Running on Reserves: Gas Prices and the American Consumer

by Alison Partin

The Organization of Petroleum Exporting Countries (OPEC) decided on October 20, to cut oil production by 1.2 million barrels per day – the first OPEC production cut since February 2004.  The organization is hoping to slow a recent decline in the price of gasoline, even though the cost of gasoline in the United States has doubled in the past 10 years. American consumers have taken notice as ethanol becomes a household term, the Department of Justice inquires into price gouging on the gas market and oil executives testify before Congress. Underneath the scrutiny, however, Simple questions remain: just how inelastic is the price of gasoline? How large a price increase can the American consumer withstand before the economy as a whole begins to suffer? And, what actually determines the price of gasoline?

Gasoline is so essential to the U.S. economy that increased prices do not significantly impact the amount of gasoline purchased, but in times of high prices, people spend less on other consumer goods, including entertainment, electronics and eating out. The complex interactions can be difficult to isolate, however. The American Public Transport Association reports that use of public transportation was approximately 4.25 percent higher in the first quarter of 2006 than in 2005, but the increase is not necessarily due exclusively to a rise in gasoline prices.

Curious about the short term effects of higher gasoline prices, I performed an unscientific poll of 76 people largely throughout the east coast. According to the survey, travel habits changed little over the summer. Of respondents, 26 percent said they traveled more this summer than last summer, 32 percent traveled less, and 41 percent did not change their travel habits at all. These figures don’t necessarily reflect changes due to gas prices. In fact, 79 percent of those surveyed said that the cost of gasoline did not influence their decision of whether or not to travel over the summer. As of August 2006, estimated gasoline costs for those surveyed ranged from $70 per month to $200 per month. Finally, to explore the question of long term economic influence, I asked respondents to estimate at what price they would begin to change their driving behavior. Projected prices ranged from $2 to $10 per gallon, with a mean value of $4.22.

Respondents attributed the increase in prices to a variety of factors. Answers included current U.S. foreign policy, President George W. Bush, greedy oil companies and simple supply and demand. In reality, prices are determined by a complex mix of influences, dominated by the price of crude oil, the raw material from which gasoline and many other chemical products are made.

According to a 2005 Government Accountability Office report, 48 percent of the price of gasoline is determined by the price of crude oil.  For comparison, the highest recorded cost of crude oil was just around $99, adjusted for inflation, in April of 1980.  Current prices peaked just below $80 in July and have been easing ever since.

Crude oil in the United States is traded on the New York Mercantile Exchange(NYMEX). Futures contracts trade in units of 1,000 barrels and contracts provide for crude delivery in several grades — light, heavy, sweet, or sour — from both domestic and international sources. And just like any other stock commodity, the market is subject to speculators who buy low and sell high in order to make a profit. This contributes to price increases in an already stressed market. Crude oil is a truly global market, and as supply is stretched nearly to capacity, new sources of demand from rapidly developing China and India pull the strings even tighter.

Origin is also a factor in price fluctuations. Crude oil from the Middle East is produced at a rate of approximately $1.50 to $2 per barrel, but it becomes much more costly in terms of geopolitics and shipping. Once the crude is delivered, it must be refined, accounting for approximately 17 percent of the total gasoline price. New refineries have not been built in the United States for over 30 years, but refining capacity has actually increased due to expansions and refinery modifications. Even with the expansions, the United States currently operates at near full refining capacity and has to import refined products, namely gasoline, from places such as the Virgin Islands and Europe. Again, this increases the cost of the final product.

The second largest component in the price that you pay at the pump is taxes.  Approximately 23 percent of the total cost goes to federal, state and local taxes. Federal gasoline taxes are earmarked for highway maintenance and transportation costs and are a vital portion of government revenue. These targeted taxes serve as a sort of highway-user fee. Similar taxes are often much higher in Europe. Petrol in the United Kingdom, for instance, was taxed at approximately 66 percent in 2005. For comparison, in May of 2006, the average price of gasoline was $6.36 per gallon in London, $2.95 per gallon in the United States, and $2.40 per gallon in Beijing. In stark contrast, April 2006 prices in Caracas, Venezuela, averaged $0.12 per gallon.

As global consumers adjust to their fate in an increasingly hostile energy market, oil companies continue to compete for finite resources. According to the Wall Street Journal, approximately 75 percent of the world’s oil and natural gas resources are unavailable to Western exploration. These fields are under the auspices of nationalized companies, and consequently international companies such as ExxonMobil and ConocoPhillips must spend more and more to develop new resources. Recently, new reserves were discovered in the Gulf of Mexico, and at least two of the wells were drilled at nearly 30,000 feet.  One well, nearly 5 miles deep, cost the industry approximately $100 million to develop.  The total cost for Gulf development is estimated to rise into the billions of dollars.

U.S. consumers can only hope that additional domestic supplies will help ease pump prices at home. In the meantime, the long-term effects of rising prices are yet to be determined, and it remains to be seen just how much influence OPEC members will exert on an already strained market. Consumers are adjusting, however, and for now at least, the price of gasoline continues to fall.

Note: In written testimony to the Senate Committee on Commerce, Science and Transportation, Jim Wells (GAO Director of Natural Resources and the Environment) outlined the various components in the price per gallons that Americans pay at the pump from 2004 average prices.  All U.S. percentages in this article are from that particular testimony.


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