The Wacky World of Oil: Why Gasoline Will Hit $4.00 a Gallon this Summer.

The price of gasoline is the sum of 5 items: crude oil cost, refinery costs, dealer & transport costs, taxes, and profit margin.

Artificial shortages in crude oil and refinery capacity coupled with soaring demand for gasoline in China and India and the rest of the developing world have created a tight supply situation with very little reserve “cushion.”

Under these conditions, the phenomena of marginal pricing and supply kicks in. A tiny decrease in supply, perhaps a fraction of 1%, can cause the selling price to shoot up by 5 to 10% or more. Likewise, a slight increase in supply can quickly deflate the gasoline price balloon.

Dealer and Transport costs inside the United States directly contribute to the overall high price of gasoline.

In a competitive market, dealer and transport costs (pipelines & trucks) adds under 9% to the overall costs. This includes the station’s overheads & profits, along with payroll and property taxes.

Throughout the USA, the number of gasoline stations has been systematically cut in half since the 80’s. This cuts supply outlets and reduces retail outlet competition.

In California and elsewhere, states now require gasoline stations over a certain age to dig up and replace their worn out underground storage tanks and clean up these alleged “hazard pollution site” — whether they are leaking or not. Independent, privately-owned gasoline stations can’t afford the hundreds of thousands of dollars to comply, so they often close down.

The big chains — owned by the oil companies and refiners — wind up with an ever-growing market share of the local retail market. The business becomes vertically-integrated due to well-intentioned government mandates. This makes it easier for the market producers to set prices up and down the supply chain to the advantage of the supplier and the disadvantage of the consumer.

The result: gas prices go up.

Fortunately, car manufacturers are making both lighter and smarter cars which burn gasoline much more efficiently then they did in, say, 1974. Cars got 14.2 miles per gallon back then. They now get, on average, 27.5 mpg (not counting so-called light trucks, which lots of people still buy in the guise of SUVs).

So consumption for gasoline, per automobile, has actually been falling.

But when gas was way below $1 a gallon, Americans fell in love with SUV’s. And why not? They are safer, more flexible and can carry more stuff and kids. Every soccer mom knows this. This love-affair is still going on today. So for many suburban middle-class families with kids, the great gas squeeze is beginning to be felt.

But taxes — at every level — are the major component of gasoline.

All states tack on the standard Federal Excise Tax and a State Excise Tax, and many cities and counties throughout the USA add local sales, usage and consumption taxes. New York, California and a dozen other states add a sales tax to top it off.

That’s right, they tax the tax.

Add in the taxes on the oil drillers, the oil producers, the oil distributors, the oil refineries, the shipping companies, the trucking companies, the pipeline companies and the local gasoline stations, and perhaps 50% of the cost of our gasoline goes to the government.

Thus because of a combination of artificial shortages up and down the distribution pipeline, increasing domestic and foreign demand, and rising taxes, gasoline is set to hit $3.50-$4.00 a gallon this summer.

But we’re getting a deal in the US!

In England, petrol now costs $7.25 per US gallon. Over 75% of that is taxes.

We should be thankful.

Now for the good news.

Gasoline, in terms of buying power, really costs less now than it did in 1974. And it takes up less of the average American household budget.

Moreover, gasoline usage accounts for just about 17% of the energy consumed in the United States — and is falling.

Unlike the relatively free market in oil, the supply of greenbacks in the US is monopoly-controlled by the government. And under government control, things get interesting.

For example, the US government continues to print more money to pay its bills by inflating its way out of its debts. And the government gets to use the newly printed money first, when it has the biggest bang for the buck.

In the US, the Federal Reserve is our central bank. The Fed creates all our money, known by the quaint euphemism “reserves”, out of paper and ink and the “full faith and credit” of the US Government. Over the past several years, the Fed has been working day and night with gusto to increase these “reserves”

Since 1973, the dollar has dropped in value by 78%. A gallon of gasoline that costs $3.00 today would have only cost 65¢ then. Perhaps it seems painful because our short-term memories are too good.

But the free market assumes that numbers don’t lie. Ask most Americans whether they live in a free-market country and they’d say, sure.

They’d be wrong.

Inflation is reported as running at under 3% in 2007. Unfortunately, the figures were jimmied a few years back to re-write the formula on how inflation is calculated. Official figures say inflation was 3.2% in 2006 — not counting energy & food.

Other people, however, argue that the real figures may be closer to 7%, depending on whether you count “core” energy prices and who you are and where you live. For the average middle-class commuter suburban family with school-aged children prices certainly feel higher, in spite of the Wal-Mart Effect — buying shiploads of aggressively-cheap merchandise from China.

So lots of made-in-America things and services really are getting more expensive — at least when you price them in ever-weakening dollars. You were right all along. (see:

The Real Solution to Cheaper Gas: Increase the supply and cut the demand.

The real solution is straight forward.

1) Drill for more crude oil in America. There’s lots there. On the land and in the waters. (The Russians even think that oil’s being recreated every day deep down in the earth’s crust, and not the result of 200 million year old decaying fossils. But that’s another story).

2) Build more new and efficient refineries throughout the country. Stop importing refined petroleum products.

3) Open up more independent gas stations to compete at the retail level.

4) Cut the taxes at all levels, both corporate and excise. Corporate tax is just a pass-through to the consumer anyway (tax to a company is just another expense to add to their costs; the companies simply raise their selling prices to pay for the taxes).

5) Encourage more companies to enter the oil business as new competitors.

6) Get the government out of the business of over-regulating the marketplace.

7) Create more fuel-efficient and hybrid-energy cars.

8) Establish cheap alternative-energy sources to ease the burden on petroleum product consumption. Electricity generated by state-of-the-art nuclear and clean-burning coal plants comes to mind.

What are the chances of this happening?

Today, quite low. But it ultimately depends on how squeezed the average driver feels. Right now, the pain is not too great and the tradeoffs may not appear so good (will our current amazingly-good US air quality deteriorate?) Ask the question again if and when oil hits $10 a gallon.

Proper implementation of the 8-point strategy could see the 2015 price of gas once again fall below $1 per gallon. But even though cheap energy, driven by oil, helped built the American economic empire of the 20th century, whether this will continue to be perceived as good public policy in the future is unknown.

And what about the stock market? How can the market continue to boom when gas is going through the roof?

Will we see the DJIA crack 15,000 before the election — or crash and burn below 10,000?

Ronald Reagan once said that an economist is someone who sees something work in practice and wonders whether it will work in theory.