Why do Gas Prices Rise?

rising gas pricesIf you have been to the pump lately, you may be asking yourself, what is going on with these gas prices? In California, consumers are paying almost $4 a gallon for gas. While this may seem low to Europeans, this is the highest we have ever paid!

So, why do gas prices rise?

Over the long term (more than 6 months), the greatest single influencer of gas prices at the pump is the cost of crude oil. However, in the short term, marketplace forces such as supply and demand, competition, and fear can all play a part.


The Cost of Crude Oil

Crude oil prices have continued to rise over the last year due to strong demand by recovering developed economies such as the United States and China, limited spare production capacity in oil producing countries (or unwillingness to add more), and political instability, such as what we are seeing in Libya.

It is important to note, however, that crude oil accounts for only about 50% of the cost of a gallon of gasoline. To turn crude into gas, it passes various refiners and distributors that all add on to the price.


Increasing Demand for Oil and Gasoline

The surging demand for oil is being fueled by recovering economic growth in both the United States and China. According to the US Energy Administration, spare oil production capacity is only about 1% of current demand, leaving very little room to compensate for supply interruptions or spikes in demand.

Global economic expansion is driving a huge increase in demand for oil and gasoline. China, for example, is now the largest market in the world for new cars. This wasn’t the case five years ago. As a result, there is a surge in demand for gasoline, and the oil that is needed to create it.

Most of the world’s oil is located in some very dangerous and politically unstable regions of the world. This makes investment in developing the oil reserves nearly impossible. It also means that supply disruptions, whether real or perceived, can have a huge effect on the cost of oil. This is happening right now with the crisis in Libya.


Other Factors that Influence Gas Prices

Since crude oil must be refined into gasoline, it is important to look at the refiners when judging the price. Right now, there is a shortage of refineries to refine the crude oil, and as a result, the price spread between crude oil and the refined product can be great. Why is there a short supply of refineries? In the United States, it is due to the increased regulatory environment surrounding the refineries, due to several mishaps over the last decade. As a result, several large refineries in the US have either shut down or limited their output. Also, there are no plans to build new refineries.

Taxes also make up a significant component of the price of a gallon of gas. As of January 2011, the average tax on a gallon of gasoline in the United States was 48.1 cents per gallon for unleaded and 53.1 cents for diesel. This is a federal tax of 18.4 cents per gallon for regular gasoline, and 24.4 cents per gallon for diesel. Then the average state tax was 27.2 cents. The, in some localities, there is even a local tax!

If it makes you, as an American consumer feel any better, some countries, such as New Zealand, pay a 50% tax per gallon of gasoline!

Competition is also another short-term driving force in the price of gasoline. This is reflected by the number of gas stations in a given area. Everyone has seen the difference in price from a lone gas station away from town and the busy corner that has multiple gas stations competing for your business.


So What Does This Mean For Investors?

As an investor, I would stay away from companies that just explore for crude, or refiners. I like the fully integrated oil companies such as Exxon Mobil, Chevron, Shell, etc. These companies are able to capitalize on each individual part of the marketplace. As a result, these companies have been able to sustain large profits, and pay shareholders a nice dividend.  Check out How To Invest in Oil to look at other plays for investors in this space.

For the very long term (20+ years), it is important to remember that oil is a limited natural resource. Today, most of the cheap and easy to extract oil has already been found and extracted. Therefore, over time, oil prices really have no place to go but upward. This is beneficial to investors of these integrated oil companies, who will reap the rewards of this price movement.

Readers, what tips and tricks do you have to save money on gas since gas prices keep rising?

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  1. says

    I completely agree with your last statement about oil has no where to go but up in the long term. The economic growth in India will also be a driving factor as they too will demand more oil. In addition, we always talk about reducing our dependence on foreign oil, but it just isn’t going to happen anytime soon as there are no true large scale alternatives.

    However, I do believe it will fall back below $100/barrel in the short term. The middle east is very unstable right now and traders have factored in a risk premium, but there really haven’t been any supply disruptions yet. Saudi Arabia increased output to ensure there would be no supply issue.

    • says

      It seems like oil has been pretty steady now around the $100 mark for a long time, and yet gas prices continue to rise. Any thoughts?

  2. says

    The current prices are at a high not due to supply problems but speculation. The same reason California had rolling blackouts in the early 2000s even though there really wasn’t a supply problem. Enron-like tactics GS and others. Can’t blame the players though, the game is rigged.

  3. says

    What’s most important about the big oil companies is that they realize they are in the energy business, not necessarily the “oil” business. There is no doubt oil will be meet a smaller percentage of our energy needs over the coming decades. But our energy use will continue to increase, as populations grow and emerging economies create new middle-classes. Though I back “green” technology, from my research it seems natural gas will be the next big energy source. And I think the major oil companies are best positioned to profit in the new markets.

    • says

      I hope natural gas is the next big thing. Right now, prices are so cheap, it makes sense to look into natural gas. It is also cleaner from a “green” perspective.

  4. says

    I’m with you on the integrated plays. Less volatility and exposure to oil, but disgustingly low PEs and high-dividends. A few are even buying back their own shares…a recipe for investment win!

  5. Nick B. says

    Interesting read. For something I spend so much money on, I never really looked into what goes into its dramatic changes. As a result of increased gas prices, I’ve used my car less.

    The bus system is great where I go to school. Although it takes slightly longer it’s worth saving a few extra bucks from gas and spend it on something more worthwhile… Although that ends up being something not as fun such as electricity, my CT car insurance bill, or tuition. But every penny counts!

  6. says

    Nearly $4 isn’t so bad compared with $1.30 to $1.40 a litre. 😛

    Oil demand is going to be up for the near term, especially with rising economies such as China. Longer term increasing efficiencies in cars and in alternate energy sources such as solar should help to dampen that somewhat.

    • says

      All of the talk of green cars and stuff will not likely lower demand in the future, because the price of these cars is still way too high. And when you compound that with emerging economies of China using more cars and gas, it won’t lower overall demand at all.

  7. says

    Once the economy really recovered, the energy price will shoot up even more. I don’t think more efficient vehicle will help all that much since Chinese and Indians consumers are buying up so many new cars. There will be so many more vehicles in the coming years and the quantity will overwhelm any efficiency improvement. Just my theory.
    I don’t have any energy stock, but probably should get in on it. :)

  8. optionsdude says

    Great points here about the integrated oil companies. These are the ones that can make a little bit of money at each point in the supply chain from drilling and exploration all the way to the end consumer. I like to hedge my living expenses by investing in energy and food companies. It makes the increased prices that I pay somewhat easier since I know that some of that will come right back to me in dividends and capital gains.

    • says

      Be careful investing in food companies – these are usually the ones that get squeezed by higher gas costs. A huge percentage of the cost of food is the cost of fuel to get from farm to processor to market. If companies don’t raise prices when gas prices rise, they get their margins squeezed.

  9. says

    Gas prices go up because of all the protests on Facebook. Oil producer executives get pissed off and raise prices just to get back at all those annoying kids.

    For the investor angle – buy a stake and then start a protest to profit from it?

  10. says

    The Chinese are going great guns with new cars and new roads. It follows that demand for refined products will increase, as will the cost of the feedstock. Agreed on not chasing small refiners, their margins get squeezed when they have to buy higher-cost inputs on the spot market.

  11. says

    Terrific breakdown on oil. 20/20 hindsight, guess should have piled on when oil momentarily went down to reasonable prices. Correction, reasonable is all relative I suppose. Logical argument so does that mean you are loading your positions in fully integrated oil companies?

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