Why Does Gasoline Cost So Much, Daddy?

Basics of the Petroleum Industry VI: The Economics of Big Oil (and Your Local Gas Station)

For most of us, our chief exposure to the economics of the oil industry comes in the form of two-foot-high letters displayed somewhere along the streets we travel to work or play. Though we may not know the current price of a barrel of crude oil¹ - may not even know how big a barrel of oil is² - we are usually aware of the price of gasoline in our neighborhood. What most of us don't know, as a rule, is why gasoline costs what it does. The answer is simple on the surface, and devilishly complex below that simple answer.

One simple fact is that oil companies, no matter how large or small, do not set the price of their product. Crude oil and refined products are commodities, like corn and pork bellies; and the price of commodities are by commodity traders who broker deals between sellers and buyers. Traders perform a balancing act between the least a seller will accept for the product and the most a buyer will pay for it. According to the law of supply and demand, buyers will pay more for a commodity when supply decreases. That's why whenever there is a restriction in the supply of oil production within or imports to the USA, the price rises. Even more, whenever there is fear of a reduced supply - due to weather, natural disaster, or political instability - the price also rises. In fall of 2008, the price of oil fell dramatically because of the belief that that economic upheaval would reduce demand for petroleum in large markets like Southeast Asia. The same supply and demand cycle affects beef and milk (mad cow disease, anyone?) and corn and soy beans: like farmers who are paid less for crops after a good growing season, oil companies get less for their product when the supply exceeds the demand.

Remember, too, that the cost of the raw materials (crude oil) is only about 65% of the price of your gasoline: there are also the costs of transporting the crude oil to a refinery, refining it, and transporting the refined product to your local station; not to mention the cost of the additives, most of which are also petroleum products. Besides the cost of producing, transporting, and refining the gasoline you bought on the way to work today, the station that sold you that gasoline also has to pay for the property and building (a small station can easily cost more than a million dollars to build and equip), employees, and the rights to sell that particular brand - very few stations that sell Exxon gasoline, for instance, are owned by the company. Most are owned by local business-men and -women. Oh, and one more cost: taxes. On top of a federal tax of 18.4 cents per gallon, every state (and some large cities) also charges "road-use" taxes. Depending on where you live, taxes range from a total of 26.4 cents/gallon (Alaska) to 65.8 cents/gallon in California (see a list of US state tax burdens here). Internationally, except for a few petroleum-exporting countries such that subsidize the price of gasoline (e.g., Venezuela and Saudi Arabia), taxes can be even higher; though the proceeds are frequently used to pay for public transportation.

Remember the twenty gallons of gasoline that cost you fifty bucks this morning? The station probably made less than a dollar of net profit - that's why they want you to come inside and buy snacks in their convenience store. Back in the mid-nineties, when oil was at nine dollars per barrel, the company I worked for made most of its profit off "The four Cs"- cigarettes, coke, chicken, and condoms - in their chain of convenience stores, and actually lost money selling gasoline. If you really want to make a gas station owner happy, come inside and pay $1.59 for a bottle of water after you're done pumping - you may double his profit on your visit.

What should you take away from this? First, oil companies don't set the price of their product -- they're at the mercy of the law of supply and demand. Sure, when prices are set high they can rack up substantial profits, but when prices fall, they'll take it in the shorts. Second, the guy in the local gas station doesn't arbitrarily jack up the price to try to fleece you: the station owner has plenty of costs to cover, not just the price of the raw material - and it's fairly likely that the station isn't making a great deal of money off the sale of gasoline in the first place.

This is number six in a series of minilectures on the oil industry:

1) Where Does Oil Come From?
2) Where Do Oil Companies Find Oil?
3) How Do Oil Companies Find Oil?
4) The Economics of Petroleum Exploration and Production
5) Refining 
6) The Economics of Big Oil <== You are here.  The next installments is:
7) The Future of Oil


¹ If you're curious, it's displayed to the right of this blog entry (assuming the gadget is working today)
² A barrel is 42 US gallons, a smidgen less than 159 liters, or just under 35 imperial gallons. It's a unit of measurement, however, not a physical container: petroleum and petroleum products aren't poured into 42-gallon drums and shipped; it's pumped into large tank trucks, rail cars, and tanker ships; or they're pumped in a continuous stream through a pipeline.

copyright © 2009-2016 scmrak

Statistics Never Lie - but Liars Use Statistics

If you’ve visited your local Valero gas station lately, you might have noticed a little political theater right there at the pumps. Not content with spending their money on K Street lobbyists in hopes of influencing the government in their favor, the Texas-based oil and gas company has instituted a “grass-roots” campaign in hopes of quashing climate legislation. Like most, although not all, other fossil-fuel companies, Valero’s management (led by CEO William R. Klesse) is staunchly – almost virulently – opposed to climate legislation. This may in part reflect the extreme rightward political leanings of former Oklahoma congressman Don Nickles, a board member, but is a position that is in no way unusual at the top of the industry. Rank-and-file employees, especially scientists (of which there are few on boards of directors) are less hard-line, by the way.

All that means, however, that Valero has begun displaying posters at company stations (many former Diamond Shamrock sites) flatly stating that the Waxman-Markey climate legislation passed by the House of Representatives this past summer is, in the words of Klesse, “a hidden tax.” Klesse further claims that “more than a million high-paying jobs will disappear from our already weakened economy, with no measurable improvement in global climate change.” Perhaps Klesse is concerned that one of them will be his, for which he was compensated to the tune of $10.5 million in 2008 (per Forbes). Valero’s poster, attributed to an organization called Voices for Energy (apparently another name for “Valero”) repeats Klesse’s statements, and states flatly that the Waxman-Markey bill will raise the price of a gallon of gasoline by seventy-seven cents - or more!!! democracydata.com, the domain hosting Voices for Energy, is a Virginia-based political consulting organization that terms itself specialists “in database management and zip to district matching supporting virtually any sort of grassroots lobbying activity.” Grassroots my ass: it’s just astroturf.

So anyway, let’s get to the claim of “77 cents per gallon.”

The impression left by the wild-eyed Uncle Sam is that, if Waxman-Markey passes, your gasoline will cost at least 77 cents more per gallon the next day. However, the 77-cent estimate comes from a compilation of studies performed by the American Petroleum Institute (API), an industry trade association and advocacy group, and represents their estimate of the increase ten years out in 2019 (ignoring inflation, if any). API didn’t crunch the numbers themselves, however; they used numbers from a study published by EIA, the Energy Information Administration (the statistical agency of the U. S. Department of Energy, nominally independent). To sum up that study: EIA estimates that if energy markets were to continue unchanged, the average price of a gallon of gasoline in 2019 would be $3.62/gallon. With Waxman-Markey in place (unchanged from its current form), EIA estimates a best-case scenario of $3.74/gallon and a worst-case scenario of $4.29/gallon – the 65-cent difference is due at least in part to variable estimates of the effectiveness of carbon offsets in reducing costs. The API’s, and Valero’s, 77-cent “estimate” is that worst-case scenario, in which no refiner or producer reduces costs by a single penny – perhaps out of distaste for the practice of using carbon offsets…

The EIA figures are used by the Congressional Budget Office (CBO, the non-partisan agency that provides economic data to the legislature), which has estimated that the use of all available carbon offsets would cut the cost of the cap-and-trade legislation by 70%, or about 54 cents of that worst-case scenario. CBO, by the way, calls the API figures “extreme” and protests that the use of the EIA’s 77-cent figure misrepresents the non-partisan group’s calculations.

Undeterred by the protests of non-partisan statistical organizations, however, the API not only continues to quote that 77-cent figure, but has also allied itself with that paragon of non-partisanship, the Heritage Foundation, to figure out on a state-by-state basis how much the cap-and-trade will “cost” people.


Both EIA and CBO have stated that the effects of using carbon offsets, details of which are still vague, on the ultimate costs can't be reliably calculated - which is part of the reason for the sixty-five cent spread in their estimates. For the API to use only the estimate that best supports their cause is, however, to be expected. It's akin to a Celtics fan shouting that The Sporting News says his team will will 80 games this year when the article says "between 60 and 80." And, of course, the Nets fans will sneer that the News said the Celtics would only win 60...

As always, the best policy is to take the Heritage Foundation’s numbers, add them to Ralph Nader’s, and divide by two… To recap: statistics never lie, but liars use statistics - only they don't use all of them. The API is cherry-picking...

Oil Industry Basics: Refineries and Refining

Basics of the Petroleum Industry V: A Simple Look at Refineries and Refining Costs...

If you’ve been following along, you’ve learned some basics about where oil comes from, how large accumulations of oil form, and how oil companies find those accumulations. Last time out, we looked at the economic realities of the oil business; how companies need to factor in not only the costs of finding new oil (finding costs), but also of getting it out of the ground (producing costs), and getting it to market (transportation costs). That’s only part one of the process, though, because there is almost no use for oil in its raw state. Crude oil, oil that’s just as it comes out of the ground, is highly variable in both chemistry and composition; but almost every use for petroleum products requires that the product fall within a narrow range of compositions. You think “Oil is just oil”? Well, no: oil is composed of lots of things, which is one reason why it’s proven so versatile over the last century or so.

Crude oil is made up mostly of two elements: hydrogen and carbon, which is why we call oil a hydrocarbon. Those two elements can combine in a great many different physical arrangements, and each of those arrangements forms a different kind of hydrocarbon molecule. You may be familiar with some of these molecules already; molecules with names like methane, propane, butane, and octane. Hydrocarbons have unusual physical properties that allow complex molecules to join with other complex molecules to form  even more complex hydrocarbons. There are hundreds of different molecules in nature, and even more among the vast number of man-made molecules that we lump together under the term "plastics." Crude oil also contains other elements in different amounts; among them oxygen, nitrogen, sulphur, and trace amounts of many metals.

Produced crudes are composed of many slightly different hydrocarbons, mixed together in different proportions. How much of which hydrocarbons are present in a given crude oil is a result of many variables. Among them are things like the original source material that was “cooked” into crude oil, the length of time the oil spent in the cooking pot, how high the temperature was, and the chemistry of the water with which the crude oil was mixed in its reservoir. If the field from which the crude comes is fairly shallow, bacteria can also have consumed some of the lighter hydrocarbon molecules over the millennia, leaving behind oil made heavier by the process of biodegredation.

Hydrocarbons are usually separated into light and heavy classes. The higher the ratio of hydrogen atoms to carbon atoms gets in a given molecule, the lighter the hydrocarbon. Methane (a gas), is the simplest and lightest hydrocarbon: it has four hydrogen atoms and one carbon atom. Heavy hydrocarbons are those with a low ratio of hydrogen to carbon atoms. Heavy hydrocarbons include the asphaltenes, which have only about 1.2 hydrogen atoms for every carbon atom. Crude oils are also classified as light or heavy, depending in part on which hydrocarbon molecules are most common. When we hear reports about the price per barrel of oil, the price quoted is usually for the best-quality oils: so-called light, sweet crude. Light hydrocarbon molecules tend to produce more energy than heavy hydrocarbons when they’re burned, and since the majority of crude oil is turned into jet fuel, gasoline, diesel, and heating oil; light crude tends to be in high demand. “Sweet,” by the way, means that the crude contains less than 0.5% sulfur – sour oil, which has more sulfur (usually in the form of hydrogen sulfide) needs more processing steps to make fuel.

The process of turning crude oil into the many different petroleum products used in our society is called refining. Refineries are industrial sites where many different processes are used to separate out individual hydrocarbons or groups of hydrocarbons. The world’s largest refinery, Paranaguá, is operated by the Venezuelan national oil company Petreleos de Venezuala, S. A. (Pedevesa). Actually a complex of three refineries, Paraguaná can process almost a million (940 thousand) barrels of crude per day (a barrel is 42 US gallons, about 1.6 cubic meters). The largest refinery in the USA is ExxonMobil’s complex in Baytown, Texas, which has a maximum capacity of 570 thousand barrels/day. Refineries usually cover large land areas, often several square miles. Most refineries are in or near areas where oil is produced, although many near the Gulf Coast of the United States process crude oil shipped in tankers from overseas. Refinery complexes are notable for their enormous, tangled masses of pipes of many sizes that come together to create towers and other strange arrays; for having few buildings for their large footprint; and for often having an open flame, or “flare,” atop one or several towers. In addition to separating out the various hydrocarbons, refineries also remove other impurities from the oil.

Many processes are used to separate the different hydrocarbon molecules from each other. An atmospheric distillation unit simply allows molecules of gas (methane, for instance) to bubble out of the oil; the gaseous portions are siphoned off at this point. Some of the gas may be flared (burned), but this product is commonly piped elsewhere in the refinery complex to be used as fuel for later steps. The liquid portion continues into giant furnaces, where batches of crude are heated. Different liquid hydrocarbons boil at different temperatures, which allows them to be separated from one another by fractional distillation: the boiling crude feeds into tall distillation columns, and light hydrocarbons like butane and propane reach the very top of the column and leave by piping there. The hydrocarbons in gasoline leave the tower lower down; followed by kerosene (principal component of aviation fuel), diesel, and heating oil. The processing is much more complex than this, of course, and even the simplest refining will involve multiple stages of fractional distillation.

Leftover heavy hydrocarbons are also processed further. The lightest remaining fraction can be turned into lubricating oil, such as that in your car’s crankcase, but most of the remaining portion of the crude oil consists of heavy molecules – those with small amounts of hydrogen, which burn poorly and aren’t suitable for fuel. Some of what remains is only suitable for making asphalt and paraffin, but a modern refinery is like a meat-packing plant that “uses everything but the squeal.” Better living through chemistry means that refineries employ several different techniques to “crack” a single heavy hydrocarbon molecule into two or more lighter molecules. These processes require more time and more energy than the first, simple distillation process, and most also require the use of catalysts – substances that speed up chemical reactions. The cracking process can turn heavy hydrocarbons into gasoline or kerosene, even propane. For those crude oils that don’t have large amounts of the lighter hydrocarbons, hydrocracking and catalytic cracking are important in producing the light fractions that can be used to make fuels. Cracking heavy hydrocarbons to make gasoline requires more time and energy than distillation, and also requires the introduction of catalysts. All three factors add to the expense of refining heavy crudes, which explains why light crude has a higher price on the commodities market.

In addition to passing through multiple separation processes and perhaps cracking as well, every drop of crude that enters a refinery also passes through several steps intended to remove metallic and non-metallic impurities. These may be as simple as salt, which comes from water mixed in with the produced oil. Sulfur is a common contaminant, one that must be removed for clean-burning fuels – US refineries generate tens of thousands of tons of sulfur every day. Metal impurities such as nickel, iron, and copper are also removed, though in much smaller quantities than sulfur.

In what seems like a violation of the law of conservation of mass, a forty-two-gallon barrel of oil usually yields fuels, lubricants, and other hydrocarbons that add up to a little less than forty-three gallons of product. The “excess” is a result of the cracking process, which transforms dense molecules into light, less dense hydrocarbons. Even though refineries seem to put out more than they take in, in truth efining crude oil into gasoline is an expensive process, in part because of the large capital investment needed to build a refinery. Energy costs are also substantial, though at least a portion of the energy is generated through combustion of “waste” gases at most sites. Additives such as catalysts are also part of the costs, as is labor and maintenance of tens of thousands of pipes, vessels, towers, and other containers that must be carefully monitored. All told, crude oil’s visit to a refinery adds anywhere from twenty to thirty cents to the price of a gallon of gasoline in the US, according to the United States Energy Information Agency.

This is number five of a series of minilectures on the oil industry:

1) Where Does Oil Come From?
2) Where Do Oil Companies Find Oil?
3) How Do Oil Companies Find Oil?
4) The Economics of Petroleum Exploration and Production
5) Refining  <== You are here.  Future installments include:
6) The Economics of Big Oil
7) The Future of Oil