The Bush administration is telling consumers to brace for gas prices averaging $2.62 a gallon this summer. Consumers are complaining, and the outrage has a new set of senators lining up to blame Big Oil for the increase. That may be the politically popular thing to do, but blaming Big Oil does not explain why gas prices are on the rise.

Gas Prices 101
There are basically four components that produce gasoline prices: crude-oil cost, refining costs and margin, state and federal taxes, and distribution and marketing costs. If you want to see how the various components add up, the California Energy Commission has assembled the data. Let's take a look at these components and see how today is different from the cheap-oil days of 1999.


April 10, 2006

April 12, 1999

Crude Oil



Refining Cost
and Margin



State and Federal Taxes



and Marketing



Price Per Gallon



What has changed? In California, there has been a $0.09-per-gallon increase in state and local taxes. Other than that, the story is all about crude oil -- refining and distribution have changed, but both are within the same range as they were seven years ago.

Another factor that has been at work outside California is that state, local, and EPA regulations have created a plethora of specially formulated boutique fuels that serve smaller, isolated markets and have added to refining costs and margin. (California regulations have mandated boutique fuels for many years, and that's why the refining costs and margin in the California numbers have remained steady.)

Can Big Oil fix the price?
Sens. Herb Kohl (D-Wis.) and Arlen Specter (R-Pa.) introduced a bill last week to increase government scrutiny of oil companies because the bill's sponsors believe that the oil market is not behaving in a competitive manner. Kohl claims that "the oil industry has unquestionably enriched itself during this period of high prices." (This is where I start yelling at my computer: "That's because they sell oil! It's like saying the homebuilders have unquestionably enriched themselves during this period of high housing prices!")

Basically, Kohl and Specter are implying that Big Oil has the power to fix prices. While I'm sure it plays well with the folks back home, it just doesn't hold up to scrutiny. Oil is the ultimate commodity, and producers have no control over prices. Prices are set by traders on the New York Mercantile Exchange (NYMEX), and that is an inconvenient fact that the senators must surely know.

There are dozens of publicly traded oil companies, from giants like ExxonMobil (NYSE:XOM) to large independents like Anadarko Petroleum (NYSE:APC) to small-cap exploration companies like Bois d'Arc Energy (NYSE:BDE). There are national oil companies like Saudi Aramco and Brazil's Petrobras (NYSE:PBR), and perhaps hundreds of small private companies drilling in fields from West Texas to Australia. Maybe I just fell off the turnip truck, but I simply don't believe that hundreds of highly scrutinized, competing companies are getting together to fix prices.

So what explains the price increase?
Commodity markets are cyclical. In 1998, oil fell to $10 a barrel, after spending most of the previous 12 years below $20 a barrel. With low prices, there was little incentive to increase production, refining capacity, or tanker capacity. There was also little reason to hire personnel. On the demand side, Americans chose to drive increasingly large and inefficient SUVs, and Asian countries' continued economic development and strong growth caused them to rapidly increase their consumption of hydrocarbons.

This period of high prices has been in place for only about 18 months. As supply and demand became more evenly matched, prices rose above $30 a barrel in 2001. OPEC still had reserve capacity, and prices fell back near $20 a barrel in 2002. At that point, one could have easily concluded that there was still a flood of oil in the world market. In fact, prices did not stay above $35 until the second half of 2004.

Geopolitical concerns have also increased the price beyond the natural supply-and-demand scenario. Nigeria, Venezuela, and Iraq are all failing to produce at full capacity because of various internal problems. Production in Saudi Arabia is also at risk because of terrorism. Iran continues to defy the international community with its nuclear program, and if the situation there heats up further, it would not surprise me to read one of these days that Iran has used the "oil weapon." Analysts claim that all of these geopolitical concerns have added a "risk premium" to current prices.

Where do we go from here?
The tight supply-and-demand situation, continuing global growth, and a risk premium have created record oil prices of nearly $70 a barrel. This situation is not going to be resolved overnight -- it takes about four years from initial discovery of an oil well to production. Activity in the oil patch has certainly increased, with the rig count on the rise and drilling companies reporting that they are running near 100% capacity.

This summer, there may be a few bumps in the road, as refiners switch from MTBE to ethanol as a gasoline additive to meet new EPA regulations. The concern is that ethanol production may not match the rapid increase in demand. (I expect any price increase caused by this factor to likely be temporary.) Of course, hurricane season begins in June, and a huge percentage of U.S. refining capacity is still located on the Gulf Coast. On that front, we can only hope for the best.

I am willing to make three bets. First, Big Oil will remain under scrutiny on Capitol Hill until oil prices fall. Second, in spite of the popularity of bashing Big Oil, nothing significant will change in the tax laws or regulations at least until the administration in the White House changes. Third, the negative publicity oil companies face whenever Big Oil takes the stand may cause oil stocks to sell off, and that could make for some temporary bargains in the oil patch. Pay attention, and you may just profit from the hoopla.

For related petro-Foolishness:

Looking to capitalize on the boom in the oil patch? Motley Fool Hidden Gems has uncovered two rapidly expanding companies that are benefiting from the boom. To see all of the Hidden Gems selections, sign up for a free trial today.

Fool contributor Robert Aronen owns no shares of any company mentioned. Feel free to share your comments with him. The Motley Fool has a disclosure policy .