Wednesday, April 11, 2012

Petrol Pricing For Dummies ;)

The prices of petrol are one of the most unstable of all the commodities. Petrol is consumed in all sectors of the economy in one form or the other. Any increase in petrol prices directly results in a rise in general price levels. In unstable third world economies, a rise in petrol prices creates a completely unpredictable and often chaotic multiplier effect*.
Recommended Reading
Understanding Oil Prices: A Guide to What Drives the Price of
Oil in Today's Markets (The Wiley Finance Series)

The actual cost of the raw material for petrol, i.e. oil, is actually about one-third of its price. Suppose if petrol is sold for 120p, then the cost of oil it represents is 40p. Most of what we actually pay, more than 55% at least, goes to the government in fuel duty and VAT. About 1%, and sometimes up to 5%, goes to the retailer.

Thus in reality, when we are buying fuel, more than half of what we actually pay goes to the government. The second biggest component of petrol price is the cost of oil itself. Sounds ridiculous but this is how this industry operates.

The refining cost of crude oil is actually very little and normally represents around 1% of the total cost of petrol. Any increase or decrease in the refining cost or the retailer margin will not change the price of petrol substantially. What matters is the cost of oil and the government taxes.
If the government decides to keep the taxes unchanged but the cost of crude oil in the international market goes up then the government can either
  1. Decrease its level of taxes to keep the petrol prices unchanged
  2. Keep the taxes/duties constant and let the petrol prices increase.
The cost of oil can then be further broken down into different components and this is where things start to get a bit complicated. Firstly there is very little transparency involved here. Oil companies operate in different countries around the world, thus they are subjected to international laws and their respective native laws. Secondly, all the oil of the world is not generated from a single place hence there is no standard costing model to follow. Oil is generated from thousands of rigs around the world, from barren deserts to deep seas. All involve variety of different costs therefore there is no such thing as a “standard barrel of oil”.

Suppose you have around $500m in your bank account. That is enough for you to get into the oil business and open your own deep sea oil rig. First you will start exploration and you have one in four shot of hitting the black stuff.
Highly Recommended Reading

During this time you will realize that someone else is either exploring or extracting the oil from your favorite location. You will probably have move to farther and farther away. This will increase your cost of exploration. But don't worry yet because you have plenty of cash available.

Suppose that you were eventually successful in finding oil in some remote corner of the world. That portion of land belongs to some country that is located near that remote corner. You will have to get a lease and a license from that country to start your operations.

Once you’re done with all the paper work, it’s time for you to start building your rig for digging and pipelines for oil transportation. You’ll need to purchase lots of expensive heavy machinery and you need hundreds of workers to work for you. You’ll need a shipping contract as well to transport all of that oil to an oil refinery.

Now check into your bank account, you’ve spent nearly $350m dollars and have $150 in reserves, that’s really good, well done. Now look at your watch, it has taken you only seven years to complete the project. Your accountants will now assess all of your costs and incorporate them in the price of crude oil. This will include the initial $350 million and other subsequent expenses plus an extra for all of your time and effort.

Multiplier effect: E.g. if you introduce (or withdraw) $1 into an economy, it results in a chain reaction that might cause an overall increase of e.g. $10. Multiplier in this case will be 10 (i.e. $1 x 10 = $10).
You might have seen this in cartoons, when a small snowball starts rolling down a glacier, it gathers more snow as it builds up momentum and the result is a 10ft high gigantic ball of snow.