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By Samuel R. Avro on Nov 24, 2008 with no responses

Oil Is Cheap. Why Is Gas, Which Is Made From Oil, Even Cheaper?

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Crude oil futures recently fell to about $50 a barrel, the cheapest they have been since May 2005. How does this relate to gasoline prices?

There is a relationship between crude oil prices and gasoline prices, since oil is used to make gasoline. But there is not a simple, linear, one-to-one relationship. In the futures markets, a gallon of gasoline has been, on average over the last six years, 22 cents more expensive than a gallon of crude, according to John C. Felmy, chief economist for API, an oil and gas trade association. (A barrel of oil contains 42 gallons, by the way.) That 22-cent difference comes primarily from the costs of refining oil into gasoline.

Right now, though, the decline in gas prices is outpacing that in oil prices on the futures markets. In fact, a gallon of gas is currently cheaper than a gallon of oil on the futures markets in the New York Mercantile Exchange. Why is this?

While one product may be used to make the other, they have different supply and demand issues. In much of the recent past, oil prices drove gas prices. Fears about a supply shortfall, plus strong demand for petroleum products like diesel, pushed up the cost of oil, which meant companies that refine oil into gasoline had to pay more for raw materials. At the same time, though, demand for gas was slowing, which meant refiners were unable to pass on all of their costs. The run-up in gas prices therefore lagged slightly behind the run-up in oil. The price of oil futures peaked on July 3, and the price of gasoline futures peaked a week later.

Then recession hit. The financial system began to fall apart, and along with it investors sold off commodity futures (like crude oil). Consumers also tightened their belts and stopped buying as much gas, even during summer, the peak driving season.

Demand for gas cratered. Since then, gas prices – both at the pump and in the wholesale futures market – have plummeted.

Article continues… NY Times