Why don't petrol prices fall as quickly as oil prices?

The huge slump in the price of oil has not been mirrored by a similar fall in prices at the pumps. We look at the various factors that contribute to the price of a litre of petrol or diesel

When the price of oil falls, so the theory goes, pump prices only drift down like a feather, while retailers pocket the difference

Motorists are finally starting to enjoy lower prices at the pumps, after months of low oil prices.

Petrol has slipped below £1 a litre in some parts of the country for the first time since 2009, while diesel has also fallen to 99p a litre at the big four supermarkets.

Even if the fuel was free, no charge was made for delivery and retailers didn't take a margin, it would still cost roughly 69.54p a litre to fill up, based on today's pump prices, all of which would go straight to the Treasury
The RAC

Brent crude oil, which cost over $106 a barrel in June last year, has plunged 64pc inn the last 18 months to around $37.91, its lowest price in more than seven years.

But why have petrol prices been so slow to follow suit?

One answer is that the price of oil only makes up a fraction of the price of a litre of petrol or diesel at the pumps. There are also retailer and refiner margins, currency fluctuations and, of course, tax.

Let's look at all those different components in order of importance.

Tax on fuel

George Osborne has frozen fuel duty over the past few years
George Osborne has frozen fuel duty over the past few years

The biggest chunk of the price of fuel is, you guessed it, tax. You pay 57.95p per litre on both petrol and diesel.

That's not all. You also pay standard rate VAT at 20pc.

So, even if the fuel was free, no charge was made for delivery and retailers didn't take a margin, it would still cost nearly 70p a litre to fill up, based on today's pump prices, all of which would go straight to the Treasury, according to the RAC.

In 2014, on average a full 62pc of the pump price of petrol and diesel in the UK was made up of excise duty and VAT, according to the UK Petroleum Industry Association.

The Chancellor reduced fuel duty by a penny a litre in his 2011 Budget and kept it frozen all through the last parliament. However, he has been making noises about raising it again at this year's Budget.

Even if the fuel was free, no charge was made for delivery and retailers didn't take a margin, it would still cost nearly 70p a litre to fill up, based on today's pump prices, all of which would go straight to the Treasury

By contrast, the RAC has been campaigning for a reduction in fuel duty.

Simon Williams, the RAC's spokesman on fuel, said: "Considering the Chancellor’s problems with tackling the deficit, achieving a cut in fuel duty is probably unrealistic. However, the Treasury’s own analysis confirms that there is a direct link between fuel duty and economic growth, so when fuel duty goes up, this impacts negatively on economic growth and visa versa.

"We believe therefore that the duty freeze has helped to keep Britain moving as the price of fuel is a significant cost both for households and businesses."

Oil prices

The cost of oil is only the second biggest element in the cost of fuel.

And this can itself be broken down into several components. Here, again, tax plays a huge role. Governments around the world charge oil companies tax as a percentage of their profits and through export duties. Other costs include those for exploration, operating and capital. The exact mix tends to be quite murky.

The failure of Opec to put a stop to the overproduction of oil at their meeting last week sent prices plummeting
The failure of Opec to put a stop to the overproduction of oil at their meeting in December 2015 sent prices plummeting

Oil, like all commodities, is also subject to the laws of supply and demand. And at the moment there is a lot of supply.

A meeting of the Organisation of Petroleum Exporting Countries (Opec) broke up in acrimony in December 2015 with members failing to agree production targets. Opec has had the taps turned on full for over a year in an attempt to force down the price of oil and put higher-cost producers, like the shale industry in the US, out of business.

So far they have not been sucessful. And so they keep on pumping.

Retailers

When the price of oil falls, so the theory goes, pump prices only drift down like a feather, while retailers pocket the difference
When the price of oil falls, so the theory goes, pump prices only drift down like a feather, while retailers pocket the difference

The third biggest component in the price of a litre of fuel - after tax and the price of oil - is the retail and wholesale margin.

This is not as much as some might think as the different retailers compete fiercely with one another on price. The UKPIA estimates that retailer and refiner margins combined made up 5pc of the cost of pump prices on average in 2014.

Nevertheless, retailers often stand accused of passing price hikes on to customers quickly but delaying price falls. It's know as the "rocket and feather effect" - up like a rocket and down like a feather.

Luke Bosdet, a spokesman for AA, cited a discrepency between oil prices and wholesale petrol prices in 2015 as the perfect example for why there should be more transparency in this area, for the benefit of the retailer and consumer alike.

He explained that at the start of February 2015, the average UK petrol price bottomed out at 106.39p a litre – the lowest since October 2009. Throughout January, wholesale petrol averaged $475 a tonne with oil at $49 a barrel. But in November, wholesale petrol averaged $479 with oil at $44.

Mr Bosdet explained: "According to the industry’s rule of thumb a $2 change in the price of oil brings a 1p change at the pump at a constant exchange rate. That would lower the price of petrol by at least 2p a litre."

The RAC's Simon Williams said retailers have a "reasonable" recent record of passing on savings, but added that RAC Fuel Watch monitors this to check they are following through.

He said: "Sometimes we’d like to see cuts being made a little quicker but there are also times when wholesale prices go up and the pump prices don’t necessarily follow them; this is why RAC Fuel Watch monitors the same data they use as they sometimes take a little encouragement."

The strength of the dollar

The dollar is strong at the moment in expectation of a rate rise by the US Federal Reserve later this month
The dollar is strong at the moment in expectation of a rate rise by the US Federal Reserve later this month

The price of crude has also been pushed lower by a strengthening dollar - the currency in which the commodity is priced - which was boosted by the US Federal Reserve's decision to raise interest rates at the end of 2015. But this benefit does not feed through to the pumps in the UK where fuel is paid for in sterling.

Williams said: "Sometimes the barrel price can reduce but the wholesale price increases, often due to the dollar gaining on the pound."

The graph below shows how the decline in cost has been slower when converted into pounds.