Thursday, May 8, 2008

What Should Be The “Right Price” For A Gallon Of Gasoline In The U.S.?

With so many people now fixated on the ever rising price of oil, a good question to ask is what is the ‘right’, or fair, price of gasoline, given that supply remains the same. The reason for this analysis is due to so many pundits that publicly state that the price is too low or too high without really providing anything concrete. In other words, all those are speculations and guesses.

Oil closed today at $123.53 per barrel. So, how fair is the price of gasoline based on total cost to produce gasoline and other distillates?

Using the EIA (Energy Information Administration) gasoline components history, from 2000 to 1Q 2008, we can break down the gasoline prices into its major cost components:
We can then convert this into dollars and cents:

If we take the historic average cost of refining, distribution & marketing, and taxes, this comes to $0.95 per gallon (average of FY2007 is $1.18 per gallon). So, the remainder of the current average gas price of $3.61 per gallon and $0.95 per gallon cost of gasoline production should be attributable to the cost of oil.

Since a barrel of oil is $123.53 and it produces 19.6 gallons of gasoline from a total of 49 gallons of distillate from a barrel of crude, we can multiply the ratio of gasoline to total distillate production to the price of barrel of oil to get a good approximation of the cost component of gasoline. So, this comes out to $2.52 per gallon, approximately attributable to the price of oil (19.6 gal/49 gal per barrel x $123.53 per barrel /19.6 gal).

So, using the historic average cost of producing gasoline plus the cost of the oil comes to approximate average of $3.47 per gallon, leaving $0.14 per gallon as the additional cost from gasoline price speculation or excess profit.

Therefore, using this pretty rough calculation (all you math and engineering majors out there know what I mean by rough), the current price of gasoline in the U.S. is pretty much in line with the historic production cost factors. If everything else stays the same, every $1 change in the price of crude should result in approximately 2 cents change in the price of gasoline, excluding speculation, reformulation, and force majeure factors.

However, this does not mean that the price of gasoline will change as quickly as the spot price of oil. Due to time lag from the purchase of oil to refining and delivery of gasoline to your local station, the price of gasoline you pay is a blended value.

If the current projections of $150 to $200 per barrel of oil is to be believed, which I do not expect to occur until sometime around 2012, then the price of gasoline can go up an additional $0.53 to $1.53 per gallon, excluding mark up for speculation, which will always occur.

Ed Kim
Practical Risk Manager

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