Why do Petrol Prices do not automatically decrease when the oil price decreases | Get Financial Freedom Tips | Transform Your Financial Future


Tuesday, August 9, 2011

Why do Petrol Prices do not automatically decrease when the oil price decreases

We are in a constant battle with fuel prices – always trying to fill up on the days of the week when fuel is at its cheapest, and watching the world news for information about the price of oil and resources disputes which have the potential to skyrocket prices at the pump yet again. So why is it that even when we do see that the price of oil has dropped, that the price of fuel doesn't drop too? It only seems fair that petrol prices should follow oil prices down, just as they follow it up.

Reasons petrol prices rise

Unfortunately, even though the price of oil is one contributing factor to the price of fuel, it is not the only one. While petrol prices are gradually dropping now that the price of oil has dropped, they are not dropping at the same rate, and there are a number of reasons for this :

Fuel is a commodity. As a commodity, the supply and demand of fuel dictate its price. Therefore, when the supply of oil is abundant, and the demand is consistent, the prices remain stable, but oil is used in a range of products, not just fuel – everything from chemicals, food and fertilizer – and so when this supply is disrupted and the short term inventory is threatened, millions of businesses and products worldwide are affected.

Supply can be easily affected. For example, in 2010 there was a fire in a refinery in Ontario, which in itself wasn’t a major disaster, however, at the same time it was an unusually cold winter and when one of the three refineries went down, it caused an almost nationwide fuel shortage. The fuel which was normally brought in from Quebec by rail was held up by a railway strike, the fuel normally brought in by ship from Michigan was blocked by thick ice in the ports. This meant commercial filling stations quickly ran out of diesel and businesses weren't able to operate. In turn fuel was expensive at the few places it was available, even several months after supply was returned to normal.

Oil is an important commodity. Around the world we should start getting used to high oil prices, for a number of reasons. Firstly, there is oil in just about everything we use and buy – oil was used in some way to create it or bring it to us; that is why oil prices are affected so significantly by consumer confidence and employment rates. Plus, since oil is global, prices at home are affected by demand in other countries, for example when oil consumption in China and India rivaled the US, oil prices were rising even though US consumption was falling. As a result, commodity markets are trading in oil in the same way they are trading in gold, foreign currency and stocks, especially with the turmoil in the stock markets oil is an attractive investment because its consumption remains stable. Oil is able to hold its value because of the control of supply – if market prices fall too far, supply can be reduced until the price goes back up.

Fuel prices do fall, just slowly. While it may appear that petrol prices don’t fall in line with oil prices the same way as they rise, according to research in 1997 by a team headed by Severin Borenstein, petrol prices fall twice as slowly as they rise after a price shock. For example, if petrol prices rise 50 cents over four weeks, after which time the reason for the increase has passed, it will take eight weeks for the prices to return to the level they were at before the price shock.

You don’t shop around when prices are low. When petrol prices are high, you will take the time to shop around for the best price to save a few cents per gallon and $10 or $20 on the price of a full tank. However, when prices go down again you are so relieved that you stop shopping around and fill up anywhere. This relieves the normal downward pressure on fuel prices and so service stations are able to squeeze out a few more cents in profit as prices slowly fall. That is because you are shopping based on a reference price – when you get a number in your head that you expect to pay for something, all of your subsequent choices are impacted by the reference price. Therefore, any time you see fuel below your reference price, you think it is a good deal and you’ll stop looking for a better deal.

Balancing competition. Petrol prices can also stay higher for longer because the service stations want to make as much money as they can, for as long as they can. When oil prices drop and fuel becomes cheaper for the service stations to buy, they won’t necessarily drop their price per gallon to directly reflect the saving they are making right away. Instead, they will wait, charging more for the fuel they are now getting at a cheaper price, to make more of a profit for as long as they can. Service stations then watch their competition for the cue on when to drop their prices, and how many customers they are losing to their competition when they don’t stay in line. Plus, many retailers will play on loyalty and convenience, for example if there is only one service station where you can fuel up and get coffee in the morning, you are willing to pay a little more than shop around and so the service station can keep their prices higher because they know they won’t lose all of their customers at once.

Service stations make a thin profit anyway. Many service stations actually make very little profit from their fuel sales, and instead use fuel as a leader for their snack and drink sales – the same way a supermarket may be able to sell milk way below its cost price, because they know once you’re in the supermarket the chances are good that you’ll buy other full priced products. As a result, service station owners are therefore slow and reluctant to drop their prices again when oil prices go down.

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