much is this? Drivers in the United Kingdom who are paying around £1.11 per litre for petrol actually pay just £0.35 for the oil. The remaining £0.76 per litre is for taxes.
Most countries have at least some gasoline taxes that are a fixed amount per gallon or litre. For example, the U.S. federal government charges drivers a fixed 18.4 cents per gallon purchased to fund highway construction and repair. These fixed taxes mean that as crude oil prices fall, the amount taxes comprise of the final purchase price steadily rises.
Because so much of the price at the pump is not impacted by crude oil prices, when crude prices fall the consumer sees only a portion of the drop. In countries like the U.S. crude oil currently comprises half of gasoline’s costs. This means if crude oil drops another 50% the customer will only see a 25% drop in price. Pump prices drop much less than crude because half of the pump price does not go up or down as crude fluctuates. For countries, like the U.K., where crude oil currently comprises less than one-quarter of gasoline’s costs, a 50% drop in crude prices means customers will see less than a 12.5% drop in price.
The supply of oil, especially from new U.S. fields, is rapidly increasing. Demand in Europe and China appears to be slowing. Understanding changes in the supply and demand for oil (explained here in chapter 2) is important for predicting where crude oil prices will go over the next few months. No matter what happens, even if crude oil prices fall to almost zero, all of us will still be paying a fair amount to fill up our cars and trucks because the cost of crude comprises only a portion of the price paid at the pump.
Note: An edited version of this post was published on March 25, 2015 in TheConversation.