Oil Prices Fell, So Why Don’t Pump Prices?
The article explains the asymmetry of crude oil and retail gasoline price spikes.
High pump prices are a hot-button topic for consumers, politicians, and the energy industry. Russia’s invasion of Ukraine and the ensuing spike in crude oil prices pushed national average gasoline prices to record levels on a nominal basis. Oil prices reversed course later in March, but gasoline prices remained sticky, declining at a much slower pace.
This discrepancy resulted in questions from the public and their elected officials about possible price gouging and market manipulation, but there are less nefarious reasons that explain the asymmetry of oil and retail gasoline price spikes. In the energy economics world, this phenomenon is known as “rockets and feathers,” where it is commonly observed that prices at the pump shoot up with oil prices like rocket but fall like a feather back to the ground after oil prices drop.
There are two reasons for this scenario repeating itself during oil price spikes: the macro-level logistics of how oil and refined products churn through the physical market, and the micro-level economic decisions of service station owners and their customers. There are also regional differences in retail gasoline prices that are sometimes obfuscated by looking only at national averages.
There Is Always a Lag
The first-order effect of a spike in the price of oil and what we pay at the pump is a logistical one. The process of oil being acquired, refined, transported, and distributed to local retailers takes time, and it starts with oil that was purchased at oftentimes a different cost than the WTI futures price that everyone sees in the news.
The underground tanks at local retailers are refilled every few days or possibly throughout the day depending on how busy the location is. Each truckload of fuel is acquired at a price that depends on area wholesale prices which are set at more than 400 distribution centers. The retailer then sells fuel with these wholesale price dynamics and other factors in mind (more on that later). In the end, while consumers may see WTI prices fell by a large amount one day and expect that to be reflected at the pump immediately, the logistics of gasoline markets make this virtually impossible at most retail locations.
Service Stations Make Less Money as Prices Surge
Selling gasoline is a low-margin stream of income for service stations and convenience stores. Most businesses make more money selling snacks, food, and drinks than they do on fuel sales. According to the National Association of Convenience Stores, a retailer will, on average, price a gallon of gasoline at a $0.30 markup from local wholesale prices. That margin goes toward their rent, fuel delivery charges, credit card fees, and other operating expenses. In the end, a $0.10 per-gallon profit is what most store owners are looking at on average over the course of a year.
Obviously, operating costs, namely rent, can vary tremendously depending on location, which is a major reason you see such a discrepancy in pricing across different neighborhoods of the same urban area. And delivery costs, with a national shortage of commercial truck drivers and rising diesel prices, have surged even more than gasoline since the start of the year and make pump prices higher at locations farther from distribution centers. With it being so difficult to turn a profit in this industry, most integrated oil companies have exited the sector over the past 30 years, with less than 1% of retail locations now owned by companies that also produce oil.
It’s also important to note service stations price their gasoline for its “replacement cost”—what they anticipate it will cost to bring in the next delivery of fuel. In an environment of rising prices, sometimes this can cause retailers to hike prices at the first sign of higher oil prices. But more often than not, in highly competitive neighborhoods retailers tend to stall their price hike for fear of losing customers to other stores during the run-up.
And that is indeed what appeared to happen in late February and early March. When looking at NYMEX RBOB gasoline as a proxy for wholesale gasoline nationally, historically there is an $0.80 to $1.00 spread between it and average national retail prices. This spread is dictated by federal and state sales taxes and the retail markup for aforementioned reasons. Again, this is a rough proxy for service station margin since NYMEX gasoline can be priced differently than the hundreds of rack prices around the country. But the recent price action demonstrated that the spread between RBOB and retail gasoline collapsed after Russia’s invasion of Ukraine. It rebounded and shot past the usual $1.00 upper end of the historical margin a few days later and has remained volatile since then.
This pattern suggests there is a strong likelihood that many retailers were not raising prices fast enough given the velocity of the price increases for oil and wholesale gasoline. A $0.10 profit for each gallon can evaporate quickly under such volatile conditions. Retailers saw rapid margin compression or may have even lost money in the initial price spike, but compensate for it by lowering their prices slowly relative to crude oil and wholesale gasoline prices. Indeed, service stations tend to make more money as gasoline prices fall or when they are low than when they are high and rising. Put another way, consumers might not pay for the true cost of gasoline on the way up but make up for it on the way down.
Market Volatility Can Create Additional Premium at the Retail Level
There are other key reasons retailers lower their prices slowly relative to oil and wholesale fuel prices. Due to the volatility witnessed over the past several weeks, and the fact that retailers set prices based on replacement cost, many station owners are hesitant to drop their prices quickly given the possibility the price of crude and the next batch of fuel could surge higher the very next day. Additionally, consumers are prone to put more effort into finding lower pump prices as they rise than they do when they fall, which hands pricing power to fuel retailers.
This behavior is not unique to the present situation. It has been observed practically every time there is a spike in crude and product prices. Extensive work by the Federal Trade Commission and the Federal Reserve Bank of St. Louis document previous episodes of the “rockets and feathers” phenomenon well before what has happened in 2022.
Retail Price Trends Can Vary by Region
However, there are variances across different major cities in how retail gasoline prices have evolved since February. In Dallas, retail prices nearly returned to pre-invasion levels like oil prices did by mid-April. But in Phoenix, prices remained close to peak levels for several weeks. This is primarily the result of different wholesale gasoline prices in different regions. Changes in wholesale gasoline prices can differ from what is seen in oil or even RBOB gasoline due to regional refining conditions, input costs, and inventories. In Phoenix, which is served primarily by refineries in southern California, an unplanned refinery outage in early March restricted supply to the region and kept wholesale prices elevated for the rest of the month. These examples demonstrate why it is difficult to look solely at national average retail pricing and benchmark oil prices and draw too many conclusions.
Additionally, as is the case every year, by 1 May all refineries are required to produce “summer blend” gasoline, which contributes less ozone pollution but costs more. Summer fuels have already entered many areas as of this writing in late April. So even if oil prices remain steady between now and then, there will be upward price pressure at the retail level due to downstream issues.
In conclusion, It’s Complicated
Because several entities, transactions, regulations, and economic decisions are involved between when a barrel of oil is produced and when it arrives in the form of gasoline in your fuel tank, there is not a simple, clear-cut answer to the question many are asking: “Why are gasoline prices up while oil prices are down?” However, the answer is not retailers gouging customers or oil companies profiteering from global conflict.
If anything, the fact that oil prices fell at one point to pre-war levels while gasoline did not demonstrates how the gasoline situation in the US is a lot more complex than just oil supply and pricing, and has little to do with companies that only produce oil. The supply and demand of refined products, how they are moved across the country, and the decisions of thousands of independent gasoline retailers and consumers are what influence retail prices. While the fact that oil prices fall faster than retail gasoline prices can be frustrating, this is simply how a properly functioning market operates.
[The article was sourced from the author by TWA Editor-in-Chief Thomas Shattuck.]