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To properly address ththree important points

First, crude oil andcommodities and, by supply and dem(Figure 1).

Second, the price ofactor determiningConsequently, the by the worldwide d

1Major Flows of Crude OilSource:BP Statistical Review of World Energy, 2005

Why?First, lets start with the facts.

How is it that over the past few years, consumers haverealized a sustained increase in the prices they pay forpetroleum products that are critical to their economic

well-being? What is it that has caused the price of crude oilto push past $70 per barrel? And how does this affect the costof gasoline and other petroleum products?

American consumers have found themselves facing higherprices for gasoline, heating oil, and other petroleum products.The question policymakers, as well as consumers, seek toanswer is:

Overview

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6Components of Retail

Gasoline PricesSource: Energy Information Administration

7Inflation-AdjustedPrice of West TexasIntermediate CrudeOil and UnleadedGasolineNote: Inflation-Adjusted January2006 Dollars

Source: Energy Information Agencyand Bureau of Labor Statistics

8Year-to-Year Chang

in World Demand fOilSource: Energy InformationAdministration

9World Spare OilProduction CapacitSource: Energy InformationAdministration

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West Texas Intermediate

Motor Gasoline

Physical Markets and Oil Prices

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MovementDistribution and marketing of petroleum products representthe third segment of the petroleum supply chain.

The forces of supply and demand at work.

Distribution and Marketing

The majority of finished product is transported from the refinery through pipelines to theproduct terminal. This is true of domestically produced crude oil, as well, as pipelines representthe most efficient method of moving large quantities of liquids. Pipeline rates are regulated bythe Federal Energy Regulatory Commission (FERC).

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They involve the movement of refined products gasoline,diesel, heating oil, kerosene, and jet fuel from the refinery tothe end consumer (Figure 11).

Like crude oil, petroleum products are bought and soldthroughout the chain of distribution. Distribution andmarketing, however, represent a relatively small share of theprice paid by consumers. For example, the marketing anddistribution of gasoline typically represent less than 15percent of the pump price paid by the average motorist.

11Gasoline Distribution Systemand Valuation Flows

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GrowthWorldwide growth gave rise to stronger-than-expecteddemand for petroleum products critical to the globaleconomy that, in turn, gave rise to stronger-than-expecteddemand for crude oil demand that outpaced the near-termability of the market to bring forth commensurate additionalsupplies. The resulting tightness in the global crude oil marketcaused prices for crude oil to increase. Specifically, prices forcrude oil in both the spot and futures markets rose in orderto bring the global supply of and demand for crude oil intobalance.

The prices faced by U.S. consumers for petroleum productsare largely a consequence of the world economys stronger-than-anticipated growth, in the face of diminished excesscapacity and increased supply uncertainty.

The markets determine the price.

Summary

The impacts arising from the increase in demand for crudeoil have been felt throughout the chain of production. Asdemand for products increased, for example, so too did thedemand for the refinery capacity necessary to turn crude oilinto saleable products. As the utilization of the worldsrefineries increased, demand for those crudes more easilyrefined into the petroleum products desired by the worldseconomy (i.e., lighter, sweeter crudes) increased relative tothose crudes more difficult to refine (i.e., heavier, more sourcrudes). These changes have been reflected in the marginsearned by refiners, providing the economic incentive toexpand global refining capacity.

Moreover, and perhaps of most consequence, these changes

in global supply and demand have increased the wholesaleprices paid by retailers and, ultimately, the prices paid byconsumers. Of course, any given individual retailers prices

will reflect the particular economic circumstances confrontingthat particular retailer, e.g., the stations location, commercialarrangements under which the station is supplied with products,and operating costs such as rent, insurance, and wages. Whatcannot be avoided, however, is the economic reality that U.S.retail prices are fundamentally determined by the world oilmarket.

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Principal Authors

Kenneth GrantDavid OwnbySteven R. Peterson

Research Assistance

Todor Stavrev

Undertaken for API

Copyright 2006 - API. All rights reserved. Wal-Mart is aregistered trademark of Wal-Mart Stores, Inc. Costco is aregistered trademark of Costco Wholesale Corporation.

A Policy Analysis Study by Lexecon, an FTI Company

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2006-038 | 05.06 | 2M