Why are UK pump prices so high?

Delannoy, Aurelie

Oil prices are once again at the centre of the economic debate, as the recent surge in crude oil prices following the nuclear stand-off with Iran raises concerns for the fragile economic recovery in Europe and in the US. The monthly average price of Brent crude oil rose by about 16 per cent between January and March this year, reaching $125 per barrel. In 2011, Barrell, Delannoy and Holland reviewed the macroeconomic effects of a rise in oil prices, describing direct effects on consumer prices, indirect effects through production costs, and second-round effects resulting from weaker aggregate demand and nominal wage bargaining. Currently, in the UK, fuel prices have reached new record levels, with diesel prices at 1.48 [pounds sterling] per litre in the last week of April 2012, up 7 pence per litre since the beginning of the year (DECC, 2012a). Still higher prices are on their way as part of the government's fiscal plans for 2012-13, with fuel duty rising by 3.02 pence per litre from August 2012, a 2 1/2 per cent price increase based on March pump prices.

Meanwhile, whilst learning about market imbalances and their effect on oil prices brings little relief to a driver filling his petrol tank, many often wonder about the factors leading to such record-breaking pump prices. Simple questions such as, "Why do I pay so much?" or "Who does it benefit?" are common, but the existing literature rarely gives answers with clarity. Studies often focus on shocks to the international oil markets, such as supply and demand conditions, to explain high crude oil and product prices (Kaufmann, 2010; Kilian, 2008).

In this note, we attempt to answer these questions, shedding light on key drivers of pump prices, and providing a clear decomposition of the fuel price paid by consumers. We proceed in two stages. In the first section, we examine the pass-through effects of crude oil prices into pump prices paid by consumers. Blair and Mixon (2011) analysed this pass-through on US gasoline prices and estimated that each $1 change per barrel of crude oil resulted in a change in gasoline pump prices per gallon of between 2.52 [cents] to 2.65 [cents], depending on their geographical location. Following a similar approach, we estimate the relationship between crude oil and pump prices in the UK, using monthly data for Brent crude oil and post-tax diesel pump prices. Estimation results show that a further $10 rise in the price of a barrel of Brent crude this quarter would result in an eventual 4.9 pence per litre rise in diesel pump prices.

In the subsequent section, we consider the impact of factors other than crude oil on pump prices. Through a full decomposition of pump prices, we show that fluctuations in the various costs and profit margins of the production and distribution chain have a relatively small impact on pump prices. High pump prices in the UK, as in the rest of Europe, primarily reflect tax revenues of the two governments involved, i.e. the government in the oil producing country and the one in the fuel consuming country. The UK is both producer and consumer, allowing the government to impose taxes on both the production and consumption of many petroleum products domestically consumed. For example, the UK government received, on average, almost three-quarters of the revenues from diesel sold at the pump in 2011. The final section summarises our findings and concludes.

The pass-through of crude oil prices to pump prices

High and ever-increasing crude oil prices are often blamed for high pump prices, especially following events such as political tensions in the Middle East, supply and demand imbalances and changes in OPEC policies and views. The world's major consuming nations, including the UK, have been considering the release of strategic petroleum stocks to minimise the risks of further crude price rises, although there has not been any decision taken yet. Figure 1 shows the price of Brent crude oil on the open market and diesel pump prices in the UK since 2002. The similarity in the behaviour of both time series is striking, with post-tax pump prices strongly positively correlated with crude oil prices (r = 0.97).

Yet a careful analysis of this relationship shows that variations in crude oil prices do not fully explain the variations in pump prices. We use data for crude oil and diesel pump prices in the UK and estimate a simple error correction relationship between the two series. Diesel prices are regressed against crude oil prices using monthly average observations for Brent spot prices and diesel pump prices inclusive of taxes in the UK in US dollars per litre. We use the average monthly GBP-USD exchange rates to convert sterling pump prices into US dollars. The sample spans the period April 2002 to April 2012, so that it includes the sharp price rise seen on the oil markets in the past decade. The long-run relationship between the two series is confirmed by an augmented Dickey-Fuller unit root test on residuals. We estimated the following error correction specification, based on three lags:

[MATHEMATICAL EXPRESSION NOT REPRODUCIBLE IN ASCII]

[FIGURE 1 OMITTED]

where D is the monthly average diesel pump price in the UK, B is the monthly average Brent spot price, and [c.sub.i] are the estimated parameters. In order to obtain a more parsimonious model, we then tested down and removed lags that were not significantly different from zero at the 5 per cent level. Table 1 reports the estimation results.

The estimation provides us with the long-run relationship between crude oil prices and diesel pump prices in the UK. Results show that a 1 per cent rise in the Brent crude oil price is associated with a 0.4 per cent rise in the diesel pump price in the long run. Thus, a $10 per barrel rise in the price of Brent between the first and second quarter this year would be associated with a 4.9 pence rise in diesel pump prices in the long run, assuming the bilateral exchange rate remains unchanged at 0.614 [pounds sterling] per US dollar. However, they would rise by only 1/4 per cent (3.1 pence) immediately after the rise in Brent crude oil.

In addition, the estimation also shows that variations in the Brent crude oil price explain only about 56 per cent of diesel price movements at the pumps. In the following section, we attempt to explain the rest of the variation through a decomposition of diesel pump prices, distinguishing between taxes, costs and profit margins that occur between the extraction of crude oil and the sale of fuels at petrol stations. We estimate their relative share on consumer prices for diesel between 2003 and 2011, and look at the fluctuations of each component in order to account for the 60 pence pump price rise over the period. Finally, based on what we learned from this decomposition, we consider the recent developments on the oil market and their effect on pump prices.

From the ground to the pumps: understanding fuel prices

Organisation of the oil market

To enable a full decomposition of pump prices, one needs to explore the production and distribution chain for finished oil products in order to identify the most significant price determinants, from taxes to costs and profit margins at each stage of the oil market, and their respective impact on pump prices.

The production and distribution chain of finished oil products is divided into four main stages, consisting of (1) the production of crude oil, which includes exploration activities and is often referred as the 'E&P' sector, (2) the refining of crude oil into usable products, (3) the marketing and distribution of refined products, and (4) the consumption of fuels. Figure 2 presents this organisation and some of the main components.

[FIGURE 2 OMITTED]

Based on this organisation of the oil market, and with available data, one can estimate the shares of pump prices that are attributable to each stage of the production and distribution chain. Wherever possible, we use UK data for the breakdown of UK pump prices. However, due to some limitations, we compute freight rates and gross refining margins using European series as proxy. We use Brent crude oil spot prices as our starting point, and then work down the production chain.

Producing crude oil

The first stage of this pump price decomposition consists of analysing the production stage of the crude oil. The free-on-board (fob)(1) price of crude oil at the point of export determines the oil companies' gross revenues and the taxes imposed by the host government. It provides an insight into the distribution of profits between the oil producer and the government of the producing country. The tax system currently in place for oil and gas exploration and production from the UK and the UK Continental Shelf is composed of a petroleum revenue tax (PRT), a ring-fenced corporation tax (RFCT), and a supplementary charge (SC). (2)

The PRT is a field-based petroleum profit tax applied to all fields given development consent before March 1993, whilst it does not apply to newer fields. The current rate is set at 50 per cent and is payable on the company's net revenues after deductions for developing and operating expenditures. It is also deductible as an expense for RFCT and SC computations.

The RFCT applies to the profits of all UK registered companies and not just oil corporations. The ring-fence applies to oil exploration and production activities to prevent the offsetting of profits with losses in other activities, such as refining. It is currently set at 30 per cent of companies' profits. The series of reductions to the main rates of corporation tax since 2008 have not been applied to the RFCT for upstream oil activities.

Finally, the SC, first introduced in 2002, is levied on profits along with the RFCT. Its rate was initially set at 10 per cent and then raised to 20 per cent in 2006 and to 32 per cent in 2011.

Altogether, this means that fields with consent obtained before March 1993 had a marginal corporate tax rate of 81 per cent of their taxable income in 2011, up from 70 per cent in 2003. Newer fields face a marginal tax rate of 62 per cent since they are exempt from PRT. When considering existing fiscal systems in other parts of the world, we observe that fiscal pressure varies greatly depending on the industry's potential in terms of costs, discoveries and/or political stability. Johnston (2008) shows that government tax share varies from less than 30 per cent in Ireland to over 95 per cent in countries such as Libya, Venezuela and Iran. Lower tax shares are usually found in countries where oil prospects are weakest and/or where costs are highest. Notably, North America has some major sources of oil sand and shale, which are more expensive to extract and to refine and, in the North Sea, oil activities remain complex and expensive. Thus, in oil regions with uncertain and/ or challenging geological prospects, governments may need to provide greater incentives to attract foreign investments. One such route could be the tax regime imposed on the oil extraction industry. Meanwhile, nations with the greatest oil prospects, which include most OPEC producers, enjoy much better prospects in terms of oil discoveries and costs, thus attracting fierce competition in foreign investments and allowing governments to extract a bigger rent.

The Energy Information Administration (EIA) provides data on finding and lifting costs up to 2009. (3) For the purpose of the 2011 pump price breakdown, we simply assumed that these costs have remained stable in nominal terms since 2009. In 2009, the European lifting costs reached $8.96 per barrel, whilst the average finding costs represented $42.32 per barrel. This is in comparison to $5.75 and $6.99, respectively, for crude streams originating from the Middle East. These costs have risen significantly since 2003, but a faster rate of increase in crude oil prices led to a cost share actually falling from 57 to 46 per cent of the selling price.

[FIGURE 3 OMITTED]

As a result, companies' net revenues (the revenue before tax and after cost deductions) increased sharply from $12 to $60 per barrel over the period, but the share of companies' profits in net revenues actually fell from 30 to 19 per cent, due to the increase in the supplementary charge rate. Nevertheless, company profit margins per barrel of Brent crude oil rose threefold between 2003 and 2011.

Altogether, these data suggest that the high crude oil prices seen over the past decade reflect rising production costs, notably finding costs, as companies increasingly face problems of limited access to cheap and lower risk oil investment opportunities. But this should not distract from the role of global supply and demand. Tight demand and supply balances on the oil market in recent years, notably due to strong demand pressures from emerging economies, have also allowed producer profit margins and government tax revenues to rise.

Refining crude oil into diesel

The estimation of the share of refining costs and profits in diesel pump prices between 2003 and 2011 is not a straightforward computation. Available data on refining operating costs and margins are normally available per unit of input, i.e. per barrel of crude oil processed, rather than per unit of output. This is because refining a barrel of crude oil results in the production of various refined products including diesel, petrol, liquefied petroleum gas

(LPG), jet fuel and other residues such as lubricant and asphalt. The economics of refining has two key elements: the crude oil input cost and a gross refining margin.

The input cost relates to the cost of the crude oil required to produce one litre of diesel and the freight costs to transport the crude oil to the refinery. About 80 per cent of the crude oil refined in UK refineries originates from the North Sea, notably from the UK and Norway (UKPIA, 2011). We therefore estimate crude oil costs using the Brent fob spot price at Sullom Voe. Due to some limitations, we assume freight rates between Sullom Voe and the British Refineries to be equivalent to the tanker rates (4) between Sullom Voe and Rotterdam refineries.

The price of a barrel of Brent crude oil at Sullom Voe almost quadrupled between 2003 and 2011, and reached $125 per barrel (159 litres) in March 2012. Assuming that about 20 per cent of a barrel of Brent crude oil yields diesel once refined (BP, 2011), refiners needed about 43.6 pence of crude oil to produce a litre of diesel in 2011. This is about a third of the price realised at the petrol pump. Meanwhile, freight costs to carry the crude oil between Sullom Voe and the refineries remained negligible, representing about 0.3 per cent of diesel pump prices (less than half a penny per litre). The sum of both crude oil and freight costs represents the cif (5) cost of crude oil to produce 1 litre of diesel. This figure reached 44 pence per litre of diesel in 2011.

The second element of the economics of refining is the gross refining margin, i.e. the sum of the total refining operating costs and profits. In other words, it is the difference between the value of a litre of diesel at the refinery (the ex-refinery price) and the cif cost in crude oil necessary to produce it. The gross refining margin between 2003 and 2011 averaged $4.45 per barrel of crude oil processed, but it was down to $2.86 per barrel in 2011. On a litre of diesel produced, the gross refining margin reached 7.2 pence in 2011, 1.1 pence in refining costs and 6.1 pence in profit margin. (6)

Figure 4 illustrates the variations between 2003 and 2011 of the refining costs and margins that compose the ex-refinery price. The rise in the ex-refinery price reflects rises in both costs in crude oil and refiners' profit margins. Meanwhile, although freight and operating costs fluctuated over time, they remained negligible as a share of the final price and their effect on the resulting pump prices may be ignored. Moreover, whilst in 2011 profit margins stood about 2.5 times their level in 2003, their share of the ex-refinery price and pump price fell significantly due to a significantly faster increase in crude oil costs.

[FIGURE 4 OMITTED]

Marketing and distribution (M&D)

The M&D gross margin is the sum of costs and profit margins occurring between the oil refineries and retail pumps, and includes the distribution of finished oil products, storage, marketing and operating retail outlets. The UK Petroleum Industry Association (UKPIA) refers to this as the retail/ex-refinery spread: the difference between the ex-refinery petrol price on the open market and the pre-tax pump price.

Data from the UKPIA suggest that M&D gross margins reached 5.8 pence per litre of diesel in 2011, which is about 4 per cent of pump prices. These margins have shown some volatility over the period 2003-11, but have remained very thin and therefore had little overall effect on pump prices. Looking at diesel prices between 2003 and 2011, M&D gross margins accounted for only a 1/4 per cent of the 60 pence increase at the pump.

The consumption stage: pump prices, consumption taxes and currency fluctuations

British consumption taxes on petroleum products represent a significant share of pump prices. Existing data series on diesel prices include prices per litre, exclusive (pre-tax) and inclusive (post-tax) of domestic taxes. Pre-tax prices represent the total costs and margins included in the price of a litre of diesel, whilst the difference between pre- and post-tax prices is the total domestic tax applied by the government on the consumption of petroleum products. In the UK, this is composed of two elements: a fuel duty, i.e. a fixed excise tax on fuel consumption, and the standard value-added tax (VAT) rate. In 2011, consumption taxes averaged about 59 per cent of the 1.38 [pounds sterling] per litre of diesel at the pump, the highest tax share in Europe. Looking at the 2003-11 period, consumption tax revenues rose by 23.5 pence per litre (40 per cent) as pre-tax prices per litre of diesel almost tripled. The government temporarily reduced the VAT rate from 17.5 to 15 per cent between December 2008 and April 2010 and raised it to 20 per cent in 2011. However, the consumption tax share on pump prices actually fell dramatically from about 74 to 59 per cent between 2003 and 2011.

[FIGURE 5 OMITTED]

In addition to consumption taxes, currency fluctuations also have a major impact on pump prices. Crude oil and refined product prices on the international market are denominated in US dollars. Currency movements therefore have implications for pump prices irrespective of global oil price developments. The weakening of the US dollar between 2003 and 2008 offset some of the increase in the dollar price of oil faced by the UK. From mid-2008, the sharp depreciation of sterling has had the opposite effect. To estimate the gain (loss) this has generated on pre-tax diesel prices, one should consider a situation where the GBP/USD exchange rate had remained stable at its 2003 level through to 2011 ($1=0.614 [pounds sterling]), and compare the hypothetical pretax diesel price obtained with the actual price observed (figure 6). Without the appreciation of sterling, the 2008 pre-tax diesel price would have been about 15 per cent dearer than the actual pre-tax price, holding all other factors constant, saving 18 pence per litre at the pump. However, weaker sterling since 2009 added 2 pence to the 2011 pump prices compared to the counterfactual of a constant exchange rate since 2003.

[FIGURE 6 OMITTED]

Conclusions

The decomposition of the pump price of diesel clearly illustrates that the main beneficiary of high pump prices is the UK government. On the one hand, the significant contribution of taxes on final prices is a widely known characteristic of the oil market. Headlines typically focus on consumption taxes at the expense of taxes on the production side of the market. While these certainly contribute a significant amount to pump prices, ignoring taxes paid by oil corporations operating in the UK underestimates the economic rent received by the government from a litre of diesel sold at a UK petrol station. On the other hand, the very small contribution of producers' and refiners' profit margins, which together represented less than 8 per cent of pump prices in 2011 (figure 7), gives a clearer dimension than the regular headlines announcing profit statistics of some major international oil companies, such as BP, Shell and Exxon Mobil (The Economist, 2011). This conclusion is also valid for most oil consuming nations and crude streams. Fuel prices over time reflect the conditions of the oil market and its fundamentals. In recent years, this is notably the increase in upstream production costs between 2003 and 2011. Even so, the final price consumers face is largely a story of taxes. We show in figure 7 that about two thirds of the diesel pump price increase seen between 2003 and 2011 returned to the government in tax revenue. Comparing the decomposition of diesel pump prices in 2003 and 2011 (table 2), we can see that the additional 60 pence per litre of diesel paid by consumers represents a rise of 23.4 pence in government tax revenue due to the increasing VAT rate and fuel duty. The government also generated a further 3.5 pence in tax revenue from the increase of the supplementary charge rate on extraction and production from 10 to 32 per cent. Meanwhile, producers' and refiners' profit margins accounted for only 6.7 pence per litre of the pump price increase.

Naturally, consumers cannot expect much support from the oil producers and refiners in order to relieve the inflationary pressures caused by fuel prices, as their pricing strategy reflects market conditions and profit maximisation. Thus the government is the only agent who might have an incentive and the capacity to lower or minimise any increases in pump prices in a significant manner. Yet, the solution is not that simple, as oil prices and fuel consumption are also key elements in wider issues such as government revenues for policymaking, as well as energy and environmental issues. Last year, fuel duty alone contributed 1.8 per cent of GDP (OBR, 2012), and was the fifth biggest contributor to government tax revenue after income taxes, national insurance contributions, VAT receipts and corporation tax receipts. Assuming diesel pre-tax prices and consumption constant, a 3.02 pence rise in fuel duty this year would increase government's duty receipts by 5.2 per cent, whilst also adding 0.6 pence per litre of diesel in VAT. This will put a further strain on low-income households, as fuel expenditure already represent 8.5 per cent of their total expenditure (DECC, 2011). However, one must also consider other policies that focus on the low-carbon economy, notably by raising energy efficiency and promoting alternative sources of energy to fossil fuels, both encouraging a reduction in fossil fuel consumption, and therefore reducing the burden of fuel expenditure, and thus taxes, on consumers. These include the 'Green Deal' and 'Energy Company Obligation', both introduced in the Energy Act 2011, which aim at enhancing energy efficiency, further reducing carbon emissions and addressing fuel poverty.

REFERENCES

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Blair, B.F. and Mixon, P.A. (2011), 'Price pass-through in US gasoline markets', available at: http://papers.ssrn.com/sol3/papers. cfm?abstract id=1876557.

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DECC, The UK Upstream Oil and Gas Tax Regime, available at: http:// og.decc.gov.uk/assets/og/ep/taxation/taxregime.pdf.

--(2011), UK Energy in Brief 2011: Dataset. Table T36: Fuel Expenditure of Households, available at: http://www.decc.gov.uk/en/content/ cms/statistics/publications/brief/brief.aspx.

--(2012), Premium Unleaded Petrol and Diesel Prices in the EU, table 5.1.1 and 5.2.1, available at: http://www.decc.gov.uk/en/content/ cms/statistics/energy_stats/prices/prices.aspx.

--(2012a), Oil and Petroleum Product Price Statistics: weekly fuel prices, available at http://www.decc.gov.uk/en/content/cms/statistics/ energy_stats/prices/prices.aspx.

Economist, The (2011), 'Big oil's bigger brothers--a high oil price is great for oil companies, but it also attracts competitors', 29 October.

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Johnston, D. (2008), 'Changing fiscal landscape', Journal of World Energy Law & Business, 1, 1, pp. 31-54, available at: http://jwelb. oxfordjournals.org/content/1/1/31.full.pdf.

Kaufmann, R.K. (2010), 'The role of market fundamental and speculation in recent price changes for crude oil', Energy Policy, 39, pp.105-15.

Kilian, L. (2008), 'Why does gasoline costs so much? A joint model of the global crude oil market and the U.S. retail gasoline market', Centre for Economic and Policy Research, discussion paper no. 6919.

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UKPIA (2011), Statistical Review 2011, available at: http://www.ukpia. com/files/pdf/stats-review-2011.pdf. --(various issues), UK Average Major Brand Petrol and Diesel Pump Prices, available at: http://www.ukpia.com/ fuel-prices-historicdata.aspx.

NOTES

(1) Thee 'free-on-board' price is the price paid at the export point, excluding freight, insurance and other costs incurring between the export to import points.

(2) Royalty payments were abolished at the end of 2002 and so do not affect the sample period covered in this study

(3) Annual data for lifting costs and 3-year average for finding COSTS.

(4) US dollars per metric tonne of crude oil transported.

(5) Cost, Insurance & Freight.

(6) Within this gross refining margin, it is possible to distinguish between the refinery's operating costs and profits. Using monthly data on the refinery gross margin on Brent in Northwestern European refineries, along with annual estimates of refining operating costs (Purvin and Gertz, 2008), we estimate how much out of total costs and profits are transferred specifically into the pump price of a litre of diesel in the UK. We compute the refining costs based on the assumption that the ratio between the value of a litre of diesel and the value of all refined products obtained from a barrel of Brent (its growth product worth or GPW) is comparable to the ratio between the costs of producing a litre of diesel and the total refining costs on a barrel of Brent. The GPW is estimated as the sum of the cif cost for a barrel of crude oil and the total gross refining margins on this barrel; the profit margin is the difference between the gross refining margin and the operating costs of producing a litre of diesel. We find that the value of a finished litre of diesel (the ex-refinery price) represented about 0.7 per cent of the total GPW. Applying this share to the total operating costs, we obtain an estimate for the cost of producing a litre of diesel, i.e. about I. I pence in 2011, leaving 6.1 pence as profit margin.

Aurelie Delannoy, NIESR, e-mail: a.delannoy@niesr.ac.uk. The author would like to thank Phil Davis, Dawn Holland, Simon Kirby and Iana Liadze for their comments.

doi: 10.1177/002795011222000110

Table 1. Error correction estimates

Long-run coefficients
Diesel 1.00
Brent [c.sub.3] -0.394 *** (0.026)
Constant [c.sub.1] 0.203 *** (0.055)
Short-run coefficients
Speed of adjustment [c.sub.2] -0.218 *** (0.057)
Change in diesel
previous periods [c.sub.4,3] 0.130 ** (0.064)
Change in Brent
previous period [c.sub.5,0] 0.247 * (0.028)
 [c.sub.5,1] 0.099 *** (0.029)
No. of observations 117
R-squared 0.56
Log likelihood 253.24

Source: Datastream series for Brent Spot (free on board) in USD
per barrel, and UK diesel prices incl. tax in GBP per kilolitre.
Notes: Monthly averages from April 2002 to March 2012. Final
equation passed serial correlation LM test. Standard errors are
presented in parentheses. *** denotes significance at the 1 per
cent level, ** denotes significance at the 5 per cent level, * denotes
significance at the 10 per cent level.

Table 2. Decomposition of the UK diesel pump price in
2003 and 2011 *

Pence per litre of diesel 2003 2011 Var.
 03-11

Consumption: Pump price 77.9 138.2 60.3
 VAT 11.6 23.0 11.4
 Fuel duty 46.1 58.2 12.0
M&D: Marketing & Distribution 5.6 5.8 0.1
Refining: Refining operating costs 0.8 1.1 0.4
 Refining profit margin 2.4 6.1 3.6
Transportation: Freight 0.3 0.4 0.1
Production: Production costs 6.4 20.1 13.7
 Petroleum revenue tax 2.4 11.8 9.4
 Ring-fenced corporate tax 0.7 3.5 2.8
 Supplementary charge 0.2 3.8 3.5
 Producers' profit margin 1.4 4.5 3.1

* Details on the calculations are available from the author.

Figure 7. Composition of the UK diesel pump price, 2011

Prod. & Ref. profit margins 7.6%
Prod. & Ref. costs 15.4%
Mark. & Distrib. 4.2%
Taxes 72.5%
Freight 0.3%

Source: Author's calculations.

Note: Table made from pie chart.