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Back in November, I published an article entitled "How Oil Really Gets Priced" here on Seeking Alpha. I immediately received at least a dozen requests to see a similar article on how the price of gasoline was derived. Still more peppered me with gas-related questions.

Did speculation play as large of a role as certain politicians claimed in the 2007-2009 run-up in gas prices, or was criticizing speculators just another opportunity for Washington to slam Wall Street? Does the price of crude oil influence the price of gasoline as much as the media would have you believe, or is it the other way around?

With national gasoline prices topping $3.75-$4 a gallon - historically a danger level for stocks - the question of how gas really gets priced becomes even more relevant. In today's article, we'll follow petroleum's journey from the wellhead to your wallet.

Infrastructure

Step 1 in the production and delivery of gasoline is the extraction of crude oil. Crude oil is then traded in a global market and transported by ocean tankers and pipelines to refineries. At the refinery, crude is converted (or "cracked") into gasoline and other petroleum products like asphalt, diesel fuel, jet fuel. (The profit margin that an oil refinery can expect to make by breaking crude's long-chain hydrocarbons into useful shorter-chain petroleum products is known as "the crack spread".)

Refiners then pipe the gasoline to distribution terminals located near major metropolitan areas. Pipelines are currently the safest, cheapest and most convenient method of transporting fuels. For every barrel of oil shipped 1,000 miles (1609.34 km), less than a teaspoon is lost from a pipeline.

Fig. 1: Industry Structure


(Click to enlarge)

Pipeline

In the pipeline, gasoline is a pure commodity in that the supplier is indistinguishable. Pipelines also batch their products to ensure that certain products do not mix together during transport. The liquid that forms between batches is known as "transmix."

Interstate pipelines deliver over 13.4 billion barrels of oil a year. Roughly 59% of the petroleum transported by pipelines is crude oil (7.1 billion barrels), the rest is in the form of refined petroleum products, like gasoline.

Fig. 2: Pipeline Product Batching


(Click to enlarge)

(Source: The Association of Oil Pipe Lines)

At the end of the pipe - known as the "terminus" - gasoline is stored in large holding tanks by the various wholesalers operating in the area. At that point, the major oil companies differentiate their gasoline with brand-specific additives.

Rack Price

The price of gasoline at the holding facilities is referred to as the "rack price." The gasoline is then shipped by tanker truck to individual retail outlets.

Fig. 3: Rack Prices - 5-year Interval, Omaha, 1982-2012


(Click to enlarge)

(Source: neo.nev.gov)

Some branded stations are company-operated, meaning that the refiner owns the retail outlet and sets retail prices. Speedway, owned by Marathon Petroleum (NYSE:MPC), is one such example.

Branded stations can be either lessee-dealer or a dealer-owned station. In the dealer-owned scenario, the retail outlet sets the final price, but still must buy the refiner's brand. The price of gasoline delivered to a station is referred to as the dealer tank wagon price.

Big Oil

Crude oil makes up the bulk of what we pay for a gallon of gasoline (see image below).

Fig. 4: Hidden Costs in a Gallon of Gas (by %)


(Click to enlarge)

When the price of crude oil increases, the tax burden decreases by %. When the price of crude oil falls, the tax burden increases by %. (Source: DoE)

However, Big Oil's profit margin isn't nearly as high as other industries. The oil and natural gas industry earned 7.5 cents for every dollar of sales in Q1 2012. The pharmaceutical, computer and the beverage and tobacco industries earned three times that and more.

Fig. 5: Oil & Natural Gas vs. Other Industries


(Click to enlarge)

Zone Pricing

Old fashioned capitalism is at least part of the reason behind your pain at the pump, particularly when we talk about zone pricing.

Zone pricing is the practice of refiners setting different wholesale prices for retail gasoline stations that operate in different geographic areas or zones. It has been a particularly contentious topic in the public policy debate for the past several years.

The Federal Trade Commission (FTC) has questioned the impact of these practices at least twice, in the 1998-2001 Western States Gasoline Pricing investigation and in the 1998-99 investigation of the Exxon/Mobil (NYSE:XOM) merger.

Refiners contend that they employ zone pricing to, as a Chevron (NYSE:CVX) (now ChevronTexaco) spokesman told an Arizona state lawmaker,

price our wholesale gasoline to our dealers at prices that will allow them to be competitive.

What's left unsaid is that in areas with fewer rivals, the refiners' wholesale prices to the station owners are higher.

From this observed correlation, state legislators and attorneys general have proposed legislation to ban zone pricing. Regulating the practice of zone pricing leads to its own difficulties, however.

If gas is priced independently of the region in which it is consumed, the result is increased consumption in those regions where gasoline is suddenly cheap, tightening supply and putting additional pressure on those regions that can least afford to bear it. For example, if gasoline in the Heartland were priced at par with metropolitan sprawls such as Los Angeles, the result would be a gradual rise in gas prices across the South and Midwest as L.A. drivers put their gas pedals to the floor.

Energy Expenditure

When it comes to the price of gas, things like average temperature, commuter distances and public infrastructure make far more difference than population density when it comes to the price of gas. In fact, rural areas (see figure below) are as likely as cities to have high energy costs.

Fig. 6: Average Energy Expenditure Per Person


(Click to enlarge)

State Taxes

But you may want to check your state taxes. Uncle Sam's federal excise tax on gasoline - 18.4 cents per gallon and 24.4 cents per gallon for diesel fuel - sounds pretty painful, until you consider state taxes. The following map is one of the best predictors of your local gas price burden relative to the rest of the nation.

Fig. 7: State Level Excise & Sales Taxes


(Click to enlarge)

New York has a higher population density and high taxes, but lower overall energy consumption because most walk or take the subway, making the commute from point A to B much less expensive. Nevertheless, taxes win out: As of this writing, New York's average unleaded prices are among the highest in the nation, at $3.94 a gallon. California state taxes are the highest in the Continental U.S.A., at $4.161/gal.

Here's a similar map indicating the states with the highest gasoline costs. Notice how closely it resembles the map in Figure 7 above. The darker the shade of blue, the higher the price of gas and vice-versa.

Fig. 8: U.S. States By Gasoline Prices.

One fact that most governors and state legislatures would like voters to forget is that a large share of consumers' pain at the pump comes from right at home through state excise taxes and local sales taxes, rather than Washington D.C.

Where Do the State/Local Taxes Go?

Where does this tax money go? On average, 25% goes to the public school system, while the rest goes to the Federal Highway Administration (FHA) that uses a complex series of calculations to allocate funds to the states to build and repair highways, including the interstate highway system, and for other transportation projects.

Caveat: Motorists in half of the states, including Texas, pay more taxes into the fund than their state receives back in federal apportionment. (The rest is either redistributed or pocketed by Uncle Sam.)

Even if you're one of the lucky 50% that do get their money back in government services, don't expect the state to spend it all on roads and construction. Many, if not most, elected state politicians raid the state's Highway Trust Fund whenever the state's General Fund runs low.

Divorcement

Arguably as much damage is inflicted on the U.S. consumer, thanks to state-level legislation as through state taxes. This primary regulatory issue is known within the industry as "divorcement," the legal restriction that refiners and retailers cannot be vertically integrated, i.e., refiners cannot own and operate retail gasoline stations.

Essentially, divorcement imposes double markups and hence higher retail prices. Whereas a vertically integrated refiner/retailer would mean only one markup, divorcement guarantees two: one for the refiner, and one for the independent retail station.

Speculation

Deriving the influence of speculation on the price of oil, and therefore, gas, is a relatively simple exercise. In June, 2011, Robert Pollin and James Heintz of the Political Economy Research Institute University of Massachusetts convincingly demonstrated the existence of the speculative premium (PDF) by applying the Hodrick-Prescott filter, a standard statistical technique used to back out cyclical components from raw data, to long run oil prices. The trend estimate was then validated by comparing it with the figure produced by the EIA:

By definition, this long-run trend figure will automatically take account of all the long-term factors influencing global oil prices, including 1) the production of oil; 2) refining, transportation and marketing conditions; and 3) changes in global demand. That is, the long-run price trend automatically incorporates all of the factors affecting oil prices other than short-term speculation.

Indeed, our method does also take account of increases in the speculative trading of oil, but only the long-run expansion of the speculative market, not the market's short-term ups and downs.

(Source: How Wall Street Speculation is Driving Up Gasoline Prices Today, Pollin & Heinz, 2011.)

The results are given in Figure 9 below.

Fig. 9: Prices of retail gasoline and spot prices of crude oil, 2000-2011


(Click to enlarge)

It's difficult not to draw the conclusion that speculators are a benign factor or that 2008 wasn't an oil "bubble" in every sense of the term when you compare this chart with the net long position of managed money traders below.

Fig. 10: Spot price of crude oil and net long position of managed money traders, 2006-2011


(Click to enlarge)

While the Saudis have been quite vocal about their objections to speculative premiums in the oil futures market in the past, the truth is that OPEC encourages such speculative endeavors as a matter of policy.

OPEC's Official Numbers: Garbage In

OPEC members' internal numbers are jealously guarded state secrets, which in turn allows OPEC to inhibit true price discovery based upon an objective examination of proven reserves. If we were to believe OPEC's official numbers (see below), no one alive today will live to see Peak Oil.

Fig. 11: Ratio of barrels of proven reserves to barrels of annual consumption, 1980-2009


(Click to enlarge)

If only we could believe OPEC. Unfortunately, OPEC takes this option off the table by routinely fudging its numbers. Naturally, where solid figures are absent, traders are free to speculate.

And they do.

Station Markup

While some consumers blame high prices on station markup, service stations usually add on only a few cents per gallon. But just because Stations don't charge a high premium over cost doesn't mean they don't get a big fat rake-off from time to time. Hence, the phenomena known as "rockets and feathers."

Rockets And Feathers

Why do gas prices seem to rise faster than they fall?

Falling expectations.

Gas stations don't make the bulk of their profit off of the gas itself. Just as the summer blockbuster playing at your local movie theater is really just a carrot to lure moviegoers into buying a $10 tub of popcorn, gasoline is the carrot that draws busy motorists in to buy a Coca-Cola, beer, cigarettes and chips at wildly inflated prices.

Gas station owner/operators are therefore incentivized to pass on price hikes without too much delay to the customer. The stations can't raise prices too much, though, because consumers tend to comparison shop bargains down to the penny when oil prices are on the rise.

During such episodes, refiners and station owners are often accused of "price gouging," exercising market power, or engaging in collusion.

There are also a much simpler explanation: Busy gas stations take delivery daily, and are therefore very much inclined to squeeze drivers today in order to cover the rising costs of tomorrow's shipment. When oil prices fall, drivers become less invested in bargain hunting.

Fig. 12: Monthly Avg. Retail U.S. Gas Prices 2008-2012


(Click to enlarge)

This phenomena provides a financial incentive for the station owners to lower prices in gradual increments rather than mark to market. Why should gas stations race to the bottom if they can keep drivers happy by knocking just a few cents off yesterday's price?

While this asymmetry may be relatively short-lived, it's also quite profitable while it lasts, which is why gas prices "go up like a rocket and come down like a feather."

As more and more localities place constraints on gasoline blends and restrict the supply chain, such episodes are likely to occur with increasing frequency.

Gasoline Market Islands

In some areas, gasoline was required to meet higher environmental standards in order to reduce the amount of smog created by burning gasoline. Producing this cleaner-burning gasoline caused problems in refining, distribution and storage, which increases the cost of gas. The result? Gasoline market islands.

California, Chicago and Milwaukee are all examples of gasoline-market islands. The clean-burning requirements in each of these areas are unique to that individual area: Heavy demand, supply problem at a refinery, or pipeline problems can cause pricing in these areas to surge, as only a few refineries have the capability to produce these specialized products, the ability to re-route shipments to these areas is limited.

California's distance from the refineries located near the Gulf of Mexico can also add to the cost of gasoline if it chooses to obtain gas supplies from those refineries.

Ethanol

While the rationale for ethanol production in the U.S. is that shifting away from petroleum imports results in increased energy security, the reality is that ethanol has become big business. Today, the U.S. is the world's #1 supplier of ethanol, with 40% of U.S. corn stocks dedicated to its production.

One of the problems with ethanol is that it has a lower energy content than gasoline. In 2011, the 133.93 billion gallons of gasoline (3.19 billion barrels) consumed in the United States contained about 12.87 billion gallons of ethanol, accounting for 9% of the total volume of gasoline consumed.

Ethanol's reduced "punch" per gallon is the reason why the de facto fuel economy of American cars has lagged the EIA's de jure estimates in the past. When ethanol production falls, the price of complying with the ethanol mandate can rise very quickly.

The cost-of-compliance with the federal ethanol blending standards has risen more than 1,000% in the past few months, as the price of "vintage" ethanol credits - known as RINs - has skyrocketed from around 20 cents in January to $1.05/$1.13 in March, as rising corn prices and decreased production has led to a shortfall in ethanol supplies.

While these costs aren't currently being passed onto the consumer, they will be if refinery margins continue to take a hit. In March 2009 Growth Energy, a lobbying group for the ethanol industry, formally requested the EPA to allow the ethanol content in gasoline to be increased to 15 percent.

Maritime Laws

Section 27 of the Merchant Marine Act of 1920 (better known as The Jones Act) deals with cabotage (i.e., coastal shipping) and "requires that all goods transported by water between U.S. ports be carried in U.S. flag ships, constructed in the United States, owned by U.S. citizens, and crewed by U.S. citizens and U.S. permanent residents."

This protectionist measure has resulted in a number of anomalies over the years - namely, it makes it cheaper to transport gasoline by tanker from S. America, Europe, or even Asia to the Boston than transporting it from Oklahoma-Texas-Boston.

The Jones Act was responsible for a number of shortages before the multinational shipping industry succeeded in watering it down. At present, there are only 9 American-owned large tankers available for transporting petroleum products.

Conclusion

U.S. shale oil concerns like Marathon Oil (NYSE:MRO), Marathon Petroleum , Valero Energy (NYSE:VLO) and Holly Frontier (NYSE:HFC) are largely dependent upon the status quo - speculation, gasoline islands, state taxes, to maintain their profits. Understanding the pricing mechanism for gasoline, diesel, etc., not only aids in anticipating the impact of rising and falling prices and federal policy shifts on such investments; it also helps insulate investors from the constant noise and misinformation of the 24/7 news cycle.

Disclaimer: This article provides opinions and information, but does not contain recommendations or personal investment advice to any specific person for any particular purpose. Do your own research or obtain suitable personal advice. You are responsible for your own investment decisions.

Source: How Gas Really Gets Priced