What Drives Gas Prices?
Author: News Bureau
Posted: Monday, August 8, 2022 12:00 AM
Categories:
School of Business | Pressroom | Faculty/Staff
Macon, GA
Dr. Bill Carty. Image: Josh Carty.
After hitting records highs earlier in the summer, U.S. gasoline prices have been declining in recent weeks. What causes gas price fluctuations? What should consumers know going forward? In this Q&A, Dr. William Carty, assistant professor of business at MGA, talks about current issues affecting gas prices.
This is a global phenomenon, isn’t it? In some countries, gas prices are even higher than they are in the U.S.
Increased gas prices, much like other price increases, are the result of the impacts of a global increase in inflation rates across nearly all goods and services. However, compared to other goods and services, gasoline has been rising at a much faster rate. Gasoline prices in some countries are higher than in the United States while they are lower in others. This is also the case even outside periods of high inflation. Because of the complexities of the determinants of gas prices, there is also a significant variance between states in the U.S.
Who, or what, determines gas prices in the U.S.?
The price of gasoline, much like the price of almost all goods and services, is a function of the basic economic concept of supply and demand. The intersection of consumer demand and available supply dictates price. When demand goes up or supply goes down, price increases, while the opposite also holds true. There are also multiple contributors to the cost of producing gasoline, which affects its price. An infographic provided on the very interesting site “Visual Capitalist” shows that the cost of a gallon of gas is 54 percent crude oil costs, 16 percent taxes, 16 percent distribution and marketing and 14 percent refining (Ang, 2022).
Gasoline is a petroleum product. Petroleum is the oil that is extracted from below the surface of the earth in various ways and is also referred to as crude oil. Crude oil, as the name implies, is an unrefined raw material that has demand globally for the products that come from it. It is classified as a global commodity. Commodities are raw materials that hold value but are not themselves consumer products, but consumer products are made from them. Common examples include energy, metals and agricultural products. Commodities like petroleum are bought and sold for the purpose of converting them into products that will end up in the hands of consumers such as gasoline, heating oil, lubricants, or plastic and nylon.
When the cost of crude oil goes up, that cost is carried forward into the price of gasoline. There are also steps along the way from an oil well to your gas tank where other costs are added. We have been hearing a great deal about issues with the supply chain, the end-to-end system that moves goods from point of origin to point of consumption. When costs in the supply chain rise, these are added to the price of the product. For instance with gasoline, when wages rise across the board due to shortages of workers, this adds cost every step of the way from oil field workers, to refinery workers, to transportation workers at every step in the process, to employees at the gas station where we fill up our cars. It gets more complex still. Costs to run railroads, trucks and oil tankers rise when the fuels that power them go up, so a cycle ensues that as demand for gas rises, gas prices rise, driving up costs to deliver gas. This results in even higher gasoline prices as gasoline is expended to deliver more gasoline in oceangoing oil tankers, railroad locomotives and tanker trucks on roads.
As with all areas experiencing inflation today, much of it began with the pandemic. When the pandemic hit and people were staying at home, demand for gasoline fell, creating excess supply and a drop in prices. This led to reduced production and the scaling back of capacity to produce and provide gasoline. This reduced capacity wasn’t an issue when demand was down. In coming out of the pandemic, demand has increased. This increase has been faster than production, supply chain, and employment can keep up with, which has resulted in supply not meeting demand and this drove up prices (Patterson and Goldfarb, 2022).
As the global economy expanded rapidly post-pandemic, demand exceeded supply in most areas of the economy. There were also a couple of compounding factors to this with gasoline. First, what normally happens is that when changes to supply and demand cause prices to rise, the supply and demand relationship will reach equilibrium and demand drops until supply meets it at an affordable price. However, the quantity demand of gasoline, regardless of the price, is generally consistent (inelastic demand), although not fixed (Hastings and Shapiro, 2013), with only minor lifestyle adjustments such as shorter or fewer trips for fun or carpooling reducing demand. What more commonly happens is people end up purchasing fewer other goods and services to be able to afford increasingly more expensive gasoline (Ma et al., 2011), negatively impacting other sectors of the economy while adding to gas price inflation. The second issue with regard to high prices and near constant demand is that in many countries, including the U.S., governments injected stimulus money into their economies. One of the results of this has been further inflation. As demand rose and supply stayed the same while prices went up, money in the form of stimulus payments and increased wages post-pandemic due to labor shortages entered the economy without it generating any new real output (The Economist, 2022). This meant that this additional available money could be spent on higher priced goods, which continued to drive an inflationary cycle of more available money being paid for the same amount of goods. Consumer behavior follows that gasoline is needed more than other products, and consumers bought less of other products to pay more for gasoline (McDaniel et al., 1986), gasoline prices inflated much faster and more overall than other sectors of the economy.
Increased demand would normally drive an increase in supply, blunting the effect on price. However, increasing gasoline supply isn’t really a case of turning a knob on a pump or throwing a switch. This is where complexity really comes in. Even if crude oil output could be increased, it would need to also be refined in greater volume and then transported in larger quantities to gas stations. In the current economy, and specifically the oil and gas industry as a whole, almost every step in this process is operating at or near full capacity (WSJ, July 2022).
Oil companies are for the most part the ones that own and oil well fields and refineries. Expanding refinery capacity or drilling new wells could result in more output, but then that would also have to be transported in a strained supply chain. Drilling more wells, expanding current refinery capacity or building new refineries is very expensive and would take years to bring online.
How much influence does an American president have on gasoline prices?
As gasoline is a product of petroleum, a global commodity, the cost of gasoline is set not by any government but by the global market based on supply and demand around the world. Russia’s invasion of Ukraine and the subsequent sanctions on Russian oil, one of the world’s largest petroleum suppliers, further added to the already inflated oil prices by reducing supply beginning in February of 2022 (Patterson and Goldfarb, 2022).
In the short term, a U.S. President has at their disposal the Strategic Petroleum Reserve (SPR). The SPR was created in the 1975 largely to address issues like we are seeing play out now. It is basically millions of gallons of crude oil stored by the U.S. Government for use in emergencies. President Biden authorized the release of some of this crude oil into the global market to increase supply, in an effort to meet demand but at lower prices as a result. The short-term effect was a minor decrease in the price of gas as supply increased, but again, as a commodity traded on a global scale, the actual price impact was minor.
There is another point to make on presidents and oil supply and this deals with energy policy. We have also heard the president discuss the role of oil companies in the price of gas. As the holders of oil fields and refineries, oil companies have a significant influence over crude oil production and refining gasoline. These processes are at or close to capacity globally, and increasing capacity by expanding wells and refineries is a very expensive and long-term endeavor. From a business perspective, this would call for a large, long-term capital outlay to accomplish. Any time something like this is considered by a company, they assess the return on this investment. Global trends have been moving toward green energy and the current U.S. President has made clear his intent to end nearly all fossil fuel use. That being the stated case, there is little to no incentive for any oil company to commit to these long-term large-scale capital expenditures. Absent a long-term incentive to build more wells and refineries with on-hand capital created by increased profits, we should expect only minor changes in gas prices in the near future.
One other note on prices at the pump. Within the price of gas at the pump are factored federal and state taxes. There has been discussion on suspending or decreasing gas taxes to ease prices on consumers. Federal gas taxes are generally used to fund transportation infrastructure across the US. With the transportation infrastructure problems that the US has, discussion of cutting the 18.4 cent per gallon federal gas tax was limited and short, ending in a decision not to. However, some states have suspended or reduced the state gas tax, including Georgia. Georgia, which had a gas tax of 29.1 cents per gallon, had its gas tax suspended by the governor in June of 2022. This tax suspension will remain in place until the state legislature returns to session in September and determines by vote whether to continue it.
Gas prices have dropped in recent weeks. What are some of the reasons behind that?
There has been some change in gas prices due to the release from the SPR and a decrease in demand with less leisure travel and reduced overall consumption, allowing for more supply. Oil as a commodity also has prices influenced by future expectations. One of the things that has caused the recent reduction in gas prices was when the US Federal Reserve Bank raised the benchmark. This is expected to have a slowing effect on the economy, with businesses and individuals spending less as a result, reducing demand, allowing for supply to catch up, and resulting in a decrease in gasoline prices. This will likely continue, especially with more benchmark rate increases as we saw again in the last week of July, with inflation still high, yet with two consecutive quarters of negative Gross Domestic Product growth. Looking ahead, consumers will likely see a continuation of falling gas prices, albeit small and slowly, for the foreseeable future.
What is your favorite gas-saving tip?
My advice for saving on gas is to control what you can control and deal with what you can’t as best as you can. Few consumers can afford a new hybrid or electric vehicle. With gas prices high, we can try to reduce our own consumption, and there are many simple and inexpensive ways to do this. Keep cars in good working order. Properly inflated tires and a clean air filter are inexpensive ways to improve gas mileage. Don’t keep things in your trunk that you don’t need that are excess weight. Driving habits can reduce gas usage as well. Plan trips, like stopping for groceries on the way home from work rather than making a special trip. Don’t accelerate or brake quickly. This wastes energy generated by burning gas unnecessarily. Crack your windows and use a windshield shade to keep the car from getting extremely hot so you don’t have to run your car with the air conditioner on to cool it down before driving. Carpool if you can.
Dr. Bill Carty is an assistant professor in MGA’s School of Business. He came to MGA after retiring as a colonel from the U.S. Army. Carty holds a DBA from The University of Florida and a M.A. in National Security and Strategic Studies from The Naval War College. He teaches multiple courses year-round including International Business and Strategic Management, and helped to develop MGA’s newest master’s degree in Professional Leadership. His research interests include leadership development, high-performing individuals in high-performing organizations, international partnered operations, and improving gender representation in organizations.
References:
AAA (July 27, 2022). AAA Gas Prices. https://gasprices.aaa.com/state-gas-price-averages/
Ang, Carmen (June 11, 2022). Explainer: What Drives Gasoline Prices. Visual Capitalist. https://www.visualcapitalist.com/what-drives-gasoline-prices-infographic/
Donnellan, Bob, (July 27, 2022). Gas Tax by State for 2022. https://igentax.com/gas-tax-state-2/#___Gas_tax_by_state__
Economist, The (April 22, 2022). Why the Federal Reservew has made a historic mistake on inflation. The Economist. https://www.economist.com/leaders/2022/04/23/why-the-federal-reserve-has-made-a-historic-mistake-on-inflation
Hastings, J. S., & Shapiro, J. M. (2013). Fungibility and consumer choice: Evidence from commodity price shocks. The quarterly journal of economics, 128(4), 1449-1498.
Ma, Y., Ailawadi, K. L., Gauri, D. K., & Grewal, D. (2011). An empirical investigation of the impact of gasoline prices on grocery shopping behavior. Journal of marketing, 75(2), 18-35.
McDaniel, S. W., Rao, C. P., & Jackson, R. W. (1986). Inflation‐induced adaptive behavior. Psychology & Marketing, 3(2), 113-122.
Patterson, Scott and Sam Goldfarb (April 1, 2022). Why Are Gasoline Prices So High? Ukraine-Russia War Sparks Increases Across U.S. Wall Street Journal. https://www.wsj.com/articles/why-gas-prices-expensive-11646767172?mod=article_inline
Wall Street Journal Editorial Board (July 4, 2022). Bidenomics 101. Wall Street Journal. https://www.wsj.com/amp/articles/bidenomics-101-joe-biden-tweet-gas-prices-refiners-markets-jeff-bezos-11656892820