Why Are Gas Prices High And Rising?

Being systematic, here are the primary reasons for the rise in gasoline prices in March 2004:

1. High world crude oil prices. These prices are partly the consequence of conscious OPEC supply constriction to raise price. OPEC’s ability to do so is typically constrained by three interrelated factors: the world demand for oil, cheating on the part of smaller OPEC members, and production from non-OPEC countries like Russia, Norway and Mexico. Economic growth, particularly in Asia, is shifting out the demand for oil according to this Ft. Worth Star-Telegram article:

Strong demand for oil in Asia is one reason for higher crude prices in recent months, although analysts also said that aggressive bets by large commodity speculators have contributed to the recent run-up in oil markets. Much of the attention on Asian oil supplies is related to the fast-growing economies of China and India.

Sales of diesel fuel in India, which account for about 40 percent of the oil sold in that country, soared 10 percent in February from the same month a year earlier; automobile sales in India grew 31 percent in the last year. India’s oil imports are forecast to continue to climb as its economy grows 8 percent this year.

This Investor’s Business Daily article points to the other two aspects of this dynamic: Saudi Arabia is still the “swing producer” because of the scale of its reserves relative to other producers, and some OPEC members have not curtailed production to meet the targets OPEC set in their 1 February meeting. Saudi Arabia’s production is the primary determininant of the world price, and with rising demand the growth in production in Russia and in Iraq has not been sufficient to change that fact. And small OPEC producers are riding the crest of this high price, not restricting their output.

No current discussion of OPEC is complete without reference to the horrendous state of affairs in Venezuela. Their low production adds substantially to the high prices we are currently experiencing.

OPEC is currently discussing whether or not to continue its output restrictions at the end of the month, and today’s news suggests that they are fighting internal battles over whether to pursue output restrictions when their benchmark price is $4 above the high end of their usual benchmark range.

2. Existing environmental regulations making supply more inelastic. Petroleum refiners in the US must meet the EPA’s federal fuel oxygenate requirement from Title II of the Clean Air Act Amendments of 1990, which mandates a 2% oxygen content in fuel in ozone non-attainment urban areas. Furthermore, refiners are required to drain all of the winter fuel from their tanks before replacing it with summer fuel, which in most markets must have inventory built up to start sales on 1 April. On top of that, states can choose to implement their own fuel formulation requirements to address their specific geographic and climatologic conditions that lead to different local air quality conditions. As a result, the US now has over 40 fuel formulation requirements at different times and places.

Think about what this does physically and economically. People continue driving in March, and continue to use winter-blend fuel while the inventory of winter-blend fuel falls, ideally to zero at midnight on 31 March. Inventory storage costs are very high for petroleum, so keeping a buffer of winter fuel through March and over the summer is very expensive (this point is in response to a question from Virginia Postrel on storage). Not only do people generally not want new refineries built near them, they also do not want new tank farms built near them. So storage capacity is a binding constraint.

So of course the seasonal fragmentation that the oxygenate requirement introduces into fuel supply would cause prices to rise in March, all other things equal. This temporal fragmentation exacerbates the balkanization of fuel markets, because of the 40+ fuel formulations in effect. Note especially that this fragmentation across both time and place makes the supply of gasoline more inelastic. Confront that with an inelastic demand for gasoline, and one that shifts out and becomes more inelastic in the spring and summer months, and you have a policy-driven exacerbation of the potential for price spikes.

The California prices are also driven by the switch from MTBE as fuel oxygenate to ethanol, a switch that is taking full effect for the first time in 2004. Ethanol, a corn-based additive, is not produced in California, cannot be shipped from the Midwest to California in oil pipelines, and is highly water soluble, so it can only be added to the fuel at the rack (basically, right before it ships out to gas stations). And Senator Boxer wonders why the price of gasoline in California has gone up to $2.18/gallon? I suggest that she review Title II, Section 211 of the Clean Air Act Amendments of 1990. You can also read my testimony to a Congressional hearing on the MTBE/ethanol transition in California from July 2003 for more background.

3. New air quality regulations taking effect in 2004. The EPA’s Tier 2 sulfur control regulations, leading to the co-development of low-sulfur fuels and vehicles optimized to the use of low-sulfur fuel, took effect in January 2004. This program to reduce sulfur content in fuel will be phased in over three years, and 2004 is the first year in which refiners will be required to meet overall sulfur content regulations, according to this EPA fact sheet on the Tier 2 regulations:

Beginning in 2004, the nation’s refiners and importers of gasoline will have the flexibility to manufacture gasoline with a range of sulfur levels as long as all of their production is capped at 300 parts per million (ppm) and their annual corporate average sulfur levels are 120 ppm.

More information on the regulations is available at the EPA OTAG Tier 2 website. The Tier 2 regulations can be found in the Federal Register from 2000.

These new regulations, while likely to deliver improvements in air quality, are going to increase gas prices, at least in the short run. Refiners are having to engage in research, in reconfiguration of their production processes, and in equipment installation to meet the new low-sulfur requirements. For example, Valero is building a new desulfurization unit in one of its Louisiana refineries, precisely to aid compliance with the Tier 2 sulfur regulations.

These factors have combined to raise the current, and expected future, prices of gasoline. The new low-sulfur requirements are not likely to exacerbate the seasonality/inelasticity problem, but they will increase fuel prices.

19 thoughts on “Why Are Gas Prices High And Rising?

  1. I just read a Reuters article which states:
    “Due in no small part to the highest oil prices in two decades, Exxon Mobil (XOM, news, msgs), ChevronTexaco (CVX, news, msgs) and ConocoPhillips (COP, news, msgs) all moved up smartly in Fortune magazine’s annual ranking of America’s largest companies, released Sunday.”
    (link: http://moneycentral.msn.com/content/invest/extra/P78903.asp)

    would anyone care to debunk this contention – that due to higher oil prices these US companies increase their fortune? (I am an engineer not an econ guy – but I still realize the comment makes little sense.)

  2. Do not discount the effect that sulfur regs are having on gasoline prices. Refiners are using their working capital to meet the regs, not expand capacity. Meeting the sulfur regs actually will lower a refinery’s output, so their effect on prices is multifaceted.

    With that said, it doesn’t mean that the sulfur regs are bad. It just means that we shouldn’t let anyone demagogue the oil companies or the Bush Administration over oil prices. Gasoline price rises aren’t a conspiracy, and any fool who says thay they are should be laughed out of town.

  3. In response to Dylan B:

    I believe the “biggest” companies, according to Fortune, are ranking in size of profit or revenues, and not number of employees. Given current oil prices, it isn’t surprising that some integrated oil companies are generating larger revenue and profit streams.

    Yes, the big oil companies are making more money from high crude prices, but most of this money comes from their upstream operations (extraction of oil from the ground), and not downstream (refining and retailing).

    Let’s say that it costs Exxon $8 per barrel to produce oil in Texas, or $15 in Alaska. When the worldwide price of crude goes up, they get to “sell” this crude to their own refining arms at the world price of $30 or $35 per barrel. That’s where the extra profit comes from, not from extra refining margins (which aren’t that great right now.)

    Any company that has a lot of domestic production will benefit from the Saudis setting prices high.

    Could Exxon sell gas for less money and still make a profit? Right now they could, but the price of gasoline is set by the Saudis and a competitive domestic market, not by any one producer.

  4. Why is it that oil companies shouldn’t profit?

    If ExxonMobil has their best year ever this year, more power to them. Unsaid is that the last decade has been extremely unprofitable for oil companies (I remeber 89 cent per gallon gas back in 1998).

    Price volatility is a problem for oil companies too. They can’t do capital planning if gas prices (and thus, profits) are all over the place. The refiners have been burned far too many times by mis-projecting demand and essentially wasting their capital on unprofitable projects.

    It will take an extended period of time of high profits for the oil companies to lose their risk aversion and invest in capacity expansion.

  5. Lynne:

    Unless I missed it while reading this article, I think you overlook another important factor: capacity constraints in domestic refining capacity. We all know that the last new refinery in the US was built in 1976, and that many small refiners are forced to shutdown because capital improvements are not economic given RFG requirements.

    This is partly due to NIMBY in the US, and is exacerbated by the patchwork RFG requirements and boutique gasolines: if there was a standard blend, we could simply buy more gas from refineries in places like the Virgin Islands, Dominican Republic, Jamaica and (in the near future) Cuba. We wouldn’t necessarily need new refineries on mainland US soil – but the boutique fuels make such projects more risky than they otherwise would be.

    Reducing the number of blends required would ease short-term local spikes caused by localized refinery and pipeline outages (which will happen, random as they might be), and would encourage more refinery construction in the Caribbean, which would add some excess capacity (which is currently zero in the summer), thus dampening non-localized (natiowide) summer supply crunches.

    New vehicle technology has made the 1990 revisions to the Clean Air Act very close to redundant. Now, if only we can get those revisions reversed without a giant handout to the ethanol producers…

  6. A few years ago refinery utilization peaked at 98.5% of capacity in the summer. Then we went through a recession and a slow recovery. That caused gasoline demand to grow much more slowly and refining capacity kept up.

    Now the economy is starting to grow. Transportation and fuel use tends to lead the growth. Indeed, we’ve seen higher refining capacity utilization during this past winter than in previous years. As we head into summer and the high demand months, we’ll certainly peg the refineries. When that happens, watch gasoline prices skyrocket.

    I expect $2.50 gas this summer and wouldn’t be surprised at $3 gas.

  7. dylan b,

    Fortune makes its size rankings solely on the basis of sales. If you sell more than anyone else, even if you lose money, you are ranked as the largest industrial company.

    So if the price of gas goes up by 50%, and you sell the same amount of gas, your sales also go up by 50%, and you will almost certainly go up in Fortune’s size rankings.

    Of course, what your stockholders care about is how much money you make, not how much you sell. In accounting jargon, they care about net income, not gross income.

  8. Why is the price of gas so high? It must be the Iragi’s, Al Queda’s, OPEC and all Arabs. Or is it really an oil shortage? Should Americans turn in their gas guzzling SUV’s and start buying Japenese cars, again? Is two dollars a gallon too much? If we went in and wiped out all the Iraqi’s would this make the price of gas go down? Every since George W. Bush became president, the economy has been going down and it was inevitable that we would be in another war with the Iraqi’s and Sadaam Hussein. The Arabs have all the oil so they must be the one’s raising the price of gas. This war is all about oil and that is why we are paying more for gas. Who and how is this war really going to be paid for especially Bush and the Republicans are not going to raise taxes? Take a lesson from slick Willie (he secretly raised taxes through gasoline), if you cannot beat’em, join’em. The old “Red-herring” strikes again. What you gonna do when they come for you? – BAD Boys, Bad Boys..

  9. Excellent point. Why are americans so afraid of smaller cars? They aren’t! They are afraid of bigger cars on the road, or so they claim. And lets face it, in our society bigger is better. Why are we afraid to pay more for gas when we are not afraid to go into monumental amounts of personal debt. Perhaps that $3,000 plasma TV can wait. Or wait. Maybe if you bought a small fuel efficient car, after the savings on the actual cost and the saved money from fuel economy you could afford that TV. Finnally I would like to comment on the hundreds of billions we are going to spend on the war in Iraq. What immediate threat did Iraq pose to us and what immediate threat dose poor air quality pose to us. We breath smog choked air every day, and to loosen any environmental regulation directly effecting air quality seems to immediatly put citizens at an undeniable and constant risk.

  10. Most important quote:

    “Strong demand for oil in Asia is one reason for higher crude prices in recent months”

    Outsourcing is the source of all evil. India and China are taking the money and jobs we give them for free, and turn around and buy more oil. That is competition we created for ourselves. Executives gain less through higher profit margins and cheap foreign labor than the american public loses. Outsourcing wages drain the US economy and then compete with the weakened US economy.

    Fine the shit out of companies that outsource and that will solve all of our problems.

  11. We need to push for more renewable alternatives to gas. If we had a cleaner renewable fuel or method to power our transportation, we would be killing several birds with one stone. Not only would we be cutting down on harmful emissions, but the source of energy would be replaceable–saving the un-renewable fossil fuels for other things.

  12. The increase in gas prices to the extent that they are reaching now is too high. In my opinion the demand for fuel will be falling steadily throughout the next several years due to the popular deman for hybrid cars, a gas and electric power car that can obtain significant better gas milaiage than normal gas engine cars. Therefore i am thinking that the equilibrium price of petrolium products should remain about the same and not continue to rise at the rate that it currently is, beucase according to the supply and demand curve with a lower demand equilibream price should be falling. I think that the steady increase of gas could be a result of a price leadership or a cartel.

  13. maybe not logical – it just seems this way to me….
    say the gas prices are at $1.25/gallon .The gas prices rise – we pay more and more – people start looking for ways around buying gas – gas prices peak around $2.50/gallon and gas pricing go back down – only the prices are 20-30 cents more per gallon -leaving the gas prices approx. $1.50/gallon or more- and people are quite glad to pay that. rather than $2.50/gallon

  14. I do not believe those people who insist on stating “hey don’t go on that Memorial Day holiday”, or “don’t drive”, or “hey the oil companies need to get there money back somehow”. There are those of us who have to work to provide for our families. There are some of us that do not benefit from a shuttle bus. Our economy has not been “flourishing” as stated. Something has to be done to decrease the price of gas. A rise of 12-cent’s in one months time is ridiculous for whatever reason. Perhaps those who feel it is o.k. to keep paying high prices for gas are sitting back in thier chair behind a desk while “someone else” takes them where they need to go. However there are some of us that do all of the driving in order to survive.

  15. In response to poster: I hate idiots who wrote: “True, another war with Iraq was inevitable.. we could have chosen to fight the war in the streets of America where thousands more of our innocent civilians would be killed. I, for one, am glad that we ELECTED a leader who was willing to take a stand against world terrorism, and have the men and women who VOLUNTEERED to fight for our country go nip this WORLD problem in the bud.”

    I got a good laugh seeing such an idiotic statement being made by someone who calls himself “I Hate Idiots”. You either are working for the Bush re-election campaign or you are an idiot who, not being able to face the truth, is just not ready to come out of the closet.

  16. I read all the statements above, however why is it that no one mentions the taxes levied on gasoline? if the government isn’t the cause of the souring prices, and it really is a supply issue, why is it that the government officials keep adding to the tax on gasoline. Can someone please answer me that?

  17. ANY “IDIOT” KNOWS THIS MUCH ???? Of course !!!!

    Since gas prices have, to some degree, turned into a quasi political debate on this site, entertain the following please: Some say
    “No War for Oil!” I say….. NO OIL FOR WAR !!!!! Couldn’t the money saved be utilized to, among myriad, paramount
    concerns and/or issues, feed the hungry, treat the ill, or closer to your own pocketbook, lower gas prices? Don’t get me
    wrong, like every red-blooded American should:

    I have always supported “our” troops… IMMEDIATE RETURN HOME !!!!

    I also have a protest sign that reads:

    HONK if you think the war in Iraq is “just”, STUPID !!!!

    Like I even for one moment “freely” chose or was asked to consider, committing “our” resources and troops to a senseless,
    unjustified and impossible war? All because, of course, the people of Iraq are going to love and adore apple pie, baseball, hot
    dogs, velveeta cheese, stolen election(s), other “American Internationalism(s)”, such as the BIG FAT LIES of our own personal
    bully in the nations “highest” office? Or, thousands of dead, innocent Iraqi civilians and the lingering, ensnared and embroiled
    US soldiers and, our inalienable right as Americans, to “freely” IMPOSE our will… by FORCE ???? These are cherished
    “AMERICAN VALUES” ???? Of course, any “idiot” knows this much?

    Shouldn’t every (mislead) American applaud waving the flag, beating the war drums (or our chests like an ape), recklessly
    sacrificing the lives of those whom volunteered to serve in the US military, and invasions of our personal privacy here at home,
    among other concerns that invoke “AMERICAN PRIDE”, all in the name of democracy? Or believe, even for a single
    moment, that the anthrax or west nile virus scares weren’t the work of the Bush Administration? Of course, any “idiot” knows
    this much?

    Don’t you appreciate the climbing oil prices and imported jobs, ALL in the name of higher short and/or long range profits for
    those whom can afford to play or manipulate the stock markets, and/or (most often) at the same time, covertly decide “our”
    future, and what is in our “best interests”; shouldn’t these things be relished by every American? Surely, if nothing else, you
    MUST believe that Mr. Bush is protecting “AMERICAN INTERESTS” abroad? Of course, any “idiot” knows this much?

    Naturally, you take pride in the cost each and every American is now paying, in dollars and (non)sense, for the bizarre choices
    of the Bush Administration and those whom would sit by with complicity, profiting from the cost of producing munitions and
    military hardware? “MILITARY SUPERIORITY” should be every American’s first concern — right? Of course, any “idiot”
    knows this much?

    Don’t you also take pride in the US military’s capacity to wreak havoc on any nation, drop bunker busting bombs, fuel the jets
    that deliver the fatal payloads, produce playing cards as if it is all a game, and simultaneously utilize the services of the Ad
    Council or CNN, to promote our “good will”, or otherwise convince the average, naive US citizen, that the “AMERICAN
    WAY” is righteous? Of course, any “idiot” knows this much?

    Certainly, you should know that the “War on Drugs” is effective, a growing prison population — courtesy of the worlds’ best
    “justice system” — is productive, and that America “values” these byproducts of an advanced society? All this while corporate
    executives sniff another line and/or smoke another $40 joint with the CEO, while tipping another glass of elitist French
    champagne, to celebrate planning another conference on a tropical island or at some exotic retreat with hookers, to discuss
    their recent accomplishments, or perhaps decide to open another 10,000 cell facility, to house those whom can’t afford to hire
    Johnny Cochran to defend them? All in the name of “AMERICAN JUSTICE” ???? Of course, any “idiot” knows this much?

    Maybe you believe in the sacrifice of social programs that contribute to physical and mental health, in the name of fighting a
    “just” war in the middle east or elsewhere — when someone in the White House throws a dart at the map, and identifies the
    “next Iraq” — all because elected officials don’t require or aren’t financially qualified to benefit from services designed for the
    poor? After all, importing our beliefs is more important than “PUBLIC HEALTH” ???? Of course, any “idiot” knows this

    Land of the free? Or home of the oxymoron?

    “JUST WAR” is an oxymoron!
    “AMERICAN VALUES” is an oxymoron!
    “AMERICAN PRIDE” is an oxymoron!
    “AMERICAN INTERESTS” is an oxymoron!
    “MILITARY SUPERIORITY” is an oxymoron!
    “AMERICAN WAY” is an oxymoron!
    “AMERICAN JUSTICE” is an oxymoron!
    “PUBLIC HEALTH” is an oxymoron!

    You the reader, I put to the challenge: point out to Mr. Bush, that “GOOD COCAINE” is another oxymoron.

    Of course, any “idiot” knows this much,

    Kevin (or perhaps, if you have actually read this rant, call me Dennis Miller)


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