Flashback: Thinking about $4 per gallon gas …

Since gas prices are on many people’s minds these days, I pulled the following post out of the archives.  Originally posted August 22, 2008, it’s strikingly current today.

* * * * *.

Most folks wonder why the pump price of gas is surging this year.

I ask a different question: why didn’t the oil companies — branded by most folks as evil profit grubbers — push the price up into the $4 /gallon range a year or two ago?

In my pricing course, I harp on a basic point: marketers should be respectful of costs (i.e. never sell stuff below “fully-loaded cost” plus an acceptable profit), but they MUST price to the market. That is, they should determine the price that the market will bear, and then adjust accordingly to maximize profits — taking into account downward sloping demand curves and volume-related cost functions.

It’s starting to look like $4 per gallon gasoline is about what the market will bear. That’s the price point where folks started to cutback in gas consumption the past couple of months.

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Question: Why did the oil companies wait for the cost of crude to push up gas prices? To me, it seems that the oil companies have actually showed restraint over the past couple of years.

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Here’s a crude analysis (pun intended):

Simply divide the price of a barrel of crude over the past couple of years by 42 (since the are 42 gallons per barrel), and compare the result to the retail price of gasoline (which is usually expressed per gallon).

The difference — gasoline’s “back of the envelope” mark-up over crude prices — is plotted below.

Note that for the past 9 months, or so, the crude mark-up been about $1 per gallon — at the low end of the historical range.


* * * * *

Since the cost of a barrel of crude has skyrocketed over the past couple of years, the percentage mark-up has trended down. Hmmm.


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Bottom Line:

It certainly looks like the oil companies price gasoline using some sort of “cost plus” formula.

I think the oil companies left a lot of profits on the table during the past couple of years — the retail gas market would probably have borne higher prices.

Now, I’m betting that retail gases will be “sticky” — there will be a “ratchet effect” and gas prices will come down proportionately slower than crude oil prices.

And, I predict that if the oil companies get hit with a windfall profits tax, they’ll just pass the tax along into retail gas prices. Just watch.

* * * * *

Analytical note:

The “real” calculations re: the economics of converting crude oil into gasoline are way more complicated than the above simple analysis (e.g. only about 1/2 of a barrel of crude is made into gasoline, there are refining and distribution costs, the 1/2 barrel that doesn’t go into gas earns other profits).

My bet: the conclusions drawn from a more precise analysis would be directionally the same, and probably pretty close to the $1 per gallon — which has a certain memorable ring to it.

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One Response to “Flashback: Thinking about $4 per gallon gas …”

  1. Claudia Girrbach Says:

    This an insightful way to analyze the price of gas. An hypothesis as to why the suppliers are raising prices now? Are they making a statement, influencing? Claudia Girrbach

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