Few things get Canadians talking more than gasoline prices. And this year we’ve seen some of the highest and most volatile prices ever.
Because we don’t have a lot of short-term substitutes for gasoline, when prices rise it leads to lots of questions about why. Is it taxes? Price gouging? Oil prices?
The short answer is that while a range of factors can influence gasoline prices and volatility, the cost of a barrel of oil is clearly the main driver.
In this commentary, we look at the main factors that affect gasoline prices and then discuss the global game of tug-of-war between oil supply and demand—a game that’s not only driven prices higher, but will likely contribute to increased volatility and price uncertainty in future.
Factors affecting gas prices
There are four main components that impact prices at the pump, though they don’t all impact price trends equally:
- Gasoline product distribution and marketing costs;
- Local and regional taxes;
- Refining costs; and
- Crude oil prices.
First, gas stations make only a small profit form the sale of gasoline itself. Shell Canada data suggests that retailer margins make up just four to six percent of the price at the pump. In fact, research indicates that gas stations make most of their money from selling snacks, car washes, and other services. All in all, gas stations themselves are not a major contributor to price spikes or volatility.
Second, regional taxes add a substantial amount to gas prices—on average, about 47 cents per litre—or 35% of the price at the pump last year. But taxes don’t change much over time, so they don’t contribute to volatility or the soaring prices we’ve seen recently. Some people have blamed the federal carbon price for the recent spike, but that’s not accurate either. To date, the federal carbon price has added approximately 11 cents per litre to gasoline prices, but the 2.2 cents per litre increase since last April is clearly not driving recent price increases.
Third, refinery margins—the difference in price between crude oil inputs and refined gasoline—have been high this year and have added significantly to gasoline prices. High refinery margins are largely the result of low refining capacity. In the United States, refining capacity at the beginning of this year was 5.5% below 2020 levels—the lowest in eight years—due to COVID facility shutdowns and some refineries converting to produce renewable fuels. The remaining refineries are running at nearly full capacity, and can thus charge more for the gasoline they produce compared to their crude input costs. However, these margins have been trending downward since late-June, and Asian refining capacity is expected to grow in the coming years.
But historically, the main driver of both gasoline prices and volatility is simply the price of crude oil itself. That’s easily seen in the figure below where the WTI spot price and gasoline prices move largely in parallel. To understand why gas prices are moving the way they are means understanding how and why crude oil prices are moving.
What affects the price of crude? The crude oil tug-of-war
The price of crude oil is determined by traders buying and selling oil on the spot market today and/or through futures contracts. These are people who estimate the price of crude at a future date based on analysis of the dynamics impacting both crude supply/demand and market sentiment. Either they try purchasing oil on a future date at a lower price than what their analysis tells them the price will be on that date; or they purchase oil to create price certainty at a cost they deem reasonable.
Effectively, traders are observing the crude oil tug-of-war match trying to determine which team—Team Supply or Team Demand—is going to gain an upper hand, and how quickly and forcefully the other team will respond. Their analysis of these dynamics and purchase decisions set crude’s market price trajectory.
Since Canada produces just 5.8% of the global total, marginal changes in Canadian oil production and consumption have little impact on global crude prices. This is why we must look to global supply and demand dynamics to understand what’s going on—and why data from the biggest economies and the biggest oil producing nations are the most important.
Before diving into the factors that traders are analyzing closely to predict the future price of oil, a quick survey of the existing state of oil supply-and-demand is necessary.
Today’s crude oil situation: the current state of the crude oil tug-of-war match
Put simply, the impact of the pandemic and years of underinvestment in oil production growth have played havoc on supply and demand dynamics.
When the pandemic first hit, global oil production suddenly dwarfed consumption as economic activity screeched to a halt and oil prices plummeted. In response, producers cut their output by a drastic 9.4% in just half a year, and their operational spending was one-third less than planned that year.
These production cuts were compounded by several years of underinvestment in production growth since 2014. Investors are demanding more capital discipline today than during previous oil price booms. They want to see profits returned to their pocketbooks rather than being invested in new output. Furthermore, years of climate policy uncertainty have added to the uncertain investment environment, further contributing to underinvestment in global production capacity.
Though production has increased enough to match demand as of early 2022, we can see the impacts of the supply shortage by monitoring crude oil inventories, which have been depleted to help supply meet surging demand while production levels took time to ramp up.
Crude inventories are exactly what they sound like—stockpiles of crude oil stored for later use and to provide a buffer in the case of unexpected supply shortfalls. Imagine a furniture retailer. If the number of recliners sold in the showroom exceeds expectations, having a stockpile in the warehouse will act as a buffer before more recliners can be ordered, produced, and shipped to meet demand at the showroom.
Similarly, companies and governments stockpile crude to help smooth out oil prices in response to global supply and demand crises (company stockpiles = commercial inventories; government stockpiles = strategic petroleum reserves, or SPR). Oil traders track inventory levels as a proxy for supply and demand. When inventories are falling, demand is likely outstripping production and prices will rise. When inventories are growing, the opposite is true.
This year, global inventory levels have been historically low. In fact, US data shows that inventories are at their lowest level since September 2003. As the chart below indicates, recent SPR releases have allowed commercial inventories to begin recovering (and global inventories may be beginning to recover), but total US inventories remain low.
When inventories are low, small changes to their levels can have outsized price ramifications. As such, oil traders closely analyze the driving factors that will impact supply-and-demand dynamics. These driving factors are the ‘players’ on Team Supply and Team Demand that oil traders watch closely to predict the how the tug-of-war match will go.
Here are some ‘player profiles’ of the factors impacting Team Supply and Team Demand.
Future of the Tug-of-War: Player profiles for Team Supply (TS) and Team Demand (TD)
Team Supply Player #1: Strategic Petroleum Reserves
The Biden Administration has been releasing SPR crude into the market at record rates to help alleviate high prices. When US SPR releases end in the fall, traders will be watching to see if this supply reduction can be balanced by increased production—especially if the US decides to refill the SPR in the near term. However, the US Energy Information Administration (EIA) is forecasting global production to outstrip consumption this year, which could help alleviate near-term pressure on inventories.
Team Supply Player #2: OPEC+
OPEC+ (Organization for Petroleum Exporting Countries), a cartel consisting of 13 member countries and 10 non-member countries, together represent about 55% of the world’s oil supply and 90% of proven oil reserves. When functioning as it intends—though this is not always the case—the OPEC+ cartel sets production quotas that create oil price stability at levels favourable to their members.
OPEC+ internal dynamics are tricky to decipher. Some data suggests that OPEC+ has spare capacity to produce more oil, while other analysts believe the cartel’s history of missing its own production quotas shows it doesn’t have the spare capacity it claims.
In August, OPEC+ agreed to increase production by a very small amount, but its largest producing member, Saudi Arabia, has suggested the cartel could cut production to support elevated price stability. What the cartel decides to do next is anyone’s guess.
Team Supply Player #3: Russian production and exports
Russia is the world’s second largest oil producer and exporter, and major disruptions to either will have big impacts on global crude prices. Prior to Russia’s invasion of Ukraine, oil prices were already on the rise and inventories were low. But when countries began imposing sanctions on Russia and major global oil companies began pulling their operations out of the country, the crude oil market understandably reflected fears that major supply disruptions would impact already-low global inventories.
However, Russian supply has been unexpectedly resilient in the face of international pressure, with Russian producers finding customers in the form of Indian and Chinese importers. Some analysts believe that this resiliency may not last as sanctions take their full effect over the long-term, but sanctions to-date have proven difficult to uphold. But if EIA forecasting is correct and Russian production declines next year, global supply will be significantly impacted.
Team Supply Player #4: The Iranian wildcard
Since the late-1970s the United States has maintained various targeted sanctions against Iran, notably including a ban against transactions with Iran’s national oil company. However, there has been recent international progress on striking a diplomatic agreement that could see Iranian oil sanctions eased. Some analysts suggest that an Iran deal could boost supply enough to lower near-term crude prices by $7-10 a barrel, but if a deal is not reached, prices could rise.
Team Demand Player #1: China’s pandemic policy
China, the world’s second-largest economy, has opted to maintain a zero-COVID policy, enforcing strict regional lockdowns impacting tens of millions with each outbreak. This has led to large oil consumption declines and lower prices globally. However, many analysts are concerned about how capable global oil production levels are of meeting resurgent demand once China stops pursuing this policy.
Team Demand Player #2: Global recession fears
For a wide range of reasons, including rising interest rates, weakening consumer sentiment in the west, and plummeting confidence in China’s real estate sector, some investors are concerned that a widespread recession may be on the horizon. Recessions weaken oil demand as business activity slows and people lose jobs and spend less. During the 2008 recession, crude oil prices collapsed by about $95 a barrel over the course of 8 short months. Even the prospect of a recession is enough for oil traders to worry about future oil demand and adjust their price valuations.
Team Demand #3: Short-term, price-induced demand destruction
One of the most effective ways to drive oil prices lower is for them to go high enough to lower demand—basically, the cure for high prices is…high prices. Gasoline demand in the United States is trending lower this year than the pre-pandemic seasonal norm. Similarly, Canada’s gasoline consumption sits at 10.1% below 2019 levels for this time of year. However, with gasoline prices falling over the summer, US consumption ticked up in August, leading some some analysts to wonder if prices have dropped enough in recent weeks to support rising gas consumption.
Team Demand Player #4: Uncertain long-term demand forecast
Long-term global oil demand forecasts are highly uncertain in part because of the uncertain pace of the energy transition and the policies introduced to support it. Some scenarios see global demand rising above today’s levels until 2045, and other scenarios see demand decreasing significantly before 2040.
This long-range uncertainty impacts investments in oil production because fewer investors want to risk building production capacity that may not end up being needed. The uncertain pace of the energy transition could make oil prices prone to volatility until the future trajectory becomes clear.
In summary, crude prices—the largest driver of gas prices—have been impacted by exceptionally low global inventories, which exacerbates the price impacts from small fluctuations in supply and demand. In addition, there are uncertain domestic and international political dynamics at play, recessionary fears, investment constraints, energy transition uncertainties, and more—all impacting crude supply and demand in different ways. Oil traders are analyzing these factors and betting on how they will impact the future balance of Team Supply and Team Demand, but this is wildly unclear because of all the variables at play. At any given time, oil traders can be uncertain about:
- The number of players on each team;
- The strength of each player;
- Whether players will enter or exit the match mid-game;
- Whether the players will unexpectedly switch teams; and
- Whether several teammates may have colluded and devised a strategy to defeat their opponent (and whether the rest of the players on their team know of this strategy, just to name a few).
Sprinkle in higher-than-typical refinery margins, some taxes, and small gas station markups, and it’s no wonder gasoline prices spiked. It’s unclear where prices will go from here, but we’re likely to see volatility continue until inventories refill and uncertainty dissipates.