When gas prices start to rise, consumers certainly take note. However, although many consumer express frustration over high gas prices, and even attempt to pin the blame, most people have very little idea of how these prices come about. Here we'll take a look at the factors that determine the price consumers pay at the pump. (For background reading, see Understanding Oil Industry Terminology.)

Commodities 101

Oil Prices: The Crude Reality
According to the U.S. Department of Energy, the price of crude oil averaged 68% of the average retail cost of gasoline in December of 2010. Federal and state taxes were the next highest cost factor, averaging 14%, followed by refining costs and profits, then distribution and marketing.

Between 2000 and 2007, the price of crude oil averaged 48% of the average retail cost of gasoline from. Federal and state taxes were the next highest cost factor, averaging 24%, followed by refining costs and profits, then distribution and marketing.

Most people believe the price of oil is the primary determinate of the price of gasoline, but the forces that influence gas prices are a bit more complicated than the numbers suggest. To help understand how gas prices are set, it helps to examine supply, demand, inflation and taxes. While supply and demand get the most focus and the most blame for the high price of gasoline, inflation and taxes also account for large increases in the cost to consumers. (To learn more, read How Does Crude Oil Affect Gas Prices?)

Supply and Demand
The basic rules of supply and demand have a predictable impact on the price of gas. (For background information on these economic concepts, check out our Economics Basics tutorial.)
Oil does not come out of the ground in the same form everywhere. It is graded by its viscosity (light to heavy) and by the amount of impurities it contains (sweet to sour). The price for oil that is widely quoted is for light/sweet crude. This type of oil is in high demand because it contains fewer impurities and takes less time for refineries to process into gasoline. As oil gets thicker, or "heavier," it contains more impurities and requires more processing to refine into gasoline.

Light/sweet crude has been widely available and sought after in the past, but is becoming harder to obtain. As the supply of this preferred oil becomes more constrained, the price climbs. On the other hand, heavy/sour crude is widely available through out the world. The price of heavy/sour crude is lower, sometimes substantially lower, than light/sweet crude.

Refining heavy/sour crude requires a higher capital investment to process lower-quality oil. This investment is possible since refiners can purchase poorer-quality crude at a lower price so they can get their return on investment. (For more information on the cost of oil, read What Determines Oil Prices?)

Change in the demand for gasoline is primarily set by the number of people who are using the fuel for transportation. The growth in the number of people driving cars and trucks, particularly in parts of the developing world, has expanded dramatically in the last few years. China and India, each with a population in excess of 1 billion, are experiencing an expanding middle class that will likely use more gasoline over time.

China is building 42,000 miles of new interprovincial express highways by 2020 to accommodate the all the new car sales in that country. By comparison, the U.S. has about 86,000 miles of interstate highways. India has plans to construct another 12,000 miles of expressways by 2022. Cars driving on those highways are going to consume more gasoline, creating more demand for fuel. (Read about how industrialization can be good news for your portfolio in Build Your Portfolio With Infrastructure Investments.)

Many countries subsidize the retail price of gasoline to encourage industrial development and to gain the popular support of the people, creating an artificially higher demand for gasoline. Changes in this subsidy will affect the demand for gas similarly to price increases or price decreases.

Creating Balance
Prices help to allocate scarce goods. Although demand for gasoline is more elastic in the long term, small disparities in supply and demand in either direction will have a large impact on prices in the short run. This inelasticity of demand means if prices go up, demand goes down, but not by very much. The problem is that people are locked into their existing life patterns for the near term. While they can change their fuel consumption by buying more fuel-efficient vehicles or moving closer to work, these things take time. (One option, hybrid cars, has gained popularity in recent years. Read Hybrids: Financial Friends Or Foes? to learn more.)

On the other hand, the expansion of new middle classes throughout the world will cause a growing demand for gasoline as they create new life patterns that include driving cars. Price will balance supply of gasoline with demand, and the global market for gasoline provides the forum for establishing that balance.

Inflation And Taxes
Inflation and taxes account for the biggest relative increases in the price of gasoline.

Inflation is the general rate at which prices of goods/services are rising (and, conversely, the rate at which purchasing power is falling). In the U.S., an item that cost $1 in 1950 would cost about $9.30 in 2010. In 1950, gas cost about 30 cents per gallon. Adjusting for inflation, a gallon of gas should cost about $2.79, assuming taxes, supply and demand stayed the same. The level of inflation varies by country, which can influence the price of fuel. (To learn more about inflation, read our All About Inflation Tutorial.)

The tax on a gallon of gas in 1950 was approximately 1.5% of the price. In 2011, the federal, state and local tax on a gallon of gasoline was approximately 20% of the total price. This means that taxes added about 48 cents to the price increase in a gallon of gas. Federal tax made up 18.4 cents, state tax made up 20.6 cents, and local and other taxes made up 9 cents per gallon as of January of 2011. Other countries have vastly different tax policies for gasoline, some of which can make taxes the largest price component.

Cumulative Effects
As a point of reference, inflation and taxes added approximately $2.83 to the rise in the price of gasoline over the 58-year period from 1950 to 2008. It is important to have this perspective when considering the impact of supply and demand on the price of gasoline.

The Bottom Line
Over the short term, as prices rise or fall, demand tends to be relatively inelastic. People only make small changes in their consumption of gasoline when there are large changes in the price, and this pattern helps balance the supply and demand of gasoline.

Over time, we can expect to see a movement toward lower fuel consumption at the individual level, but an increase in the number of people who depend on gasoline worldwide. These changes will no doubt impact the price we pay at the pump.

While there is a common belief that the price of gasoline is solely determined by the supply and demand of crude, several other important factors come into play as well. Taxes, depending on the country, can add substantially to the retail price of gasoline. Over time, inflation also results in higher gas prices.

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