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.)

Tutorial:
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.)
Supply
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?)

Demand
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
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.)

Taxes
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.

Related Articles
  1. Economics

    4 Countries Pleading for Higher Commodity Prices

    Discover what countries are struggling the most from the price collapse in commodities and what these countries require to return to economic growth.
  2. Budgeting

    Blue Apron Review: Is It Worth It?

    Read about one of the top meal-kit delivery services in the United States, and learn more about what it offers and how much it costs.
  3. Stock Analysis

    Glencore Vs. Noble Group

    Read about the differences between Glencore and Noble Group, two companies in the commodities business. Learn about accounting accusations facing Noble Group.
  4. Chart Advisor

    Watch This ETF For Signs Of A Reversal (BCX)

    Trying to determine if the commodity markets are ready for a bounce? Take a look at the analysis of this ETF to find out if now is the time to buy.
  5. Stock Analysis

    JCPenney's Path To Profitability (JCP)

    Learn about what J.C. Penney's management team has been doing to profitably grow its business as the company recovers from years of revenue declines.
  6. Home & Auto

    The Latest Airbag Recalls: What to Do

    The latest warnings are from Honda/Acura and Dodge. How to look up your car – and what to do if you find it on the recall list.
  7. Investing Basics

    The Importance of Commodity Pricing in Understanding Inflation

    Commodity prices are believed to be a leading indicator of inflation, but does it always hold?
  8. Fundamental Analysis

    The 3 Best Investments When Bull Markets Slow Down

    Find out why no bull market lasts forever, and why investors should shift their assets away from growth and toward dividends when stocks slow down.
  9. Economics

    Industries That Thrive On Recession

    Recessions are not equally hard on everyone. In fact, there are some industries that even flourish amid the adversity.
  10. Economics

    Economist Guide: 3 Lessons Adam Smith Teaches Us

    Learn three critical lessons about economics from 18th century philosopher Adam Smith, considered by many to be the father of economics.
RELATED FAQS
  1. What's the difference between microeconomics and macroeconomics?

    Microeconomics is generally the study of individuals and business decisions, macroeconomics looks at higher up country and ... Read Full Answer >>
  2. How does a cost-of-living adjustment (COLA) affect my salary?

    Some companies build salary adjustments into their compensation structures to offset the effects of inflation on their employees. ... Read Full Answer >>
  3. Where can you buy NetSpend reload packs?

    You can only purchase NetSpend reload packs at Giant Eagle, Albertsons, Roundy's and Pathmark supermarkets. NetSpend cards ... Read Full Answer >>
  4. How do you make working capital adjustments in transfer pricing?

    Transfer pricing refers to prices that a multinational company or group charges a second party operating in a different tax ... Read Full Answer >>
  5. Which mutual funds made money in 2008?

    Out of the 2,800 mutual funds that Morningstar, Inc., the leading provider of independent investment research in North America, ... Read Full Answer >>
  6. Do hedge funds invest in commodities?

    There are several hedge funds that invest in commodities. Many hedge funds have broad macroeconomic strategies and invest ... Read Full Answer >>
Hot Definitions
  1. Black Swan

    An event or occurrence that deviates beyond what is normally expected of a situation and that would be extremely difficult ...
  2. Inverted Yield Curve

    An interest rate environment in which long-term debt instruments have a lower yield than short-term debt instruments of the ...
  3. Socially Responsible Investment - SRI

    An investment that is considered socially responsible because of the nature of the business the company conducts. Common ...
  4. Presidential Election Cycle (Theory)

    A theory developed by Yale Hirsch that states that U.S. stock markets are weakest in the year following the election of a ...
  5. Super Bowl Indicator

    An indicator based on the belief that a Super Bowl win for a team from the old AFL (AFC division) foretells a decline in ...
Trading Center