Why is the fuel price so high?

published 12 December 2005

Is fuel at an all-time high? Not in real terms, no. Adjusting for price inflation, we have seen prices above 90p a litre several times in recent decades in 2000, 1986, 1981 and 1974. Moreover, in the three decades since 1974 (and even in the five years since 2000), average incomes have risen rather faster than inflation, while cars have become much more fuel-efficient. So all things being equal, you are almost certainly paying rather less in overall fuel costs than previous generations did. Motoring costs have held steady in recent years, particularly in comparison to the surging cost of travelling on public transport (see chart, below left). That said, petrol prices have recently risen sharply and are at an all-time high in nominal terms.

Why have prices risen so much?

Mainly because the price of crude oil the raw material that is sourced and refined into petrol or diesel by oil companies has also been hitting new price records in nominal terms. It is now trading above $60 a barrel. The price of oil is determined by global demand and supply. Right now, demand is very strong, thanks partly to the rapid industrialisation of China, whose primary energy consumption has risen 80% in the past two years. At the same time, supply is pretty tight. Most oil-producing countries are already operating at or near full capacity, and no big oil finds have been made for decades. Political turbulence in the Middle East has also restricted oil supplies. However, recently, the price of petrol has risen more than the price of oil. This is because of a shortage of refining capacity around the world, made worse by Hurricane Katrina, which put several big refineries out of action.

Taxes may be responsible for high prices, but not for rising prices. While the price of fuel has almost doubled over the past decade, the level of fuel duty has risen very little (see chart, below right). And in fact, the proportion of the pump price accounted for by duty has actually fallen. Just five years ago, when the fuel protesters' blockades caused panic buying and shortages, 77% of the price of a litre went straight into the Treasury's coffers. Now, at 67%, it's rather less. It's also broadly in line with the amount paid by consumers in the other big European economies. The latest statistics from the AA show the average UK price for a litre of petrol at 91p (earlier this month), with 67% paid in tax (fuel duty and VAT). That compares with Germany (90p, 65%), France (86p, 66%), Italy (87p, 63%) and Denmark (92p, 64%). But these figures don't tell the whole story. France and Italy also have expensive motorway tolls, while Denmark drivers have to pay a hefty tax on car purchases, making the overall cost of motoring much more expensive. In the US, however, fuel is much cheaper: the average cost of a litre is 37p, with 7.5% paid in tax. Paradoxically, this makes American drivers far more vulnerable to sudden surges in the oil price, since more of the pump price is dictated by the fluctuating cost of oil.

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They certainly are. Thanks to the high price of oil this year, oil companies are generating vastly more cash than anticipated. According to Goldman Sachs, Shell and BP will each generate around $35bn of operating cash flow this year that's based on a conservative estimated average oil price this year of $50. Of this cash mountain, Goldman expects BP to pay out $7.5bn in dividends and spend $10bn on share buybacks, and Shell to use a total of $12bn on dividends and buybacks. But that still leaves them with more cash than they know what to do with.

Fair' or not, it is how capitalism works. Oil is a cyclical and high-risk business, which is particularly vulnerable to peaks and troughs in supply and demand owing to political and other external macro-factors far beyond the control of oil companies. The firms concerned might well point out that they have been suffering from a depressed oil price for the best part of a decade and are entitled to benefit now. Also, last year, £5bn of the £39bn paid out by UK firms in dividends came from oil companies, so they are more than doing their bit for all our pensions. Even without a windfall tax on excessively high profits (called for by the unions, but politically contentious), big oil is contributing healthily to the Treasury's income in corporation tax. According to industry calculations, Gordon Brown will receive an unexpected tax windfall of £10bn if prices stay above $50 until the end of the year. It almost doubles government revenues from oil and comes on top of the £25bn collected in petrol duty each year.

Simon Wilson’s first career was in book publishing, as an economics editor at Routledge, and as a publisher of non-fiction at Random House, specialising in popular business and management books. While there, he published Customers.com, a bestselling classic of the early days of e-commerce, and The Money or Your Life: Reuniting Work and Joy, an inspirational book that helped inspire its publisher towards a post-corporate, portfolio life.

Since 2001, he has been a writer for MoneyWeek, a financial copywriter, and a long-time contributing editor at The Week. Simon also works as an actor and corporate trainer; current and past clients include investment banks, the Bank of England, the UK government, several Magic Circle law firms and all of the Big Four accountancy firms. He has a degree in languages (German and Spanish) and social and political sciences from the University of Cambridge.