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Wednesday, May 4, 2011

Why Does My Gasoline Cost So Much

“To act on the belief that we possess the knowledge and the power which enable us to shape the processes of society entirely to our liking, knowledge which in fact we do not possess, is likely to make us do much harm.” — Friedrich August von Hayek

Everybody is asking that question these days. The average nationwide price for all grades this week is $3.96/gallon; Californians are paying on average $4.26, the highest in the nation.

Why does it cost so much, especially considering that the price was below $2.00/gallon just within the last couple of years?

Nearly seventy percent of the price of a gallon of retail gasoline is the price of the crude oil it is refined from. Two graphs from the Energy Information Administration (EIA) make that point. The first shows the price of a gallon of gasoline (left axis) plotted against the price of a gallon of crude oil (right axis). The two move in virtual lock-step; if you know the crude oil price per gallon, add $1.00 and you’ll know the price of gasoline within a few cents. (At $111 per 42-gallon barrel, the per-gallon price of crude is $2.64; add a buck, and you get a gasoline price around $3.64.)



Nationwide, the average of state and federal taxes embedded into the price of a gallon of gasoline is 43 cents. We usually think of taxes the other way around, as with sales taxes. If you look at it that way, the effective “sales tax” on gasoline is 13.6%.

But as the next graphic shows, tax burdens vary greatly by state. Californians pay as much as they do at the pump largely because of the difference in state taxes. On top of that, California and a few other jurisdictions levy their tax as a percentage of the sales price (exactly like a sales tax), so that the California state treasury benefits handsomely from a higher gasoline price. (That’s not true in most jurisdictions, where the state tax is a fixed rate per gallon. Also, the tax burden shown in the graphic includes 18.4 cents per gallon in Federal taxes which apply to us all.)


Let’s take a mathematical look at California. You can get out your calculator and follow along.

  • Price of a 42 gallon barrel of oil (May 4, 2011) $111.04
  • Price per gallon $2.64
  • Add one dollar $3.64
  • Federal Tax $0.184
  • California State Tax $0.18.0
  • UST Tax $0.012
  • Federal, State and UST Tax (added at the pump) $0.376
  • Price before California sales tax $4.020
  • California & County tax at (7.5% and 1.25%) $0.352
  • Total price per gallon when you pump $4.372
  • Total tax at $111 per barrel $0.73*

*This tax will vary depending on the retail price of the fuel. The higher the price per barrel the more sales tax the State of California will collect. So the next time you drive down the road and see unfilled pot holes, raveling pavement, littered highways contact Jerry Brown and ask him what he is doing with the extra money.

Chances are the next network news report you see concerning high gasoline prices will come from one of the high-tax states on this map. (Note the map developed by the American Petroleum Institute (API) is based on oil at $105 per barrel)

That leaves about 53 cents per gallon of your retail price that go toward the “downstream” end of the business: refining and marketing. Whether or not that’s a fair price to pay for these services is probably a story for another diary (or another diarist!), but it would be fair to say that the financial returns in the downstream end of the energy business have not been consistently impressive.

$4.00 for a gallon seems expensive, relative to what we are accustomed to paying. But a fair economic analysis of the value of the product must include its utility. A gallon of gas can transport four or more people in relative comfort 20 or more miles, and they can go when and how they wish to go. What is the value of that?

From the perspective of a producer (the “upstream” of the business), it is difficult and expensive to replace a gallon of gasoline in inventory. The price should be high enough to discourage waste, and high enough to reflect the true replacement cost of the resource. Increasingly hostile government policies regarding domestic exploration only increase the cost and difficulty of replacing reserves. An administration which threatens higher taxes on exploration and development dampens drilling plans. Supply tightens, prices go up. The cycle continues.

One last point — even at $4.00, it is difficult to name a liquid product which is cheaper per unit volume than gasoline.

And according to Democrat from Texas Martin Frost, the four billion Obama’s been talking about hasn’t gone to the “big” oil companies since 1975.

Frost stated; “I’m concerned that he’s [the President] going to lose credibility on this oil and gas issue, because he’s not telling the truth, entirely..

What he is saying is that you need to eliminate four billion dollars worth of tax breaks for major oil companies because major oil companies have obscene profits. The problem with this is that one of the big tax breaks that he’s citing, percentage depletion, was repealed by congress in 1975, thirty-six years ago, as it affects major oil companies.

The only ones that get percentage depletion any more are domestic independents, who drill most of the wells in the United States and employ four million people.

Frost claims to be worried that if people find out “the president is not telling the truth about the depletion allowance, that it doesn’t go to the major oil companies, he’s going to have some additional problems in the polls.”

It may still be a good idea to simplify the tax code so that independents don’t have to hire tax experts to reduce their tax burden, but we do need to understand what the current effects are if we expect to make any positive changes. If we don’t know what we’re changing, we can’t expect good results.

This is part of why it’s important, when we talk about ending subsidies, or ending loopholes, or ending deductions, to reform the entire system. When we focus on one particular subsidy or deduction, we become susceptible to lobbyists, who will lobby to ensure that it’s the other guy’s subsidies and deductions that get cut. This naturally puts the bigger companies in the position of being able to hurt smaller companies who can’t afford as many lobbyists and lawyers. In this case, Obama has been convinced by someone that he needs to hurt “independent oil”, which will naturally benefit “big oil”.

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