Everybody is asking that question these days. The average nationwide price for all grades this week is \$3.96/gallon; Californians are paying on average \$4.26, the highest in the nation.

Why does it cost so much, especially considering that the price was below \$2.00/gallon just within the last couple of years?

Nearly seventy percent of the price of a gallon of retail gasoline is the price of the crude oil it is refined from. Two graphs from the Energy Information Administration (EIA) make that point. The first shows the price of a gallon of gasoline (left axis) plotted against the price of a gallon of crude oil (right axis). The two move in virtual lock-step; if you know the crude oil price per gallon, add \$1.00 and you’ll know the price of gasoline within a few cents. (At \$105 per 42-gallon barrel, the per-gallon price of crude is \$2.50; add a buck, and you get a gasoline price around \$3.50.)

OK, so where does the \$1.00 go that’s not paying for the raw product?

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Nationwide, the average of state and federal taxes embedded into the price of a gallon of gasoline is 43 cents. We usually think of taxes the other way around, as with sales taxes. If you look at it that way, the effective “sales tax” on gasoline is 13.6%.

But as the next graphic shows, tax burdens vary greatly by state. Californians pay as much as they do at the pump largely because of the difference in state taxes. On top of that, California and a few other jurisdictions levy their tax as a percentage of the sales price (exactly like a sales tax), so that the California state treasury benefits handsomely from a higher gasoline price. (That’s not true in most jurisdictions, where the state tax is a fixed rate per gallon. Also, the tax burden shown in the graphic includes 18.4 cents per gallon in Federal taxes which apply to us all.)

That leaves about 53 cents per gallon of your retail price that go toward the “downstream” end of the business: refining and marketing. Whether or not that’s a fair price to pay for these services is probably a story for another diary (or another diarist!), but it would be fair to say that the financial returns in the downstream end of the energy business have not been consistently impressive.

\$4.00 for a gallon seems expensive, relative to what we are accustomed to paying. But a fair economic analysis of the value of the product must include its utility. A gallon of gas can transport four or more people in relative comfort 20 or more miles, and they can go when and how they wish to go. What is the value of that?

From the perspective of a producer (the “upstream” of the business), it is difficult and expensive to replace a gallon of gasoline in inventory. The price should be high enough to discourage waste, and high enough to reflect the true replacement cost of the resource. Increasingly hostile government policies regarding domestic exploration only increase the cost and difficulty of replacing reserves. An administration which threatens higher taxes on exploration and development dampens drilling plans. Supply tightens, prices go up. The cycle continues.

One last point — even at \$4.00, it is difficult to name a liquid product which is cheaper per unit volume than gasoline.

Cross-posted at stevemaley.com.