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Why is the Price of Oil So High?

When gas prices start to rise to astronomical levels, there’s a lot of chatter about gas rising to “$100 a barrel” and about supplies in the Middle East; but what, exactly, causes the fluctuations in gas prices and why do they get so high? We've got to have something for our fuel injectors and fuel pump assemblies to operate on! We’re going to discuss a very simplified version of how gas gets from the ground into your vehicle, and how the price changes along the way.

First thing to understand is that there are three different markets for oil: contract, spot, and futures. Each is influenced by different factors that affect the price of gas at the pump. The futures market is publicly traded on a sales floor like you see on Wall Street. The spot and contract markets are informal networks of people in the business.

The contract market is a market made up of agreements between oil companies and oil refineries. Oil companies’ main business is in exploration to find new deposits of crude oil to drill. The oil companies drill for the oil and have contract agreements with oil refineries to decide exactly who gets the oil, and how much they get. Oil refineries play an equally important role. Oil doesn’t come out of the ground as the gas you put in your car – it must go through a process at the refinery to separate it out into the many petroleum based products we use, from gasoline and diesel to jet fuel and petroleum jelly. Refiners plan their business around how much oil they plan to get from oil companies laid out in the contracts. Because they know how much oil they will get beforehand they pay a premium which they pass on to their customers.

The spot market consists of the spare product oil companies have left over after fulfilling their contractual obligations. They will put the extra oil onto the spot market, and if a refinery needs extra oil they purchase it at a spot, or daily, price. Since there is no contract involved and there is never any guarantee whether or not there will be spare oil to buy on the spot market, prices are usually much cheaper than contract prices.

Oil futures are traded on the American Mercantile Exchange. The futures market represents the state of the entire oil market at any given time – thus it can be extremely volatile. When you hear reporters talking about the price of oil reaching $100 a barrel, they are speaking about the futures market. The prices of the futures market are driven by information; they are often referred to as speculative markets because the price can change violently purely on speculation. Most people buying and selling oil futures rarely want the actual barrels of oil, but just trade paper contracts in order to make money, much like the Dow Jones, Nasdaq, or other stock markets.

Refineries have played a large role in the increase of gas prices over the last few decades. There used to be over 350 refineries in the early 80’s, most of which were owned by oil companies. They saw refineries as an integral part of their business and not a place to make extra profit. Now there are only 153 refineries, the majority of which are independently owned and of course exist to make a profit. Gas coming out of a refinery is sold at a “rack price,” which is the cost of gas to dealers. This rack price is often influenced by the spot and futures markets, and can be further inflated when it is labeled by a premium brand. Branded gas is more expensive because it is perceived as being of higher quality than non-branded gas (which is typically untrue), but also because they have much more stable contracts and thus a more reliable supply of gas.

Gas stations also play a role in gas prices, but maybe not as much as you think. Some are owned outright by the oil companies, where some are leased by dealers who sell one particular brand of gas. There are of course plenty who are independent and sell unbranded gas as well. Branded gas stations have a contract that states a minimum amount of gas they must buy where unbranded stations get their gas wherever they can – obviously as we discussed before the uncontracted gas will be less expensive, and thus allows independent gas stations to get the gas cheaper.

At oil-company-owned stations, the oil company decides the price of gas, and that’s what is charged. With leased gas stations, the oil companies sell the gas by the DTW or Dealer Tank Wagon. The DTW price is set by the oil companies and is driven by the spot and futures markets. Oil companies decide what to charge by looking at their competitors stations in the same market. Lessee’s can’t negotiate the DTW price because they signed a contract saying they have to buy a certain amount of gas, but the oil companies allow them to tack on a profit margin from 3-10 cents per gallon to guarantee income. The gas stations can’t go crazy with the profit margin however because they are still in heated competition with the other gas stations in the area and might lose business if they charge too much.

Lastly, taxes make up about 18% of the price of gas depending on what state you live in. California in particular has more expensive gas because California has passed restrictions that require even cleaner burning fuel than the rest of the nation, which is more expensive to refine and in shorter supply. So, as an example, for every dollar you spend the price of gas might be broken down like this:

Taxes: 13 cents

Distribution and Marketing: 8 cents

Refining: 14 cents

Crude oil: 65 cents

As you can see, what determines the price of gas is involved and complicated, even in this over-simplified explanation. No one entity has complete control over the price of gas (although there are some, like the Organization of Petroleum Exporting Countries/OPEC, who have more control than most). Next time you’re at the pump and you’re frustrated about the high price of gas, see if you can follow down the chain to see what caused the recent inflation so you know where to rightly target your angry letters.

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