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Understanding Gas Prices

Internal combustion engines move most things in our society. The price of gasoline can dictate everything from your weekly grocery budget to whether or not you can afford a trip to the beach. Have you ever wondered where gas comes from and why its price fluctuates so much? It’s an enormous topic that you could spend years studying, but here’s a primer that will help you get the gist of it.

Gasoline and Oil

Over the long term (10 or more years), changes in the price of crude oil foreshadow proportional changes in the price of gasoline with a very high degree of accuracy. For example, if the price of oil spikes, the price of gasoline will probably jump soon too. This is because gasoline is derived directly from crude oil in a process called “fractional distillation.” In fractional distillation, crude oil is heated at different temperatures, so that as each component vaporizes, it may be collected separately, in a pure form. For each 42-gallon barrel of crude oil, 19 gallons of gasoline can be collected. Because crude oil is an actively traded commodity, gas prices change constantly to ensure that suppliers will be able to replace what they sell.

The Price of Oil

Crude oil is one of the most useful and widely demanded commodities in the modern world. Naturally, it follows that at an international level, the business of oil production and distribution can get political pretty quickly. Trade agreements and cultural disagreements between countries can cause dramatic price movements.

One of the major determinants of the price of oil is production levels from the Organization of the Petroleum Exporting Countries (OPEC). Together, OPEC nations account for more than twice the oil production of either the United States or Russia, the next two largest producers. Historically, this has allowed OPEC to strongly influence (if not dictate) the price of oil by adjusting production targets. However, in recent years, alternative sources of oil, like shale, have loosened OPEC’s market control.

From Station to Station

You may have noticed that the price of gas varies from one city to the next ¾ or even from one mile of road to another. This is because gas stations are often owned and/or operated independently and are able to set prices as they please. There are many factors that affect an individual station’s pricing strategy, but the main drive is the overall profit of the station. Convenience products sold inside the station generally yield a much higher margin than gasoline, so gas prices are set lower than the nearby competition in order to attract more business. However, prices set too low may cause a serious loss if the supply price spikes. In general, the idea is to set the price as high as possible while keeping it lower than “the other guy.”

You may wonder, “If stations are owned independently, then why do I see the same handful of gasoline brands everywhere I go?” The answer is that, while stations are independently owned and/or operated, they frequently sign exclusive, multiyear supply contracts with a particular brand. In return, a station generally receives marketing help, property improvements, and an assured supply in times of shortage.

Can You Hedge Against the Price of Gas?

Major industries use financial instruments like RBOB gasoline futures to “lock-in” their gasoline expense for the year and protect their balance sheets from dramatic swings in price. Unfortunately for an individual consumer, a single standard contract is for 42,000 gallons¾a lot more than your household will consume in a year. There are some hedging options for retail-level consumers, like buying shares in a gasoline ETF, but doing so will tie up money you could keep in better investments. Your best bet to protect against changing gasoline prices is probably to just budget for the worst-case scenario and hope for the best.

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