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By Robert Rapier on Mar 28, 2006 with no responses

A Primer on Gasoline Pricing

There was a story today in the Detroit Free Press on rising gasoline prices (1). Two items caught my attention:

“We’ve seen a dramatic increase in gasoline prices,” said Mark Routt, a senior consultant with Energy Security Analysis Inc. in Wakefield, Mass. “Why? The bulk of it is due to an annual and normal change from winter to summer gasoline. Unfortunately for us this year, there is also a significant impact on prices because refiners are switching from MTBE to ethanol as an oxygenate to make summer gasoline.”

Methyl tertiary-butyl ether (MTBE) is a gasoline additive that oil refiners have used to help meet emissions standards set by the Clean Air Act of 1990. Refineries around the country have stopped using MTBE and are switching to ethanol as the preferred oxygenate to make the specialty fuels for the summer months. Others cite the astronomical profit taking by oil companies such as ExxonMobil as the main culprit for rising prices.

I highlighted the two pieces in bold so I can elaborate a bit. First of all, it is true that gasoline prices are currently going up due to the MTBE to ethanol switch. There is not enough ethanol to meet demand, and there are logistical problems getting enough ethanol to where it is needed. This has driven the price of ethanol pretty high, and is putting some upward pressure on gasoline. Imports from Brazil are expected to cover the near term shortfall. New ethanol plants will cover the demand in the longer term (unless other states get the same oxygenate waiver just granted to California). This should bring the ethanol price down somewhat (but grain-ethanol still has serious shortcomings as detailed in my previous essays).

The second highlighted portion – that astronomical profit taking is responsible for rising gas prices – has mixed up cause and effect. It seems that some people think an oil company can just dial in a profit number, and raise gasoline prices to meet it. If that were so, why didn’t ExxonMobil make $37 billion in 2004, like they did in 2005? Because that’s not the way it works. Profit-taking does not drive gasoline prices.

OK, Then What Does Drive Gasoline Prices?

The contribution from the ethanol shortage was mentioned above. A second major item that you may have heard in the news is the switch from winter blends. OK, what does that mean? In the winter, when it is cooler, large amounts of butane can be added to the gasoline pool. The vapor pressure of butane is quite high, so you can’t do this once the weather warms back up (otherwise your gasoline might boil). The return of warm weather means that butane must be backed out of the blends. This reduces the overall fuel supply, because a readily available ingredient in gasoline, butane, is no longer available. So, the supply has been reduced, just in time for the season in which people tend to drive the most – summer. Which leads us to the third, and primary, factor in rising gasoline prices.

The main reason gasoline prices go up is that they follow the laws of supply and demand. If a refiner starts to run low on product, they raise prices so they don’t run out. This has the effect of reducing demand. They will raise prices to the point that their supply is balanced by the demand. This is exactly what happened after Hurricane Katrina. Around 25% of the refining capacity in the U.S. was knocked off line. In this case, there are 2 options. The first is to hold the price where it is, and let the public completely drain gasoline inventories. Unless they voluntarily cut their gasoline consumption by 25%, we are going to run out of gasoline in this case. That is not an acceptable option. So, we go for option 2. We start to raise prices until demand reduces to the point that our production can meet demand, but at a higher price. This tends to anger the public, who feel they are being gouged (especially when oil companies make more money as a result). But it is not profit taking that is driving up gasoline prices. Rising gasoline prices, primarily due to tight supplies, are driving up profits.

The price of oil also has an impact on the price of gasoline. A barrel of oil contains 42 gallons, and around 35 gallons of that (depending on the refinery configuration) will ultimately be turned into gasoline, diesel, and jet fuel. So, every $1 increase in the price of oil will translate into an increase of almost 3 cents per gallon of gasoline. There are also costs associated with processing. State and federal taxes add another $0.40-$0.50 per gallon (more than the oil company makes). But the single most important factor behind higher gasoline prices is simple supply and demand.

In my opinion, gasoline prices will continue to escalate higher and higher in the long-term. Supply is very tight, and yet demand continues to grow. The only way to mitigate this situation is 1). Increase supply; or 2). Reduce demand. Oil companies are reinvesting a lot of those multi-billion dollar profits right back into their companies with the intent of debottlenecking refineries. This will open up more supply, but China and India are gobbling up excess production as fast as it comes online.

Whenever it is apparent that oil production has finally peaked, I expect prices to go through the roof. There is a certain fear premium built into oil prices right now, but nothing like the premium that will occur when we start down the other side of the production curve. Oil companies will certainly make a lot of money during this period, as prices will have to rise to stem demand. I plan to write an upcoming essay on the potential fallout of record oil company profits during a period where energy costs are breaking people’s budgets.

To be certain, oil companies are not charities. They are in the business of making a profit for the shareholders. If you really want to do something about rising prices, I can offer a couple of suggestions. You can get yourself a very fuel-efficient vehicle, which will lower the demand just a bit. If everyone did this, demand would plummet, and prices would follow. Or, if you want to drive a gas-guzzler, buy some stock in an oil company so you can share in those profits. Many people think E85 will help mitigate this problem, but you are only shifting the issue from gasoline to natural gas – required for making the ethanol – which will put upward pressure on natural gas prices. Big Oil makes a lot of that natural gas.

Reference

1. Ahead: More Sun, Higher Gas Prices: New Additive Will Contribute to Rise