These days it may be easier to predict with accuracy the weather for the next morning than the price of gasoline at the pumps.  Indeed, if the price at the pump drops evens a penny it's newsworthy, as gasoline prices hover around $3 per gallon in many places across the country. A Layman's Guide to Understanding Gasoline Prices

These days it may be easier to predict with accuracy the weather for the next morning than the price of gasoline at the pumps.  Indeed, if the price at the pump drops evens a penny it's newsworthy, as gasoline prices hover around $3 per gallon in many places across the country.

As lawmakers clamor to address rising gas prices, the average American wants help understanding how those prices are determined.

Recently Tom Tanton, Senior Fellow with the Institute for Energy Research, joined CFIF Corporate Counsel & Senior Vice President Renee Giachino to discuss gasoline prices.  What follows are excerpts from part one of the two-part interview conducted on "Your Turn – Meeting Nonsense with Common Sense" that airs on WEBY 1330 AM, Northwest Florida's Talk Radio.

GIACHINO:  Another hot issue in the news today has to do with energy.  Have you filled your car up at the gas pump lately?  Well I have and it was a painful experience.  I need some help understanding why gas prices are what they are.  I kind of understood the situation last fall after Katrina struck, but I don't now.

As ambitious as this sounds, I have invited our next guest on the program to educate us and help us better understand this issue and to offer a layman's guide to gasoline prices.  I'd like to welcome to "Your Turn" Tom Tanton who is a Senior Fellow with the Institute for Energy Research.  Mr. Tanton has over 35 years experience in the energy, economy and environmental fields.

Thank you for joining us this afternoon on "Your Turn."

TANTON:  Thank you for having me.

GIACHINO:  Could you please take a minute and tell us about the Institute for Energy Research?

TANTON:  The Institute for Energy Research does have a website that your listeners can access at www.energyrealism.org.  The Institute conducts historical research and evaluates public policies in oil, gas, coal and electricity markets.  We were founded in 1989 from a predecessor non-profit organization.  We are a 501(c)(3) non-profit and through publications, speeches and media attention we try to articulate free-market positions that respect private property rights and promote efficient outcomes for energy consumers and producers.  And we believe that the best solution to panic and anger in times such as this is through education.

GIACHINO:  Okay, that is what I am hoping you can do this afternoon is educate some of us, myself included.

Tom, what are the factors that make up the cost at the pump of a gallon of gas?

TANTON:  In simple terms, it is the cost of crude oil and lifting the crude oil out of the ground, moving the crude oil to refineries (which are very large and complex chemical factories, as it were), refining the crude oil into a multiplicity of products – it is not just gasoline or grades of gasoline and diesel.  Refineries actually make an astounding number of different products out of that barrel of crude.  Then taking the products – and in the case of today's crisis it is the gasoline and diesel fuel, and moving it to the distribution points which are the retail gasoline stations at which you fill up your automobile.  And finally, the cost of those retail stations makes up a part of it.  The majority of the cost of the gasoline that you buy today is made from the price of crude – lifting the crude from the ground, finding it and producing the crude oil.  That is about 50% of the cost that you experience at the pump.

GIACHINO:  So is that essentially how daily gasoline prices are set – the majority of it is set on the cost of obtaining and processing that crude?

TANTON:  Generally speaking, but there are times such as just after Katrina and Rita where the refinery cost and the ability to refine and the capacity to refine becomes the dominant factor.  We refer to that as coupling or de-coupling.  When the price is coupled to the cost of crude, which is the normal situation, or whether it is de-coupled from the cost of crude and it is driven more from the cost of refineries or the capacity to refine.

GIACHINO:  What is the percentage of price made up of taxes, generally, recognizing that there are state variations?

TANTON:  It is about 25% of the total cost at the pump is made up of federal and state taxes.  Some locations have local sales taxes and things of that sort.

GIACHINO:  You talked about how a great part of how the daily gas prices are set has to do with going through the supply chain of gasoline – from obtaining the crude to refining it and so forth, what is the role of the oil companies in setting these prices?

TANTON:  They have a role to play but it is not what the general perception is.  They do not go out and set the price other than as it is determined by the level of demand and the prices that people are paying.  They are really price takers and not price makers.

GIACHINO:  Of late, with this last spike of prices at the pumps, I have been hearing about something called the changeover to summer gasoline blends.  What are summer gasoline blends?

TANTON:  What they are talking about is requirements in different locations.  It is pretty universal although the specific level will vary from state to state and air quality region, etc.  What they are requiring at the federal level and at the various state levels is the addition of an oxygenate.  Previously that oxygenate was supplied by MTBE.  There are some environmental issues with MTBE and so they are now adding ethanol which is produced primarily from corn into the gasoline.  They blend that into the gasoline and it adds oxygen which helps reduce carbon monoxide formation, particularly during the summer months.

And there is some supply reductions right now in the ethanol market so what you see in the supply shortage in gasoline is driven largely by a supply shortage in ethanol and not in the gasoline itself.  And those are various environmental requirements.

The other thing that is going on – I mentioned earlier that the refineries do not produce just three grades of gasoline and a grade of diesel, they actually produce about 27-30 formulations that are unique to different regions of the country.  So if there is a problem say in California, say a refinery shuts down for one reason or another, one cannot immediately and easily make up that shortfall by imports from other parts of the country unless there are waivers.  Now after Katrina and Rita there were environmental waivers issued so that gasoline could move around the country a little more easily.

GIACHINO:  Is that what the president recently did?

TANTON:  No, what the president did was associated with the Strategic Petroleum Reserve (SPR).  What the Strategic Petroleum Reserve is are large tanks if you will – they are actually underground storage tanks, but large reserves of crude oil that can be called upon in times of emergency.  And what the president did was recognize that the time to fill up those reserves is not when the price of crude is at near all-time highs, but you fill up for emergencies when prices are more reasonable.  So what he did was quit filling up that reserve.

And what he did after Katrina and Rita was actually draw down those reserves; he released some crude from the SPR.

GIACHINO:  Okay, now I understand that.  You brought up the issue of ethanol, is it okay if we take a call from someone on that issue?

TANTON:  It's okay by me.

GIACHINO:  Go ahead caller, it's your turn.

CALLER:  I am a real proponent of ethanol.  There is a sugar cane grown here in our area of Florida and I would like to be able to make ethanol but you need a federal license.  I would like to not have to get a federal license.  I don't know if you do any work on trying to get the law changed so people could make their own ethanol?

TANTON:  I have not.  And part of the reason why there are rules about producing ethanol is because of its substitutability for alcohol.  I mean ethanol is essentially what people drink – it is the same alcohol, but different.

CALLER:  But it's a legal substance and so I don't know why we cannot make it.

TANTON:  Well, as with many things that people make and produce, there are laws that restrict that production.

CALLER:  But it's legal and it would be so much cheaper if I could just make it from the sugar cane here.

TANTON:  It may be cheaper than the current price of gasoline, but I am not sure that it is necessarily a financial smart thing to do given the capital cost of building an ethanol refinery.

CALLER:  No, you can just make a still in your backyard.  Well we have acreage here, but we could perhaps even grow it ourselves.  It's not very expensive.

TANTON:  But then you have to deal with chemical compatibility issues.  Ethanol is hydroscopic and it will absorb moisture from the air and that is not good for your tankage or for your car.  So when they blend ethanol into gasoline, the gasoline will help avoid absorption of moisture and degradation of the fuel.  But it might make sense on an individual basis.

CALLER:  Yes, flex-fuel vehicles are ready for that.  And I did not know how much research you all do with flex-fuel vehicles and people using the 85% ethanol?

TANTON:  The nice thing about flexible fuel vehicles is that it can use different fuels at different times.  So as the price of gasoline goes up and the price of ethanol maybe goes down, you burn more ethanol.  But as the price of gasoline recovers to normal levels and the price of ethanol stays more or less fixed because of the capital investment, then you switch back to gasoline.  So the nice thing about flexible fuel vehicles is their flexibility.

CALLER:  I hear about them using corn but do you know of any areas where they use sugar cane?

TANTON:  Not domestically I am not aware of any.  But that gets into another whole other issue of sugar price supports and issues of that sort.

GIACHINO:  We'll save that for another program if that's okay.

CALLER:  Sure. 

GIACHINO:  We had another question that someone wanted me to just go ahead and ask and it is a question that I had as well.  Why do gas prices at the pump seem to go up as soon as you hear about crude increases?  If the retailer already has the gasoline in their tanks, why when they hear about the increase in crude oil do their prices go up?

TANTON:  I think it is a fairly standard business practice that you sell at your replacement cost.  It is your purchase cost.  So as crude oil goes up the retail store needs to stay in business and needs to sell at the price to replenish or replace his inventory, not to just make a margin on what he has. If he just makes a margin on what he has then he cannot replace when prices are going up and then next thing you know is that he is out of gas and the consumer is hurt in that situation as well because he has to drive to five or six different stations to just fill up.

GIACHINO:  I need to pay closer attention to this because I know I always pay attention when I hear that crude oil prices have gone up, and I see that gas prices go up, but what I don't see is prices going down as quickly when I hear that crude oil prices have gone down.  There doesn't seem to be an immediate reduction going on at the pumps.  Shouldn't that happen if we are really paying for replacement fuels?

TANTON:  You are right and frankly I don't have an answer for why the response up is a lot faster than the response down.

GIACHINO:  We've got another caller on hold.  Go ahead, it's your turn.

CALLER:  Tom, may I ask you a series of short questions and you can give me answers if possible to the questions?

TANTON:  I'll sure try.

CALLER:  Is it true that they cannot even keep up with demand already for ethanol?

TANTON:  That's true.

CALLER:  There is benzene in the ethanol to mix with the gas so it chemically bonds.  Is that true?

TANTON:  Without getting into the complexities of distillation, without the benzene there is water carried over through the distillation process and so benzene is in there as a tactic to keep the water out.

CALLER:  So it burns better?

TANTON:  No, just to keep water from coming over in the distillation process.

CALLER:  So if water were to stay in the ethanol and therefore get in the engine it would not burn efficiently, right?

TANTON:  That's a fair statement although not strictly technically correct.

CALLER:  Is it true that the cheapest oil in the world to get out of the ground is in the Saudi Arabia area at about $20 a barrel?

TANTON:  Well it depends on what you mean by the cheapest.  If you are talking about lift costs, then yes.  Although the lift costs in Saudi Arabia are significantly less than $20 per barrel.

CALLER:  That is the cheapest lift cost in the world?

TANTON:  Yes, that I am aware of.

CALLER:  What is the highest?

TANTON:  Most of the lift costs in the domestic U.S. is higher than elsewhere in the world.

CALLER:  And that's because old wells and you have to draw them up so far?

TANTON:  A lot of it is old wells and it is the viscosity of the oil – or what is referred to as the gravity of the oil.  There are a lot of reasons.  Unions drive the price of lifting in the U.S. up higher than elsewhere as do some of the environmental regulations.

CALLER:  Is it true that only two of the refineries that were knocked out by Katrina are back on line?

TANTON:  No, I think only one is still off line.

CALLER:  What percentage of the oil rigs are back on line?

TANTON:  That I don't know right now.

CALLER:  Would you speculate that if the manufacturers of ethanol, even though they are receiving billions of dollars in subsidies from the federal government, if they cannot keep up with demand at this early stage of replacing MBTE, how could they possibly do this nationwide?  Is there any possibility of them doing this?

TANTON:  Well yes, but not necessarily immediately.  Part of the problem is that there is a disconnect from what I will call the proposed curve for ethanol and the ability to build the factories to make the ethanol.  And the factories to build ethanol take a lot of time and money to build, just like building a new refinery.  So the supply has not yet caught up and neither has the support infrastructure – the movement of the ethanol around.

CALLER:  When they first introduced MTBE I noticed a definite drop in gas mileage.  We will see that with ethanol.  What other comparisons are there?

TANTON:  A gallon of ethanol contains about 65% of the energy that a gallon of gasoline does. 

CALLER:  So we will see a healthy drop in gas mileage?

TANTON:  Well all other things being equal.  But the ethanol being added as an oxygenate does not make up that large of a percentage of the gasoline.  It is significant but it is not half.  So we can perceive some reduction in gas mileage, all other things being equal – same vehicles, same driving conditions and everything else.

CALLER:  If we opened up the continental shelf and the rest of the Gulf, the West Coast and Alaska and the Great Lakes, can we drill our way out of this problem?

TANTON:  It would be a contributor to getting out of the problem, but the problem is not simply crude oil.  The problem is also in support infrastructure – the refineries and a lot of other things.  So it would be an important step but it would not be a total solution.

CALLER:  Is it true that it takes billions of dollars and years to build one refinery?

TANTON:  Tens of billions of dollars, yes.

CALLER:  Thanks Tom, you have been very helpful.

GIACHINO:  Thanks so much for the call.  We appreciate your interest in the issue.  I will probably have to invite Tom to come back again to discuss this issue with us.  He is an expert on the issue of ethanol as well.  We have about two minutes left and I want to ask you another question because it has recently been in the news.  House Speaker Dennis Hastert and Senate Majority Leader Bill Frist wrote a letter to President Bush asking him to order investigations of the potential price manipulation in the oil supply chain and in futures and in the derivatives market.  It seems that every time gasoline prices rise significantly Congress investigates.  Are you aware, has there ever been a finding of wrongdoing in any of those investigations?

TANTON:  Not that I am aware of.  You are right that there is always a call for investigations.  Congress is very good at having hearings and it is one of the few things that they do well.  The most recent Federal Trade Commission testimony on the issue of price gouging and manipulation was as late as November 2005 and they found no collusion, no wrongdoing.  That is not to say that any current investigation might not find something, but history tells us that if people had been behaving well in the past, why are we so worried about them misbehaving now?

GIACHINO:  That's all the time that we have today.  This is an issue that is not going away and obviously the listeners are extremely interested in the issue and knowledgeable about it too.  I want to become more educated about it too.  Will you join me again on the next program?

TANTON:  I can do that.

GIACHINO:  Thank you so much.

TANTON:  Thank you, Renee.

(Editor's Note:  This is part one of a two-part interview.)
To view part two of this interview series, click here.

May 11, 2006
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