When gasoline prices rise, consumers certainly notice at the pump. But many people have very little idea why the amount of money needed to fill their car's tank rises and falls. Here, we take a look at the factors that determine the price consumers pay from day to day.

Key Takeaways

  • The law of supply and demand regulates gasoline prices, as it does nearly all commodities.
  • Both supply and demand are changing all the time, as new oil wells are discovered and as economic conditions impact consumer demand.
  • As a longer-term general trend, the supply of high-quality oil is fixed and dwindling while global demand is increasing with a rising population and economic growth.

Oil Prices: The Crude Reality

Logically enough, the price of gasoline is determined in part by the price of oil. But a whole host of other factors impact the average retail price of gas.

According to the U.S. Energy Information Administration, the price of crude oil actually comprised only 54% of the average retail cost of gasoline in 2019. Federal and state taxes were the next highest cost factor, averaging 18%, followed by distribution and marketing costs, refining costs, and profits.

Those figures varied between 2010 and 2019 but, overall, the price of crude oil comprised 59% of the average retail cost of gasoline.

To understand how gas prices are set, consider the core factors of supply, demand, inflation, and taxes. While supply and demand get the most focus (and the most blame), inflation and taxes also play a part in increases in the cost to consumers. The law of supply and demand has a predictable impact on the price of gas. Less predictable are how the supply side and demand side will change over time.

Oil Supply

Oil does not come out of the ground in the same form everywhere it is discovered. It is graded by its viscosity (i.e. light to heavy) and by the degree of impurities such as sulfur that it contains (i.e. 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. There is a positive correlation between crude oil and gasoline prices. It seems logical there would be a positive correlation between the commodities, especially since gasoline is a product of refining crude oil.

Light/sweet crude is simply becoming scarcer and harder to obtain. As the supply of this preferred oil becomes constrained, the price climbs. On the other hand, heavy/sour crude is widely available throughout the world. The price of heavy/sour crude is lower, sometimes substantially lower, than light/sweet crude to compensate for the higher cost to process it.

Note that oil supply among large producing nations is regulated by the cartel called OPEC (organization of petroleum exporting countries). OPEC's 14 members aim to regulate the supply of oil in order to set the price on the world market. Within OPEC, each member nation is allocated a production quota. International oil companies operate independently of OPEC, but because OPEC controls a larger percentage of world crude oil exports (supply not consumed by the producing nation), OPEC's policies impact the price of oil worldwide. If the demand for a good increases while supply remains constant, the price of that good will rise. While oil companies might benefit from OPEC's supply constraints, they do not participate in OPEC's decision-making process, and could just as easily be hurt by OPEC's policies if OPEC (assuming its member nations were able) decided to attempt to increase the supply of oil worldwide.

Consumer Demand

The growth in the number of people driving cars and trucks, particularly in parts of the developing world, has expanded dramatically over the last few years. China and India, each with populations in excess of one billion, are experiencing expanding middle classes that will likely drive more cars and use more gasoline over time.

China alone had built more than 80,000 miles of interprovincial highway by late 2020, and it is continuing to add more than 6,000 miles a year, according to a Chinese government site.

By comparison, the U.S. has a total of about 47,000 miles of interstate highway, according to the Federal Highway Administration.

Many countries subsidize the retail price of gasoline to encourage industrial development and gain popular support, creating an artificially higher demand for gasoline.

Creating a Balance

Prices help allocate scarce goods. That is, consumers respond to higher prices for any commodity by using less of it. Although demand for gasoline is elastic in the long term, small disparities in supply and demand in either direction will not have a significant 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 reason is that people are locked into their lifestyles for the near term. While they may change their fuel consumption by buying more fuel-efficient vehicles, moving closer to work, or taking public transportation, they can't or won't do so in response to a temporary hike in prices.

The price will balance the supply of gasoline with the demand for it. The global nature of the market for gasoline assures that balance.

That leaves inflation and taxes to account for the biggest relative increases in the price of gasoline.

Other Considerations: Inflation and Taxes

Inflation is the general rate at which the prices of products and services are rising (and, conversely, the rate at which purchasing power is falling). In the U.S., an item that cost $1 in January 1950 would cost about $10.98 in January 2020.

In 1950, gas cost about 27 cents per gallon. Adjusting for inflation, a gallon of gas should cost about $2.98 in January 2020, assuming taxes, supply, and demand stayed the same.

The tax on a gallon of gas in 1950 was 1.5 cents. In July 2019, the combined federal, state, and local taxes on a gallon of gasoline averaged 18% of the total price. Federal tax made up 18.4 cents, while state tax made up 29.66 cents.

Other countries have vastly different tax policies for gasoline, some of which can make taxes the largest price component.

The Bottom Line

Gas prices, like most other commodities, are ruled by the forces of supply and demand. Holding demand constant, when supply rises prices fall and. Holding supply constant, when demand goes up, so do prices.