How Gas Prices Work

Photo by Mario Tama/ Getty Images
Traders work in the crude oil options pit at the New York Mercantile Exchange, April 22, 2008. Oil posted a then-record high of more than $118 following oil demand from China and supply concerns from Russia and Nigeria.

When you pump $30 into your tank, that money is broken up into little pieces that get distributed among several entities. Gas is just like any other consumer product: There's a supply chain and several groups who are responsible for setting the price of the product. The media can sometimes lead you to believe that the price of gas is based solely on the price of crude oil, but there are actually many factors that determine what you pay at the pump. No matter how expensive gas becomes, all of these entities have to get their slice of the pie. According to the U.S. Department of Energy, here's an approximation of where each dollar you spend on gas goes:

• Taxes: 13 cents
  
• Distribution and Marketing: 8 cents
• Refining: 14 cents
• Crude oil: 65 cents

[source: DOE]

This is what the average breakdown looked like in April 2011. Let's look at those components in more detail.

• Crude oil - The biggest portion of the cost of gas goes to the crude-oil suppliers. This is determined by the world's oil-exporting nations, particularly the Organization of the Petroleum Exporting Countries (OPEC), which you will learn more about in the next section. The amount of crude oil these countries produce determines the price of a barrel of oil. Crude-oil prices averaged around $35 per barrel (1 barrel = 42 gallons or 158.99 L) in 2004. And, after Hurricane Katrina, some prices were almost double that. In April 2008, crude-oil prices averaged around $104.74 per barrel. During that month, the price of oil reached a record price of almost $120 a barrel [source: DOE]. By May 16, prices had topped $117 per barrel [source: MarketWatch]. On May 22, markets in New York and London reported prices past $135 per barreland, and on July 11, oil hit an all-time high of $147 [source: Forbes, New York Sun]. Analysts speculated that everything from investment in oil futures to increasing demand from countries like India and China contributed to the spike in price.

  Sometimes, gas prices go up even though there is plenty of crude oil on the market. It depends on what kind of oil it is. Oil can be classified as heavy or light, and as sweet or sour (no one actually tastes the oil, that's just what they call it). Light, sweet crude is easier and cheaper to refine, but supplies have been running low. There's plenty of heavy, sour crude available in the world, but refineries, particularly those in the U.S., have to undergo costly retooling to handle it.

• Refining costs - The cost of refining diesel fuel can be considerably higher than the price of refining regular gasoline. To learn more about oil refining, read How Oil Refining Works.
• Distribution and marketing - Crude oil is transported to refineries, and gasoline is shipped from the refineries to distribution points and then to gas stations. The price of transportation is passed along to the consumer. Marketing the brand of the oil company is also added into the cost of the gasoline you buy.
• Taxes - Federal and state governments each place excise taxes on gasoline. There may also be some additional taxes, such as applicable state sales taxes, gross receipts taxes, oil inspection fees, underground storage tank fees and other miscellaneous environmental fees. Add that to the state excise taxes, and it can average 27.4 cents. It could be worse. In Europe, gas prices are far higher than in America because taxes on gas are much higher.
• Station markup - Of course some of the money you spend at the pump does go to the service station. While some consumers blame high prices on station markup, service stations typically add on a few cents per gallon. There's no set standard for how much gas stations add on to the price. Some may add just a couple of cents, while others may add as much as a dime or more. However, some states have markup laws prohibiting stations from charging less than a certain percentage over invoice from the wholesaler. These laws are designed to protect small, individually-owned gas stations from being driven out of business by large chains that can afford to slash prices at select locations.

Gas prices also vary from state to state for several reasons. Taxes are probably the biggest factor in the different prices around the country. Additionally, competition among local gas stations can drive prices down. Distance from the oil refineries can also affect prices -- stations closer to the Gulf of Mexico, where many oil refineries are located, have lower gas prices due to lower transportation costs. There are also some regional factors that can affect prices.

World events, wars and weather can also raise prices. Anything that affects any part of the process, from the moment the oil is drilled, through refining and distribution to your car will result in a change in price. Military conflicts in parts of the world with lots of oil supplies can make it difficult for oil companies to drill and ship crude oil. Hurricanes have damaged offshore drilling platforms, coastal refineries and shipping ports that receive oil tankers. If a tanker itself is lost or damaged, or leaks its oil into the ocean, that will put a dent in the market as well.

Photo courtesy Phillips Petroleum Company
Most of the American crude-oil supply is imported using tankers similar to this one.

The new legislation to input ethanol comes from environmental standards that have been in place in some parts of the country for several years. In some areas, gasoline was required to meet higher environmental standards in order to reduce the amount of smog created by burning gasoline. Producing this cleaner-burning gasoline caused problems in refining, distribution and storage, which increases the cost of gas. "The result of this targeted approach to air quality has been to create gasoline market islands," John Cook, director of the petroleum division of the DOE's Energy Information Administration, said before the U.S. House of Representatives Committee on Energy and Commerce on May 15, 2001.

Cook pointed at California and the Chicago and Milwaukee areas as primary examples of gasoline-market islands. The clean-burning requirements in each of these areas are unique to that individual area, and only a few refineries can produce the specialized products. High demand, a supply problem at a refinery or a problem with a pipeline can cause pricing in these areas to surge. Other states and municipalities also have their own requirements for cleaner fuel.

In California, the state government has set its own reformulated gasoline rules that are stricter than the federally mandated clean-gas laws. The state adopted requirements for cleaner-burning fuel in 1996 [source: ARB]. This is why Californians pay a higher price for cleaner fuels -- this, plus a local sales-and-use tax, the federal excise tax and a state excise tax. California's distance from the refineries located near the Gulf of Mexico can also add to the cost of gasoline if it chooses to obtain gas supplies from those refineries.

Another area where prices have far exceeded the U.S. national average is the Midwest. In 1999, before the rest of the country started using ethanol-blended gas, the Midwest region became subject to rules that required the use of ethanol. Few refineries outside the region produced this type of reformulated gasoline, which meant that demand could outstrip supply. This was one of many factors contributing to higher gas prices in the Midwest in the early 2000s. The problem cropped up again across the United States after the national call for ethanol-blended gas in the spring of 2007.

Crude oil inventories have the single biggest effect on gas prices, and the United States depends heavily on foreign oil supplies. In July 2008, the United States imported about 13 million barrels of oil and petroleum products per day [source: EIA]. We'll look at exactly where that crude oil comes from next.

The single largest entity impacting the world's oil supplies is the Organization of the Petroleum Exporting Countries (OPEC), a consortium of 13 countries: Algeria, Angola, Ecuador, Indonesia, Iran, Iraq, Kuwait, Libya, Nigeria, Qatar, Saudi Arabia, the United Arab Emirates and Venezuela.

Together, these 13 nations are responsible for 40 percent of the world's oil production and hold the majority of the world's oil reserves, according to the Energy Information Administration (EIA). [source: EIA]. When OPEC wants to raise the price of crude oil, it simply reduces production. This causes gasoline prices to jump because of the short supply, but also because of the possibility of future reductions. When oil production dips, gas companies get nervous. The mere threat of oil reductions can raise gas prices.

In April 2001, OPEC decided to reduce its collective production by one million barrels per day. This was at the same time that American consumers saw gas prices rise, hitting an average high of $1.71 per gallon on May 14, 2001.

OPEC increased its production in June 2005, when it raised to 28 million barrels per day with an increase of 500,000 barrels per day pending changes in oil prices. In September 2005, it made all of its member countries' "spare output" available, an estimated 2 million barrels per day. However, in November 2006, OPEC again reduced its rate of production by 1.7 million barrels per day to keep the price from falling below $50 per barrel [Source: Joint Economic Committee ]. OPEC's production for the second quarter of 2008 was an average of 36.87 million barrels per day [source: EIA].

Beyond OPEC, there are several other countries that contribute to the world's crude-oil supplies, including the United States, Mexico, Canada, Equatorial Guinea, Russia and China. In April 2008, the United States imported approximately 1.8 million barrels of crude oil per day from Canada [source: [ Energy Information Administration]. OPEC tracks the oil production of these nations and then adjusts its own production to maintain its desired barrel price.

Cause and Effect

Numerous forces can influence the price of gas at the pump, but fuel costs are only one part in the vast web of global economics. Gas prices have an impact on other parts of the economy as well. You're already aware of the immediate effects of rising prices - that feeling of stunned disbelief as the numbers climb and climb while you fill your tank. There are secondary effects as well. You might decide against a long road trip because the gas would cost too much. When it comes time to buy a car, you might decide against a gas-guzzling SUV and find something with better mileage instead.

Let's look at the big picture. Does a hike in gas prices lead to inflation in the overall economy? It could, as long as the increase is a steady, long-term rise in prices. Expensive gas means it's expensive to ship products by truck, expensive to drive long distances and expensive to fly in airplanes. All those costs mean the cost of virtually any product you can think of will go up if gas prices stay high.

However, economists don't look at gas prices as a leading indicator of inflation. The price of oil, along with food costs, are far too volatile -- that is, they are easily influenced by things like weather, labor strikes and wars. The costs swing up and down, depending on world events. To watch for inflation, economists keep their eyes on the core Consumer Price Index, which is a measure of the cost of certain goods, like DVD players, hotel rooms or college textbooks, which stay more stable in the short term.

Photo courtesy U.S. Department of Energy
An aerial view of the Bryan Mound storage site of the Strategic Petroleum Reserve

After seeing how much oil the United States imports, it may be surprising to know that the United States is the world's third largest producer of crude oil. The biggest production region is around the Gulf of Mexico, and the largest producing state is Texas. The Gulf Coast region is home to two important producing areas: the Permian Basin, located in west-central Texas and eastern New Mexico, and the federal offshore portion of the Gulf. Other big oil-producing states include Alaska, Louisiana, California, Oklahoma and Arizona.

Even with the United States producing so much oil, it is still heavily dependent on foreign sources. It's that dependence that crippled the country during the oil embargo of 1973 and 1974. To make sure that this situation never happens again, the federal government formed the Strategic Petroleum Reserve (SPR). While most domestic oil is sent directly to refineries and then to the consumer market, some of it is held back and sent to the SPR.

As of April 30, 2008, the SPR stores about 707 million barrels of oil in underground salt caverns along the Gulf of Mexico [source: DOE]. Given that the United States imports about half of its oil, the Strategic Petroleum Reserve holds about a 60-day supply of oil if all imports were suddenly and totally cut off. See What is the Strategic Petroleum Reserve? for more information about how the storage sites work.

On Sept. 22, 2000, President Clinton directed the U.S. Department of Energy to tap into the SPR to bolster oil supplies. When oil supplies shrink, the SPR can be used to help make sure that people have enough affordable oil to heat their homes. President Clinton authorized the Department of Energy to release up to 30 million barrels of oil in a swap with oil companies. The companies took the oil in fall 2000 and were required to return it by fall 2001.

The SPR is the largest emergency petroleum supply in the world. It was first used during the Persian Gulf War in 1991 to keep oil plentiful and prices stable. It currently has the capacity to hold 727 million barrels of oil. In 2005, the Energy Policy Act included a directive to expand the SPR and fill it to a capacity of 1 billion barrels. President George W. Bush also recommended expanding the reserves in his 2007 State of the Union Address. The Department of Energy announced in February of 2007 that it will expand two existing sites: Big Hill, Texas, and Bayou Choctaw, La., to comply with the Act. When complete, the expanded reserves will have a capacity of 1 billion barrels.

In May 2008, in light of record-breaking crude oil prices, Congress passed a bill that mandated a halt in the filling of the reserves.

Now, we'll take a look at one of the more controversial sources of U.S. oil: the Arctic National Wildlife Refuge.

Out of Gas

If gas prices are influenced by the world supply of oil, what will happen when we run out of oil? The surprising answer is, we probably won't. That doesn't mean that the rampant use of fossil fuels isn't a concern -- they are very harmful to the environment, and dwindling supplies will still cause massive changes in our economy -- but oil will get too expensive to use long before we run out.

The world oil supply acts like an asymptotic value, which is just a mathematical term for a value that gets closer and closer to another value, but never actually gets there. In this case, the "other value" is zero, or no oil left anywhere. Why would we never get there? Oil companies start out with the easiest (and cheapest) oil to find and bring to the surface. Once that runs out, they have to find more oil, which might be harder to harvest. As time goes on and the oil supply dwindles, it will get harder and harder (and more and more expensive) to find what's left. Eventually, it will get so expensive to find and harvest the remaining oil that no one will be able to afford it. The rising costs will force us to develop other energy sources.

In March 2006, the U.S. Senate passed its 2007 Budget Resolution, which included a provision for lease sales of the right to drill for oil in the Arctic National Wildlife Refuge (ANWR) in Alaska. The Congressional Budget Office estimates that income from lease sales could top $4.2 billion in the next five years [source: ANWR].

The Arctic National Wildlife Range was established in 1960 to protect the "unique wildlife, wilderness and recreational values" of the area. In 1980, Congress passed the Alaska Lands Act, which renamed the area and more than doubled its size. Today, the ANWR encompasses nearly 20 million acres, which is about the size of South Carolina. The same act authorized the study of the oil and gas potential of the northern part of the Refuge, called the 1002 Area. This region is still being looked at as a possible oil-development site, but environmental groups say that any oil production would upset the natural ecosystem within the ANWR.

It's still uncertain just how much oil exists under the ground of the ANWR. A 1998 analysis conducted by the United States Geological Survey (USGS) estimates that there are about 7 billion barrels of profitable oil in the 1002 Area alone, but the price of crude-oil determines how profitable that oil is. If the price of crude oil dips below $16, the cost of producing the oil would offset any profit -- prices rose above $130 per barrel in June 2008 [source: EIA].

The issue of gasoline prices is often a volatile one. As long as cars and other vehicles run on gasoline, the price of gas will continue to affect every part of the U.S. economy. While other fuel sources exist, none of them could be quickly integrated into the economy, which leaves Americans dependent upon gasoline for the time being.

This gas dependency makes everyone from the daily commuter to the shipping company executive very aware of price fluctuations. These fluctuations may vary from week to week or month to month, but over time are relatively stable. Still, limited resources, as well as environmental concerns related to oil use and production, encourage scientists to look at new technologies, such as fuel cells, to reduce our dependence on oil and gas.

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