Why the Heck Does Gas Cost So Much – Commodities Investing Series

July 28, 2008

GasLast time I filled up my gas tank it cost me $64.28. As I was standing there at the pump I started thinking.

I realized I had absolutely no idea why the price of gas was so high.

I mean sure, I get emails from MSN money every day telling me that oil hit a new record high.

I hear mutterings about China, and problems in the Middle East.

But, when it came right down to it, all I really understood was this:

I’m getting squeezed at the pump – and I want to know why.

So, with that in mind, I thought I’d do a little digging, and share with you what I learned.

Basically the price of gas breaks down like this:

  • Federal, State and Local Taxes account for about 15% of the price per gallon.
  • The price of crude oil accounts for roughly 55% of the price per gallon.
  • The cost of refining the oil is about 15% of the total price per gallon.
  • Advertising costs also make up about 15% of each gallon of gas.

This is just an average breakdown. The actual numbers vary from year to year and company to company.

Now, the taxes I understand. I’m not happy about it, but I get it. I also understand the refining costs and the advertising costs. Based off of these numbers, I decided that the main reason I am getting my pocket picked twice a week when I fill up has to be the base price of crude oil, which is at an all time high.

So, what’s going on with crude oil?

High Demand:

Right now there is a booming commodities market where there used to be hardly any at all. Namely, all over Asia – especially China and India. They are demanding all types of commodities in quantity, especially oil. Over here in the U.S. much of the way we live our lives also depends on oil. Not only do we put the refined version of it into our cars as gas, but it’s used in everything from plastic bags to Styrofoam. Even though oil prices are at an all time high, our demand is not really decreasing.

Low Supply:

There have been disruptions in the supply of oil all over the world in the last few years. Nothing that would normally make much of a difference, but when you couple it with record demand for oil and oil based products, it is pushing the price up. Here are a few specifics:

  • In April of 2008, Nigerian rebels launched attacks on Exxon Mobil. They temporarily stopped production of 800,000 barrels of oil a day.
  • On July 18,2008 Eni SpA (Italy’s largest oil company) also stopped production in Nigeria because of faulty pipelines. They will lose 47,000 barrels a day until the problem is fixed.
  • Saudi Arabia (which claims to own about 21% of the world’s oil) isn’t exactly falling all over itself to increase production – but they are finally going to. The good news is, they are planning to increase oil production by as much as 500,000 barrels per day starting this month. (July 2008)

Fear of a Limited Supply:

Many economists buy into a theory that we are reaching “Peak Oil.” That’s the theory that the world’s oil reserves are limited and that we will eventually hit a point where we reach a maximum output. A place where companies will begin to cut back on production to avoid running out of oil.

While there’s no arguing that oil reserves are limited, exactly when we will reach “Peak Oil” is anyone’s best guess. With the increasing demand from Asia, this theory is getting more and more attention.

Some people even speculate that Saudi Arabia has refused to produce more oil because they are afraid of reaching a “Peak Oil” phase sooner than anticipated.

War in the Middle East:

Obviously, things aren’t looking too good over there. If Iran is attacked and they actually back up their threats by closing off Straits of Hormuz then they would effectively cut off one fourth of the worlds oil supply. If that does ever happen, oil prices at $200 a barrel will seem generous. The threat of that alone is probably driving oil prices higher than they have to be.

The Declining Dollar:

In some ways, it appears we can thank the housing bubble for the rise in oil prices too. The price of oil is measured in U.S. Dollars. When our dollar value declines compared to the rest of the world, then the price of oil goes up because it takes more dollars to reach the actual value of a barrel. (Gotta love that logic!)

It’s our fault too:

Yeah, I know, that’s a hard one to swallow. Still, some economists believe that as the U.S. economy takes a dive, most investors start looking for “safe” places to put their money. Usually, they turn to commodities. This actually drives the price of those commodities up because of the sudden increase in demand.

So, what do I think about all this?

There are some investors who believe that oil prices are in a bit of an unnatural bubble right now. While I do agree that prices are at record highs, I also believe that this is just a natural part of the commodity process. Commodities run in cycles. When demand outstrips supply, prices rise. Usually there is a short period where supply stays low, and prices stay high.

Eventually, more and more companies with $$ signs in their eyes jump in and increase production. In the mean time, we (the consumers) simply find ways to do without whatever it is as often as we can. So, eventually the increased supply and decreased demand helps the price to “right itself”.

There are a couple of wild cards in this scenario. Mainly the increased demand from developing countries and the threat that we may be running out of oil sooner than anticipated. Still, I believe that eventually the price will right itself (though I don’t think the price of gas will ever return to it’s pre-cycle lows).

In fact, I think that if you truly understand the principles of supply vs. demand, as well as how the economy, and government factor in, then you can apply that knowledge to any commodity. The same rules are still going to apply, whether you are talking about oil, or oranges.

Allright. I’ve told you what I thought – It’s your turn!

Do you think we are about to see a turn around in gas prices? Do you think now is a good time to begin investing in oil, or a good time to start selling your shares?

Let me know – you can use the comment form below! And, if you loved (or hated!) this article, then this post explains how you can offer your feedback for a chance to win $50. Thanks!

Photo © Connie Brooks


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Comments

8 Responses to Why the Heck Does Gas Cost So Much – Commodities Investing Series

  • rhenry

    Nice that you would do some research and post it. Been a couple years since anybody commented on that. Got any more discoveries or insight into this? I’m a mechanic working in information technology. I hear stories about how the electrical power demands of the computing world threaten the survival of data. Elec power is dependent on fossil fuels. This is a most fragile system, so I’m turning my lawn into gardens and growing food. E tu?

  • Shadox

    I actually think that the price of oil (& gasoline) is not high enough. The best way to kick the oil guzzling addiction is for the price of alternatives to be cheaper in a sustainable, long term kind of way.

    I am not advocating higher taxation or other strange measures, however, I think that the use of oil does not reflect all the social and environmental problems that are associated with its use. If the price of such ills were included in the price (e.g. the price of carbon, the price of keeping troops in the middle east etc.) – the price of oil would be higher and its replacement by alternatives would happen much faster. All the better for the planet and for the people of the world in general…

  • Connie

    That’s a really good point James. Thanks for your comment!

  • James@capitalcouplesfinance.com

    Even though actual miles driven is being impacted by the high prices, it’s still summer driving season and I think that’s playing yet another part in driving up gas prices.

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