Like your article on "what is high octane fuel" (where I've posted an expanded explanation of the 3 basic factors that determine the octane requirements for any gasoline engine), this article on how gasoline prices are determined is correct, but not complete.

The total crude oil refining capacity in the United States is not large enough to produce enough gasoline (or diesel fuel) to meet the market demand for these fuels, particularly in the summer months when more people drive. There has not been a new refinery built in the US in about 30 years (the Marathon refinery at Garyville, LA being the last new refinery built in the US). So this domestic product shortage must be met by imports of gasoline (and some diesel) from others -- mainly Canada, Venezuela and Europe. Basic enonomics says that the cost of the marginal (last) supply sets the market clearing price for a product. In the case of the USA, this is set by the cost of imported fuels -- which tend to have higher supply costs than domestic produced fuels (with California being an exception that I will discuss separately, below).

New refineries have not been built in the USA for these 3 reasons:

- Environmental regularions and requirements (by the EPA and state agencies) have substantially increased the cost and complexity of getting permits and then building a new refinery, above these costs 30 years ago. There are many hoops that an oil company must jump through to build a new refinery. It is cheaper (but still quite expensive) to expand an existing refinery.

- There are few if any communities that want a relatively dirty crude oil refinery located in or near them. "Not in My Backyard" is the current watchword for most locations in the USA.

- Until recently (about the last 5 years), the profitability of crude oil refineries was not very good -- with about a 5% return on invested capital in the 90s -- so oil companies invested money on finding crude oil (that had a higher ROIC) rather than on refining it.

Supply and Demand do set the price of gasoline, but the supply is restricted (with incremental supply being more costly) while demand is only restrained by the cost of gasoline. It does not appear that this situation will change any time soon.

Now, California is a special case -- resulting in even higher gasoline prices in CA than in the rest of the country. The reason for substantially higher prices for California gasoline is the very strict California specifications on gasoline -- what I call "California Boutique Gasoline." California had environmentalists determine the specifications for gasoline that could be sold there, and these restrictive specs meant the following:

- Less gasoline volume can be produced from a barrel of crude oil than can be produced for sale in other states.

- Substatial investments in new refining equipment were needed to produce gasoline to meet California specs.

- A few older California refineries either shut down or stopped producing gasoline rather than make these high-cost investments, and the others spent the money.

- Other than the 10 remaining operating refineries that produce gasoline in California, there was only one refinery in the world (when I was still working in the industry in 1998) that could produce any real volume of California Boutique Gasoline -- and it was located on the Texas Gulf Coast.

Because California has such restricted supply (due to specifications), the market clearing price for gasoline in California is much higher than in the rest of the USA.

SilverMax