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Most people believe that the price of gasoline is directly related to the price of oil, but this is only partially true. To help understand how gas prices are determined, one must examine supply and demand, inflation, and taxes as well.

Crude oil does not come out of the ground in the same form, and is graded by its thickness (from light to heavy) and its purity or sulfur content (sweet to sour). The price of oil that we often hear quoted in the media is usually a light/sweet crude oil. This type of oil is in high demand because it is light and contains fewer impurities, making it quicker and easier to process into gasoline by refineries.

Although light/sweet crude oil has always been sought after, it is no longer as plentiful as it once was, and when its supply tightens up, the price increases. Although processing heavy/sour oil is more expensive, refineries can buy it at a substantially lower price than light/sweet oil, so they can still get a favorable return on their investment.

Supply and Demand

Not surprisingly, the basics of supply and demand have a big impact on the price of gasoline. The demand for gasoline is set by the number of people worldwide who are using it to power their vehicles.

While demand for gasoline in the U.S. has always been high, China and India, both with populations over 1 billion, are currently experiencing an expansion of the middle class and, along with it, more people driving automobiles and burning gasoline. To accommodate rising new car sales, China is building 42,000 miles of express highways to be completed by 2020, and India is adding another 12,000 by 2022.

According to NPR.org, some countries, especially in the Middle East and North Africa, also subsidize the retail price of gasoline to create an artificially higher demand. Many developing nations set gasoline prices artificially low, less than the cost to produce it.

Inflation

Inflation is the amount of money that is in circulation, measured by the rate at which the price of goods and services is going up and the rate at which purchasing power is falling. The more money in circulation, the higher prices tend to be because there’s more money available. The level of inflation varies by country and can influence the price of fuel.

According to Investopedia, when oil prices rise or fall, inflation follows in the same direction because oil is an input that used in critical activities such as fueling transportation, running factories, and heating homes, and if input costs rise, the cost of end products usually goes up too.

Taxes

According to the American Petroleum Institute, the federal, state, and local tax on a gallon of gasoline in the U.S. was a little over 20% of the total price in 2013, meaning that taxes added about 49 cents to the price of a gallon of gas. But these taxes vary widely by state. In California, for example, the price of gasoline includes a federal motor fuel excise tax, a California motor fuel excise tax, state and local sales taxes as well as other state and local fees totaling more than 68 cents a gallon, while taxes added only about 32.4 cents to the price per gallon in Wyoming, and 26.4 cents in Alaska. New York’s gasoline taxes were the highest in the nation at 68.9 cents per gallon.

Balancing Act

As a general rule, people only make small changes in their consumption of gasoline even when there are large changes in the price, and this behavior helps to keep the supply and demand of gasoline in balance. Over time, experts expect to see a tendency toward lower fuel consumption among individuals, but a worldwide increase in the number of people who depend on gasoline. These behavior patterns will no doubt affect the price we all pay at the pump.