If crude oil prices have dropped almost 25% per barrel since June, why haven’t gas prices at the pump decreased a similar amount? At the end of June a barrel of crude oil on the NYMEX exchange was selling for over $103. This morning (Oct. 16th) the price was below $80 a barrel. At the end of June the average gas station in the USA was selling a gallon of regular unleaded gasoline for $3.70. The government shows today that the average price is $3.21, a drop of only 13%. Why has the price at the pump fallen by roughly half as much as crude oil prices?
I have heard numerous callers on talk radio shows state that the reason prices are not falling is because oil company executives are greedy. The real reason is less sinister. The figure below (original is here) shows that crude oil comprises only two-thirds of the pump price in the U.S. Three other factors make up the other third. Federal, state, local and city taxes make up about one-eighth of the price of gasoline. Almost all of these taxes are a fixed price per gallon and average about 42 cents per gallon. Refining, turning crude into gasoline, distribution, trucking it from the refiner to your local gas station, and marketing, convincing you to buy brand name gasoline instead of a generic are all also fixed price components that do not depend on the current price of crude oil.
Because one-third of the price at the pump is not impacted by crude oil prices, only part of the fall in crude prices is seen by the consumer. A simple numerical example shows why only part of the drop in crude prices is seen at the pump. To keep all the calculations clear let’s pretend that gasoline is $3.00 per gallon, crude oil is $100 per barrel and oil executives pass any savings on to consumers instantly (lots of economics research show they don’t. See here). If crude oil drops 25% to $75 per barrel, what happens to the price of gasoline?
One-third of the $3.00 per gallon price at the pump, or one dollar is fixed because it covers taxes, refining and distribution. This $1 does not go up or down as crude fluctuates.
The other part of gasoline’s price is based on raw material costs. Only two dollars out of the $3.00 pump price is impacted by the falling price of crude. When the $2.00 part falls by 25%, the raw material component in each gallon of gasoline now costs $1.50.
Combining the new $1.50 raw material cost with the $1 fixed costs, results in a new gas price of $2.50 per gallon. At a price of $2.50, gas at the pump has dropped just 16.7% (the calculation is [$3-$2.5]/$3), even though crude prices have fallen by a quarter.
I predict that crude oil prices will fall much more over the coming weeks. However, because almost one-third of gasoline prices are fixed only some of the fall in oil prices will be passed on to you the next time you fill up.