From production to consumptionConsider the three-month average price of a barrel of West Texas Intermediate crude. Through the end of May, it was $106.52. Given that 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 into June as WTI surged to $120.64 a barrel, or an implied price of $2.87 a gallon. When the national average price of gas reached $4.95 per gallon by June 8, the spread increased to $2.08 a gallon—an outsized increase. A big contributor to the surging price of gas is the near-doubling in the cost for 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 has an effect on the cost of goods and services downstream in the economy.
A global market for fossil fuelsThe 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 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 prices of gasoline. 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.
Price markupsThe 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 a gallon, and retail markups increased from 50 cents to 85 cents over the same 25 years—hardly the stuff of price gouging.
The cost of drilling a new wellWith 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.
The price of WTI has dropped to $40 a barrel twice in the past six years, making investors wary.
A two-pronged approachIf 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 sources of energy will only increase. This is one reason why accusations of price gouging in the energy market ring hollow.