September 1, 2015
Few economic phenomena attract as much attention in Poland as fuel prices. This is not surprising, considering that an average household owns at least one passenger car, and the share of fuels in total consumer spending has long surpassed 5%, which is more or less the same we spend on healthcare, appliances and running our households, and only slightly less than we spend on meat and bread (6% each).
According to ACEA, there were 559 cars per 1,000 people in Poland at the end of 2014, which is only slightly less than in Norway – one of the wealthiest countries in Europe thanks to its natural riches, and more than in Germany, the United Kingdom and France.
Fuel prices turn into a particularly hot topic during holidays, when people travel and buy more fuel. This year, the media grow excited as oil prices continue to drop below USD 50 per barrel. However, looking at the price displayed on the fuel dispenser, we cannot help but reminisce about the times when a full tank of gas cost a lot less than PLN 200. How come fuel at service stations is more expensive than before the crisis if crude is cheaper?
Gasoline is the most popular fuel. According to a report on transport published by the Polish Central Statistics Office (GUS) in May 2015, over 56% of passenger cars on Polish roads in 2013 had petrol engines, 27% ran on diesel oil, and close to 15% used LPG. Let us take a closer look at the many factors which prevent retail prices of E95 from mirroring the changes in the price of crude oil. For convenience, two aspects of the overall mechanism responsible for fuel prices can be identified: a global and a domestic one. The global aspect covers the correlations between the price of crude oil and gasoline on global markets (in USD). The domestic aspect consists in the transmission of the market price of gasoline expressed in the US dollar to a wholesale price expressed in the złoty, after which the wholesale price is transmitted to a retail price.
Global transmission mechanism
The transition from crude prices to fuel prices – the oil price transmission mechanism – is a very complex process, as those following the blog could learn from my ‘ABC of Crude Oil and Fuel Prices’ series of articles. The first step in analysing the transmission mechanism is therefore to simplify it, so that we do not get lost amid all the details. How we simplify it should depend on the context of our analysis, for which we should specify the time frame to be used in filtering out the data to be reviewed. Typically, we can distinguish a daily time frame (quoted prices), as well as quarterly, annual and multi-annual ones, which provide average prices in their respective periods, eliminating fluctuations extending beyond a given time frame.
When looking at the crude oil and gasoline market through a daily, weekly or monthly time frame, we can clearly see that prices on these markets fluctuate constantly over the short term, often in opposite directions. As a result, a single crude price level may correspond to several, or even a dozen or more, widely different gasoline price levels, and vice versa – the price of gasoline can remain the same despite changing crude oil prices. For example, in the case of daily Brent crude prices in USD per barrel and 10ppm gasoline prices in USD per tonne on the ARA market, in the period from the beginning of the year until August 17th we saw seven days in January and five days in August in which the price of Brent remained virtually unchanged (only oscillating within a 3-cent range, between USD 47.5 and USD 47.8 per barrel). On the same days, the price of gasoline fluctuated by USD 152.2 per tonne, i.e. between USD 468.50 and USD 620.75 per tonne. The price of gasoline peaked at USD 738 per tonne (June 10th) and USD 738.5 per tonne (July 8th), while the price of Brent crude stood at USD 63.9 per barrel and USD 55.7 per barrel respectively.
These simple examples show that over short periods of time, global oil markets and petroleum product markets function independently of each other, reacting to their respective demand and supply signals. Therefore, in order to analyse the extent to which price signals originating on the oil market are transmitted to the gasoline market, we would have to create a model which would take into account not only the price of crude oil, but also all material demand and supply factors which affected the price of gasoline in the period under analysis. As parameters of multivariable models should be interpreted in accordance with the ceteris paribus principle (other things being equal), it would not be possible to use the model to predict the price of gasoline based on the price of crude oil.
Changes of gasoline prices on the global market in 2015 (until August 17th)
In the period from January to early May, the global price of Brent grew, with a brief correction in the first half of March. This period of growth ended in early May, with a consistent, and still continuing, decline beginning in mid-May. This behaviour of crude oil prices (rising and falling) is consistent with the scenario I discussed in February, further aggravated by a strong US dollar.
The price of gasoline essentially followed the price of crude in the period, ignoring any short-term price fluctuations desperately looking to the marginal costs of production, as yet undetermined, to support oil prices. This is, after all, a problem of the oil market, not of the fuel market. After a period of growth, which lasted a month longer than in the case of crude oil, and a two-week period of hesitation as to further direction of change, the price of gasoline has been declining steadily since early July, hitting mid-March levels on August 17th.
In this rough outline, showcasing how the price of gasoline mirrors the price of crude oil over the long term, there is a gap (beginning in early May and ending in late June) at which we should take a closer look. The gap came to be because, following the deceleration seen from late April to mid-May, the price of gasoline began to soar rather than match the declining crude prices, reaching its highest point on June 20th and remaining high until the end of the month, only to enter a downward trend in early July.
The short-term dissociation between gasoline prices and oil prices was caused primarily by the US changing its position on the gasoline market from passive to active. After three years of meeting gasoline demand from domestic sources, the United States suddenly began importing gasoline. The change of position resulted from slumping oil production amid growing fuel demand, which was in turn a consequence of economic growth in the US, lower fuel prices (permanent effect) and the beginning of summer holidays (temporary effect). All of these factors drove the price of gasoline in the US to a level which made importing it from Europe a viable choice. The unexpected increase in demand for European gasoline temporarily increased its price despite declining crude oil prices. The temporary effect disappeared when European refineries adjusted their gasoline output to meet the elevated demand on the American market, and the price of gasoline started declining in the second week of July.
The wholesale prices of gasoline produced in Polish refineries (in Płock and Gdańsk) are tied closely to ARA gasoline prices translated into the Polish złoty according to PLN/USD exchange rates. However, the transmission process is not purely mechanical for several reasons.
Quoted on the ARA market is the price of standardised gasoline, ready to be mixed with biofuels and fuel additives, while wholesale prices are for retail-ready gasoline, which contains appropriate doses of ethanol and antiknock agents increasing its octane rating. These additives can constitute up to 10% of the finished product. As both ethanol and antiknock agents are more expensive than standard gasoline, and their price can fluctuate, the wholesale price of gasoline is higher and can change in a different manner than the price of pure gasoline translated into the złoty.
Furthermore, the wholesale price of gasoline includes excise duty and fuel charge, which drives it well beyond quoted prices (in USD) converted into PLN. According to the data published by the Polish Organisation of Oil Industry and Trade (POPiHN), the average wholesale price of E95 was 82% above the quoted price throughout the period from January to July. Thus, a 10% decrease in quoted prices of gasoline, other things being equal, produced a 6% decline in its wholesale price. The wholesale price of fuel is also affected by the cost of accumulating and maintaining mandatory stocks.
Finally, given the cost of changing prices (known in economics as a menu cost), limiting the number of changes is a good strategy. The economic cost of making no change is taken into account when making such decisions. If a decision is made not to increase wholesale prices in reaction to higher quoted prices or exchange rates, the cost is that of lost profits which could have been achieved with higher prices. If wholesale prices are not decreased in reaction to lower quoted prices of gasoline or exchange rates, the cost is that of lost profits which could have been achieved on higher sales volumes (customers will purchase cheaper fuel from competition).
Since changes in gasoline’s wholesale prices translate into new retail prices, the principle outlined above is also applicable to retail prices, which, however, change less frequently and to a lesser extent than wholesale prices due to VAT. According to estimates by the Polish Organisation of Oil Industry and Trade, taxes (and mark-ups) represented over 50% of the price of the E95 gasoline in the first half of 2015. Thus, other things being equal, a 10% decline in quoted gasoline prices causes the retail price of the fuel to drop by less than 5%.
- The price of gasoline is tied to the price of oil over the long term. However, their daily prices quoted on international markets can diverge for as long as several weeks depending on the situation on the gasoline market. European refineries (including those of PKN ORLEN) therefore set domestic gasoline prices based on ARA gasoline stocks (rather than the price of crude oil), translating prices expressed in the US dollar into their respective local currencies.
- In periods of the US dollar’s appreciation against the Polish złoty (and the euro), gasoline prices expressed in the złoty (and the euro) decline at a slower rate than ARA prices.
- Prices quoted on international markets are those of standardised gasoline, ready for blending. The finished product sold at service stations contains up to 10% of components which are more expensive than gasoline itself and whose prices are not tied to those of gasoline.
- As taxes account for a large portion of the retail price of gasoline (over 50%), changes in ARA prices and exchange rates can affect less than half of the retail price.