Canadian Retail Gas Pricing 101

(Or “Talk To Me About Gas Retail Pricing—Like I’m in Grade Four”)

Last year back in April-May, when I visited family and friends in Hamilton, Ontario, regular gas was being retailed at the $1.37 to $1.45 per litre range. You could literally hear groans from motorists each morning as they saw the daily updated pricing posted at refuelling stations. During my three-week stay the upward trend was a sustained phenomenon.

 Some close friends — upon learning I worked for the oil and gas industry (sort of, that is) and being based in Alberta — bombarded me with questions about gasoline pricing in Canada. (As if I had something to do with the increases, or that I would know enough to help them understand what was happening).

Truth was (and still is) the explanations I’ve heard from TV talk shows at that time have not greatly eased the clutter in my mind about the subject. I am still far from having a firm grasp of the relevant pricing mechanism.

Most popular questions/observations I received were as follows:

1.“We are a major oil-producing country, aren’t we? How come our gas prices are so high?”

 2.“Can you explain why gas is cheaper South of the border (U.S.A)?”

 3.“Is it true a major portion of the price is taxes?”

 4.“Can government not intervene and make gas prices more affordable especially for low-income families?”

I tried to give them a lay person’s answer to some of the questions but, being as befuddled as they were, I didn’t think I made much headway. The most I achieved,  I think, was to make many of them understand  I was as much in the dark as they were about the issue.

In the aftermath of this encounter with largely disgruntled inquisitors (disgruntled with the system, that is) I tried searching for answers and explanations.  What follows is the result so far of reviewing information at certain key internet sites, particularly the excellent pages devoted to the subject at the Natural Resources Canada website, and at the Department of Finance Canada website.

Item #1:  Petroleum Products Rack Pricing and The Law of Supply and Demand

Source: Google Images – Shortage attributed to State price ceiling (leading to either artificially high consumption and/or supply tightening)

Let’s begin with the rack pricing system which, as in everything else — particularly in a free-market economy or, the very least, in a mixed-economy — is based on the operation of the Law of Supply and Demand.

The rack price of petroleum products is of key importance to refiners because it determines viability of refinery operations. It is the product selling price available to the refiner at the loading rack (hence, “rack price”). And as any sensible product seller would do assuming product mobility — as is the case, for instance, of US and Canada — a refiner (either Canadian or US) would go for the best price available in a given choice of markets.

Thus, to use the illustration at the Natural Resources Canada website – “…if the rack price for gasoline was lower in Toronto than it was in Buffalo, refiners in Toronto would choose to ship their product to Buffalo to sell at the higher price, as long as the cost of transporting it to Buffalo was less than the price difference. …” .

[Translation: In a free-market economy (or a mixed economy with sufficiently strong market forces at work and not one run entirely or mainly by command or dictatorial fiats) refiners will always seek to maximize their revenue and profit by choosing the market with the best selling price. Profitability is the key determinant of such business decisions – not patriotism, not benevolence, or anything else one may consider a higher value or a loftier ideal than so-called “filthy lucre”.]

But eventually, as more product is shipped to Buffalo due to the attractiveness of the rack price in that market the supply will soon build up and the price will soon drop until it is no longer advantageous for the Toronto refiner to ship his product over to Buffalo. Soon the two markets will be in balance.

Item # 2: Effects of North American Petroleum Products Market Integration and Global Market Conditions

It is not just the local supply-demand equation that comes into play when pricing petroleum products. Domestic refiners are “price takers” –  meaning (and using Canadian local refiners as an example) the price of imported petroleum products is used by local Canadian refiners as basis for their own competitive pricing even if Canada were not importing any such products at all.

[Translation: Local or domestic pricing is affected by import pricing regardless of whether we (in this example, we, Canadians) are doing any actual importation of such products or not. The Natural Resources Canada website refers to this practice as exercising “pricing discipline”. Hence, even when a local refiner’s cost structure is very competitive and the supply-demand equation may indicate a lower domestic price is sustainable (or attainable), actual pricing will still be close to the higher import price available in the integrated market.]

Again, the so-called “profit maximization function” will lead a refiner to seek opportunities to exact a higher price to maximize revenues. To repeat the dictum –  for-profit-ventures, such as refining operations, are not driven by patriotism or benevolence: profitability is the moving force behind such a key business decision as product pricing.

Item #3: Effects of Substitute or Alternative Products

Source: Wikipedia – “Porter Five Forces” Diagram showing, among others, substitute products affecting markets and price regimes.

It may be difficult to understand but it is reality: petroleum products pricing is affected not just by the demand-supply situation for a given  petroleum product but by the equation and pricing as applied to alternative or substitute products. Take for example propane which is described in as follows:

 “Propane is a three-carbon alkane with the molecular formula C₃H₈, normally a gas, but compressible to a transportable liquid. A by-product of natural gas processing and petroleum refining, it is commonly used as a fuel for engines, oxy-gas torches, barbecues, portable stoves, and residential central heating.

A mixture of propane and butane, used mainly as vehicle fuel, is commonly known as liquefied petroleum gas (LPG or LP gas). …………………………. .” (Source: Wikipedia)

Thus, for instance, automotive fuels (gasoline and diesel) directly compete with propane as far as its use as a vehicle fuel is concerned. The overall supply and demand equation for petroleum automotive fuels and resulting price regime are thus affected by the demand-supply-price behaviour of propane.

  Item #4: The Very Nature of the Petroleum Product and How It is Used Affect the Price Consumer Pays for  It

Source: Natural Resources Canada – As an illustration the price of diesel fuel, a highly flexible products with competing uses, is affected by how consumers actually use it.

This point is still pretty much along the theme of demand-supply equations. The way consumers use (or consume) the product has a direct bearing on the demand-supply situation and, therefore, its price. One may even correctly say a given product may have competing “uses”; and the whole set of such competing or alternative uses necessarily affects the price consumers are willing to pay. A good example will illustrate this point more clearly and none can probably do it better than diesel fuel.

People who track economic activity – to determine whether it is waning or is on the rise – usually observe diesel demand and consumption patterns as a proxy indicator of economic activity.  A healthy, growing economy will have a strong demand for diesel fuel because goods and services need to be moved and distributed increasingly in such a robust economy. This translates to an increase in truck traffic which largely relies on diesel fuel to run the engines of such huge tractor-trailers and other freight trucks.

Add to this the fact that most agricultural machinery and equipment likewise use diesel fuel. Then also diesel fuel can be easily converted to furnace oil for heating purposes. So versatile is diesel fuel that it is used as a fuel of choice in transportation, agricultural, industrial, and residential applications. The whole slew of such competing uses (translation: demand) is a big factor to diesel fuel pricing.

Item #5: The Tax Regime Applicable to a Given Market Affects the Price Consumers Pay for Petroleum Products

Source: http://www.treehugger.com/corporate-responsibility/ – Comparative fuel tax rates of selected OECD countries.

You must have heard the old cliché about the two things certain in this life: taxes and death. And in Canada automotive fuels are certainly subject to federal excise tax, GST and, depending on the province concerned, provincial tax.

The sum total of such taxes amounts to approximately $0.32 for a representative $1.00 per litre price of automotive fuels.

Item #6: Retailer’s Operating Costs Plus Any Retail Marketing/Promotion Strategy Affect the Price Consumers Pay

Source: http://www.roadtripamerica.com/roadside/ – The only Frank- Lloyd- Wright-designed gas station in the world!

Retail operations entail costs that must be recovered and, to stay in business, such operations must give the operators a sufficient profit margin. Such considerations all affect the actual retail price offered to customers. Also, in certain instances, a retailer may opt to implement a promotion campaign to attract a bigger market share; price competition may be the best option. By offering a lower price they may drive more traffic to a particular retailer.

Summary

How these different key items affect pricing is summarized in the following graph from Department of Finance Canada using gasoline at an illustrative price of $1 per litre:

Approximate Price Components of Gasoline at CAN $1 per Litre (in cents)

Source: Department of Finance Canada (which is careful to note that “Values for crude, refiner and retailer are estimated and are for demonstration purposes only”). Click on image to have a clear view.

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I hope this post sheds some light on the subject of automotive fuel pricing in Canada. I will continue with this topic to touch on some other factors that affect the price customers have to actually deal with. Among the most controversial ones are the effects of a) speculative demand, and b) US $ fluctuation.

I must admit, though, this post hardly meets the challenge of explaining gas pricing in terms easily understood by a Grade Four student. I give up! But go to the Canadian government websites mentioned above. Also, at next post on the subject I will include non-government sites that I stumbled upon recently. They have a better way of reducing the complexity of information on this largely misunderstood topic.

 GeoLogic