American consumers were confronted with the highest retail gas prices in history over the Memorial Day weekend as the national average for a gallon of regular reached $4.62 per gallon, according to AAA. While most of the reasons are well known, fuel price spikes are painful for households and inevitably give rise to a persistent but false belief that big oil companies are somehow manipulating prices at the pump. The reality is that numerous market factors determine prices, none of which involve a conspiracy to gouge consumers.
To begin, let's examine the structure of the U.S. motor fuel industry. While a small number of large companies dominate, there are 9,000 independent oil producers in the United States, each of which, including the majors, sells crude oil into a global market at the prevailing price. There are also 145,000 gas stations in the country that independently set pump prices based on the wholesale cost of gasoline plus local competitive factors. Only 1% of all gas stations are owned by oil producers; most are independent businesses operating under a licensing agreement.
The largest factor in determining fuel prices is the cost of crude oil. Oil makes up 59% of the U.S. pump price, the rest being taxes, refining and distribution costs, and retailer profits. Over the long run, say one year or more, retail fuel prices move consistently with fluctuations in crude oil. In fact, as shown in the accompanying chart, gas moves in concert with oil but not as much in either direction. Over the past 10 years on average, a 10% rise in oil has produced about a 5% hike in gasoline. If oil companies had the ability to manipulate prices, they would have done a much better job.
In the short run, the correlations are less obvious. In fact, one factor that contributes to the misapprehension of price gouging is the well-documented tendency for gas prices to rise faster than they fall in relation to oil. Economists refer to this phenomenon as "asymmetric price adjustment" and attribute most of it to the behavior of drivers. When confronted with rapidly rising gas prices, consumers become more diligent in price shopping, increasing competition among stations and reducing the variation among retailers. The average price quickly adjusts upward to find equilibrium. Furthermore, drivers tend to refill more frequently to avoid expected increases, artificially increasing demand and driving prices even higher.
On the back side as oil prices fall, drivers are less incented to shop if they see a drop in price at the corner station, reducing competition as consumers leave money on the table. This increases variability among retailers and allows retail prices to retreat more slowly. The pattern is so well known that in 1991 economist R. W. Bacon dubbed it "rockets and feathers." Prices appear to rise like a rocket but descend like a feather. Over time, the correlation with crude prices inevitably returns.
Some in Congress are proposing legislation to address a non-existent issue. As with every cycle of energy price surges, some members point to surging profits of major oil companies as evidence that families are being deliberately squeezed. ExxonMobil, for example, reported record profits of $23 billion in 2021 and announced $10 billion in share buybacks. Critics fail to note Exxon's $22 billion loss in 2020 or how cyclical the oil industry has historically been. The company's earnings are a function of higher demand for oil resulting in more barrels sold, combined with higher prices yielding more dollars per barrel. By comparison, Apple's fiscal 2021 profit of $95 billion and its net profit margin three times larger than Exxon's has failed to produce demands for relief from smartphone price gouging. Economist Larry Summers, who served in senior posts during the Clinton and Obama Administrations, told Bloomberg that such legislation was "dangerous nonsense" and sardonically compared it to the 2020 discussion of injecting disinfectants to fight the COVID-19 virus.
One additional but entirely predictable factor is feeding consumers' suspicion: seasonal variation. Each year, refiners shut down in the spring to reformulate their gasoline to meet various states' environmental regulations. Summer blends must be less volatile to minimize evaporation and reduce tailpipe emissions in hot weather and are more costly. Notwithstanding the price of oil, fuel prices rise through spring until Memorial Day, stabilize during summer before peaking around Labor Day, then recede to previous levels in the fall. This summer reformulation coincides with the peak driving season. Meanwhile, damage to refineries from the hurricane season has not been fully repaired. And to top it off, several aging U.S. refineries were shuttered during COVID with no immediate replacement plans on the board.
It's easy to feel like we're being taken advantage of when prices rise. The facts say otherwise, although that may not help much while the gas pump is flowing.
Christopher A. Hopkins is a chartered financial analyst and co-founder of Apogee Wealth Partners.