The Real Economy

Is price gouging behind the rise in gas prices?

Jul 11, 2022
Economics The Real Economy Energy

Rising energy prices have stimulated a fierce debate around inflation and what is behind the surge in gas prices. Are companies taking advantage of a stressful time in the economy and raising prices more than they need to?

Accusations of price gouging and corporate greed now permeate the public discussion and are entering the debate about public policy. So what’s going on?

To start, it helps to understand what happens to a barrel of oil as it goes from the well to the consumer. There are many costs added along the way, from refining to retailing to federal, state and local taxes.

Breakdown of the cost of gasoline in selected periods

Breakdown of the cost of gasoline in selected periods
Breakdown of the cost of gasoline in selected periods

Such an analysis shows that the answer is more nuanced than notions of price gouging or corporate greed. Rather, the analysis shows that the primary cause of the price increases can be traced to the significant impact of Russia’s invasion of Ukraine on global energy markets and OPEC’s continuing influence over those markets.

In the end, the impact of these broad, global market forces far outweighs whatever influence retailers or refiners have on the prices that consumers pay at the pump.

From production to consumption

Consider the three-month average price of a barrel of West Texas Intermediate crude. Through the end of May, it was $106.52.

Given there are 42 gallons in a barrel of oil, that implies a price of $2.53 a gallon. But the average price per gallon of regular unleaded gasoline was $4.26 at the time. The $1.73 spread reflects refiner margins, retailer margins, federal taxes and varying state and local taxes.

Those prices continued to increase early into June as WTI surged to $120.64 a barrel or an implied price of $2.87 a gallon. When the national average gas price reached $4.95 per gallon by June 8, the spread increased to $2.08 a gallon—an outsized increase. And the volatility continued, as WTI prices dropped back to $105 in the last weeks of June.

A big contributor to the surging price of gas is the near-doubling in the cost of refining crude into gasoline. There were shortages at Gulf Coast refineries during the regular spring maintenance period, as well as outages in Europe. And the implementation of European Union sanctions against Russian oil helped push up the cost of crude as well.

All of this affects the cost of goods and services downstream in the economy.

A global market for fossil fuels

The price you pay for a gallon of gasoline at the pump is determined by the global market for crude oil. Using annual data—compiled by the U.S. Department of Energy from 1997 through 2022—we show a near-perfect correlation between the price of crude oil and both the wholesale and retail gasoline prices.

That means that if the supply of crude oil is less than the demand for fossil fuels, then the price of gasoline will rise. If there is a glut of crude, then the price of gasoline will fall accordingly.

And because crude oil is fungible for all practical purposes, the price of crude is arbitraged within a global market. That means that prices for West Texas Intermediate crude oil paid by refiners in Louisiana will depend on the supply of and demand for crude produced in the Middle East, Russia, Venezuela, as well as the Permian Basin.

Crude oil determines the price of gasoline*

Crude oil determines the price of gasoline
Crude oil determines the price of gasoline

Price markups

The intermediate markups imposed by refiners (which create the wholesale price of gas) and retailers have been increasing over time. That would be expected given the general trend of rising prices in a vibrant economy.

So while the price of crude on the global market has been volatile, the markups by wholesalers and retailers have been subdued by comparison. Wholesale markups increased from 25 cents per gallon to 50 cents per gallon, and retail markups increased from 50 cents to 85 cents over the same 25 years—hardly the stuff of price gouging.

Marking up the cost of gasoline, from the well to the pump

Marking up the cost of gasoline, from the well to the pump
Marking up the cost of gasoline, from the well to the pump

The cost of drilling a new well

With oil prices so high, why haven’t U.S. producers responded with significant investments in drilling new wells?

Estimates of the breakeven cost of drilling a new well in the Permian Basin are around $50 a barrel. The implication is that at current prices, producers could conceivably flood the U.S. market with barrels of crude to be refined at U.S. facilities and sold to American consumers. But that argument ignores two important factors.

First is the financial willingness to invest in a century-old industry. The price of WTI has dropped to $40 a barrel twice in the past six years, making investors understandably wary. Who would put money down on the chance those price drops won’t occur again?

The second factor is the market-based setting for the supply-side of the pricing equation. Let’s start with the lack of excess capacity among the world’s producers, most of whom are state actors. With the exceptions of Saudi Arabia and the United Arab Emirates, most producers are already at capacity. And Russian oil is being taken out of the picture, at least for the developed economies in the West.

The Saudis and the Russians are special cases. Keep in mind that the breakeven cost for existing wells in Saudi Arabia is estimated in the range of $25 per barrel or less. But keeping prices for crude above $50 per barrel would attract competition from non-OPEC producers.

In recent decades, it was in OPEC’s best interest to keep fossil fuel prices low enough to hold on to market share and keep U.S. consumers driving inefficient vehicles.

A two-pronged approach

If anything, the recent surge in gas prices reinforces the need for a two-pronged approach to domestic energy policy.

  • Don’t ignore fossil fuels: First, investment in the production of fossil fuels like natural gas, as well as oil, to bridge the long transition to renewable sources of energy will need to increase in the near term. Domestic refining capacity needs to expand as well.
  • Promote renewable energy: Second, the transition toward the development of alternative sources of energy needs to accelerate. As long as prices remain high, the incentive to invest in alternative energy sources will only increase. That is one reason why accusations of price gouging in the energy market ring hollow.

    Here’s another way to think of it: If an excessive concentration of power exists inside the energy industry, prices would have increased to these levels long ago.

Moreover, prices at these levels will create the conditions for a broader increase in the supply of alternative energy sources, which will bring down demand over the medium to long term.

Price competition is a precondition for a functioning market and an increase in choices to supply energy, whether the source is oil, natural gas, nuclear, electricity, solar, wind or geothermal. Let that competition begin.
Given geopolitical tensions in Eastern Europe, Asia and the Middle East, a rational energy policy that fosters alternative sources makes every bit of sense.

The takeaway

The U.S. economy, in nominal terms, generates $24.3 trillion annually. Energy is required to sustain the general level of welfare across the economy. We can walk and chew gum at the same time. Increasing the production of fossil fuels and accelerating the transition toward renewables are not mutually exclusive goals. Widening the supply of fuels that support the economy is both necessary and wise.

RSM contributors

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