A commonly observed phenomenon that takes place within the retail gasoline market is the asymmetrical way in which gasoline prices adjust to changes in crude oil prices. While there is a general belief that gasoline prices should adjust proportionately and symmetrically to crude oil’s price movements, this is actually a misconception.
In fact, the way that gasoline prices adjust is commonly referred to as a “rockets and feathers” reaction, whereby gasoline prices adjust rapidly to increases in crude prices, while adjusting slowly to decreases. Given the recent attention global energy markets have garnered, and to better understand why this relationship between gasoline and crude exists, we take a look at the various factors influencing the not-so-perfect relationship between crude oil and gasoline prices.
To begin with, during the production process and before crude makes its way to end users, both the raw materials (crude itself) and finished goods (gasoline) change hands multiple times. For each time that inputs change hands, additional costs related to anything from refining, shipping, and storing are incurred, and inflate the final price. These supplementary costs are referred to as “pass-through” and make up roughly 30% of gasoline’s retail price. Furthermore, all of these various steps within the production process have their own individual pricing structures that will fluctuate over time. As a result, pass-through may skew gasoline prices and prevent them from moving in lock step with the price of crude.
It is also important to keep in mind the slim profit margins that gasoline retailers achieve when selling fuel at the retail level. If the price of crude oil increases, the cost to purchase it increases for retailers and they must quickly raise prices on gasoline or face losing money. Because of this, is it any surprise that gasoline prices swiftly adjust to crude price increases? Alternatively, when crude prices go down, it is not as important for retailers to quickly adjust their pricing proportionately. In fact, lower oil prices may give them an opportunity to bolster cash flow in preparation for eventual crude price increases.
Finally, consider the psychological impact that even slight price decreases in gasoline have on consumers’ mentality. If drivers recognize that prices have dropped, even by a few cents, they become content with the bargain they have found relative to their last fill up. This gives consumers less incentive to drive around looking for lower prices and may even entice them to fill up their entire tank versus a partial fill up. Happier customers, coupled with no real short term risk of losing market share, create a situation where gas stations have practically no pressure on them to lower prices as sharply in response to falling crude prices.
The bottom line is that while gasoline prices do move in the same direction as crude oil prices, the magnitude and speed of the move is not a perfect response. With that said, even as motorists could have seen bigger relief at the pump, drivers still have a lot to be thankful for this holiday season as lower fuel prices essentially amount to a tax cut for the masses.