The year 2004 has seen a steady climb in the price of gasoline. From January of 2004 to May of 2004 there has been a jump of approximately .50 cents a gallon (Energy Information Administration). For many Americans high gas prices have been a hot issue with them, and there seems to be no rhyme or reason to these fluctuations. With the continued popularity of the sport-utility vehicle and the high volume of gasoline it requires, the issue of high gas prices doesn’t seem to be going away anytime soon. Many factors go into determining the price of gasoline. This paper will explore the various factors involved to determine the price of gas and attempt to gain a better understanding on how it arrives at its decision.
The gasoline industry is an oligopoly. In Mark Hirschey’s book called Fundamentals of Managerial Economics an oligopoly is defined as, “A market structure characterized by few sellers and interdependent price/ output decisions”. This market structure only allows a few large rivals to produce the majority of the industry’s output (404). The oligopoly controlling the gasoline industry is the Organization of the Petroleum Exporting Countries (OPEC). OPEC consists of 11 oil producing countries: Iran, Iraq, Kuwait, Saudi Arabia, Venezuela, Qatar, Libya, United Arab Emirates, Algeria, and Nigeria (OPEC.org). These countries control gas prices by the amount of crude oil they produce. To gain a better understanding of how the United States gets its gasoline and who supplies it, we will have to take a closer look at the degree of competition.
Because of the nature of an oligopoly there is very little competition. The OPEC countries account for nearly 50% of the United States crude oil imports. The top three oil producing countries in thousand barrels per day are: Venezuela (1,372), Saudi Arabia (1,161), and Nigeria (1,044).According to OPEC’s website, WWW.OPEC.org, their principle aim is the, “Co-ordination and unification of petroleum policies of Member Countries and the determination of the best means for safeguarding their interests, individually and collectively. The Organization also seeks to devise ways and means of ensuring the stabilization of prices in international oil markets with a view to eliminating harmful and unnecessary fluctuations, due regard being given at all times to the interests of the producing nations and to the necessity of securing a steady income for them; an efficient, economic and regular supply of petroleum to consuming nations; and a fair return on their capital to those investing in the petroleum industry.”
The remaining 50% of imported crude oil comes from non OPEC countries. Of these countries the top three producers are: Canada (1,569), Mexico (1,565), and Angola (325). These statistics are according to The Energy Information Administration’s website. Taken from Table 49 Net Imports of Crude Oil and Petroleum Products into the United States by Country, April 2004.Although the United States is not currently importing a large amount of oil from Russia, Russia hopes to change that very soon. Russia is the world’s second largest exporter of oil however their customer base is mostly European. Russia has plans in the works to aggressively try to expand their market to the world’s largest energy importer, the United States. This understandably is a concern for OPEC.
Many projects are being planned. Some include an Artic oil terminal and pipelines to make the long journey to the United States. Four Russian companies have teamed up with a goal of a million-barrels-per-day terminal aimed almost exclusively for the United States. Julian Lee of the Centre for Global Energy Studies in London says, “There will be room in the U.S. for Russian oil, but it means the growth potential for OPEC is more limited than they’d like to believe”(www.bradynet.com). In addition to importing oil from OPEC and non OPEC countries, America is also capable of producing its own oil to supplement their needs.
It may surprise people that the United States is the world’s second largest producer of oil. It was estimated that in January of 2001 The United States produced about 181 millions barrels of crude oil. The largest producing state is Texas. Other major producers include Alaska, Louisiana, California, Oklahoma, and Arizona. It may further surprise people to learn that even with the high volume of oil production the United States is still very much dependent on foreign oil. It’s this dependency that caused hardships on this country during the oil embargo of 1973. In order to avoid such hardships in the future the federal government created the Strategic Petroleum Reserve (SPR). Most of the domestic oil is sent to the refineries but some of it is sent off to SPR (How Gas Prices Work). When gas prices begin to soar many Americans get angry and begin to question why don’t we tap into the SPR.
The Strategic Petroleum Reserve is the world’s largest stockpile of crude oil reserves. The federal government owns this oil reserve located in underground salt caverns along the coastline of the Gulf of Mexico. After the oil embargo of 1973-74 President Ford signed the Energy Policy and Conservation Act (EPCA) on December 22, 1975. This established an oil reserve up to a billion barrels of petroleum (www.fe.doe.gov). These oil reserves were continually added to until 1991.
On January 16, 1991 President George H.W.Bush ordered the first ever drawdown of the SPR. Prompted by Iraq’s invasion of Kuwait, this drawdown and an international supply response helped to stabilize the oil market. The original plan was to sell 33 million barrels of oil but the oil market soon stabilized, and only 17 million barrels were needed. The reserve was tapped into once again by President Clinton. On September 22, 2000 President Clinton authorized the Department of Energy to use up to 30 million barrels of oil to ensure that people will have affordable oil to heat their homes (www.fe.doe.gov).
These two drawdown directives by Presidents G.H.W.Bush and Bill Clinton were examples of how when Americans were hit with economic hard times, the president tapped into the SPR to help ease the cost of oil. On November 13, 2001 President George W. Bush ordered the SPR to be filled to its maximum capacity. The Strategic Petroleum Reserve’s maximum capacity is 700 million barrels of oil. As of July 2, 2004 it is about 95% full at 662 million barrels (www.fe.doe.gov). The 95% capacity is what many Americans feel frustrated about. The argument is, isn’t 95% full, full enough? Why not put those barrels of oil into the marketplace to help drive down the cost of gasoline? Especially now with the summer driving season here. In addition to many oil producing states, the United States has potential for even more oil production in The Artic National Wildlife Refuge in northern Alaska.
The Artic National Wildlife Refuge (ANWR) is a section of land in northern Alaska that was created in 1960. Its size is about 19 million acres or about the size of South Carolina. Within the ANWR is the 1002 Area. The 1002 Area is about 1.5 million acres of land. This area has a great potential for oil and gas discovery because it is an extension of already productive lands in Prudhoe Bay to the East and the Mackenzie Delta for the Canadians to the West. Congressional approval would be required to open up the lands for exploration and development.
The Department of Interior in 1987 recommended opening the area for exploration and development. In 1995 congress approved the 1002 area to be developed but it was later vetoed by the President (www.eia.doe.gov). Opponents to the development of the 1002 Area say it would destroy the ecosystem within the ANWR. No one knows for sure how much oil is under the ANWR but a study done by the United States Geological Survey suggests that there is about 7 billions barrels of oil in just the 1002 Area alone (How Gas Prices Work). It’s no wonder this was a political issue during the 2000 presidential election. It will be interesting to see if this topic resurfaces during the 2004 presidential debate. Now that the degree of competition is little better understood, a closer look at supply, demand, and elasticity is in order.
In his book Fundamentals of Managerial Economics author Mark Hirschey defines supply as the quantity of a good or service that producers are willing and able to sell during a certain period under a given set of conditions (110). There are many determinants that influence the supply of gasoline in the United States. Some of these are price, price of a related good, technology, weather and many more.
One major determinant of supply is the output of production by OPEC. In an article by AOL business news dated June 3rd, OPEC will increase output to two million barrels a day in order to ease the price of oil. Saudi Arabia which is OPEC’s largest producer was pushing for 2.5 million barrels daily immediately (OPEC Prepares Oil Deal to End $40 Crude Prices). Another determinant of supply that is closely tied in with output of production is price. The amount of crude oil these countries produce determines the price of a barrel of oil.
The prices of related goods also have a role in the supply of gasoline. Because there is more than one use for oil, companies will sometimes switch production from one product to another. In the autumn when heating oil rises the supply of gasoline normally declines. During the spring and summer months when heating oil prices decline, the supply of gasoline will increase (Hirschey). In 2000 President Clinton tapped into the SPR to ensure that people had affordable oil to heat their homes (How Gas Prices Work). The SPR is another determinant of supply that gets talked about when the price at the pump begins to rise.
The SPR is the largest stockpile of petroleum in the world. Hypothetically if the United States were to be cut off from its foreign oil imports the U.S. Strategic Petroleum Reserve holds about a 60 day supply of oil (How Gas Prices Work). Because many OPEC countries are located in the Middle East this can become another determinant to supply.
The Middle East has been a hot bed for conflict for many years. These conflicts can contribute to problems getting the normal output production. The concerns of political instability in Saudi Arabia were multiplied by a deadly attack by Islamic militants in the oil city of Khobar (OPEC Prepares Oil Deal to End $40 Crude Prices). With American troops fighting in Iraq for over a year now, efforts have been under way to get the Iraqi oil production running again. News reports regarding Iraqi oil can be heard almost daily on your nightly news. Just the reports of these conflicts can send the price of crude oil upwards. All the efforts to get the supply of oil to the United States are due to consumer demand.
Author Mark Hirschey defines demand as the quantity of a good or service that customers are willing and able to purchase during a specified period under a given set of economic conditions (103).There are a many determinants of demand. A couple of them are the summer driving season and the lack of refineries.
Probably the most common factor that most people think of when it comes to rising demand is the summer driving season. Most people with families travel during the summer when their children are out of school. Travel by car in the United States has become more popular since the terror attacks on September 11, 2001. With the popularity of the sport-utility vehicle these gas guzzlers push the demand even higher.
Even when OPEC produces its oil to maximum capacity the United States lacks refineries to refine the oil. Trent Lott represents Mississippi in the U.S. Senate. At the website truthnews.com he writes, “The Saudis blame America saying that even when Saudi Arabia produces the maximum amount of oil they can send here, America can’t refine it. I’m afraid they’re right. America hasn’t built a new refinery in about 20 years, severely limiting our ability to keep up with energy demand”.
In Mark Hirschey’s book Fundamentals of Managerial Economics he defines the price elasticity of demand as the responsiveness of the quantity demanded to changes in the price of the product, holding constant the values of all other variables in the demand function (138). Gasoline has a low price elasticity of demand. This is because gasoline is seen as a product of necessity. America is a country on the move. Sport-utility vehicles which consume a lot of gas are very popular. To further illustrate we are country on the move DVD players are being installed in some vehicles making that long drive a little more comfortable.
The pricing strategy used in the gasoline industry is mark-up pricing. Hirschey describes markup pricing as setting prices to cover direct costs plus a percentage profit contribution (456). Like any other consumer product there is a supply chain and groups that set the prices all of who get a percentage of the profits. At the website www.howstuffworks.com there is a pie diagram in the shape of a gas pump and it breaks down where your money goes: Crude oil-43%, refining costs and profits-13%, Distribution and Marketing costs and profits-13% and the second largest slice of the pie is taxes-31% (How Gas Prices Work).
Government regulation in the gasoline industry comes in the form of taxes. As illustrated above taxes account for 31% of the cost of gasoline. The federal government imposes a tax of 18.4 cents a gallon. In addition to a federal tax there is a state tax. Taxes vary from state to state. According to the website clevelandgasprices.com the Ohio tax is listed at 24 cents a gallon but has since gone up.
There are many factors that are involved when determining the price of gasoline. Because of the nature of an oligopoly OPEC tends to dominate the oil industry but the United States still has other sources for oil. Determinants of supply and demand will also be major factors when determining the price of gasoline. Government regulations in the form of taxes are not going away any time soon with a recent tax hike here in Ohio. In fact gas prices for the foreseeable future look to be high. With the fight against terrorism and instability in Iraq OPEC’s output seems to be on shaky ground as long as there is continued conflict in the Middle Eastern world.