Whenever gas prices spike at the pump, explanations abound. Media stories invariably include soothing comments from self-serving economists and industry officials and rarely deviate from a predictable path that can be summed up in a few sentences: The supply of gas was disrupted, and price hikes are just the free market at work regulating supply and demand. A few unscrupulous retailers might be gouging, but no widespread abuses are evident. The price will regulate itself downward when supplies return to normal. Barrels of crude have hit a record high, and OPEC has something vague to do with our problems. And by the way, gas prices are still cheap compared to what they were in the past when adjusted for inflation.
The reports might just as well add a disclaimer: This issue is ultimately far too complicated for you to understand, and we don’t really get it, either.
Like figuring out how airlines set their fares from day to day and city to city, deciphering the gas pricing code does in fact pose a challenge beyond the reach of most mortals. That’s one reason why repeated investigations into illegal profiteering by major oil companies have come up empty. A fresh probe of the petroleum industry by the Federal Trade Commission in the wake of Hurricane Katrina might as well have been announced on Comedy Central.
But at least a few elements of the equation can be identified with some degree of confidence. And they put the lie to the simplistic analyses that flow so freely from the Fourth Estate and the vested interests.
The idea that “market forces” are the primary driver of gas prices is often cited by free-market types. N.C. State economist Michael Walden penned an op-ed in The News & Observer in which he characterized the post-Katrina spike as part of some natural order akin to the law of gravity, in which “prices are set by the interaction of supply and demand.” That was true in the most narrow of contexts: Reduced supply caused by pipeline and refinery outages meant that prices rose, which in turn constricted demand, thus achieving a balance and avoiding dramatic shortages. That is, except for the brief panic triggered by Gov. Easley’s ill-conceived post-Katrina call to conserve gas, which caused a stampede to fill up every vehicle and gas can in the state.
This and similar analyses ignore the basic fact that the oil industry does not operate in a free market, at least in any traditional sense. Rather, the major oil companies have systematically constricted gas supplies over the last 15 years to the point where any disruption–even planned maintenance at refineries–causes prices to leap, reaping massive profits for the companies at the expense of the consumer.
Lest this sound like another paranoid rant by the anti-corporate liberal media, consider a few facts and figures: According to the National Petrochemicals and Refiners Association, capacity to refine crude oil into gasoline and other products in the United States fell by about 9.3 percent between 1981 and 2004, from a peak of 18.6 million barrels per day to 16.9 million. Since 1981, the number of refineries has dropped from 324 to 153; most of those lost were independent operators.
Similarly, the amount of gasoline the companies keep in storage at terminals around the country has substantially decreased. The U.S. Energy Information Administration keeps statistics by region–across the board, on-hand supplies have dwindled by almost 20 percent since 1991. With adequate storage to offset a refinery or pipeline disruption, prices will remain relatively steady until supplies can be restored. Without it, prices hit the ceiling.
Industry apologists have ready explanations for this evolution. Stricter environmental rules passed by Congress and the states at the request of green groups caused the refinery attrition, they say. Companies are simply managing their storage more efficiently, using the “just-in-time” model that manufacturers employ to limit the amount of product sitting around gathering dust and costing them money.
But considerable evidence exists that the refinery shrinkage was by design, not the fault of well-meaning but misguided Sierra Club activists. A 2001 report issued by Oregon Sen. Ron Wyden cited numerous company documents unearthed in lawsuits that urged a consolidation of the refining business and a reduction in the supply of gas. A 1996 internal Texaco memo, for example, noted that “the most critical factor facing the refining industry on the West Coast is the surplus refining capacity, and the surplus gasoline production capacity. The same situation exists for the entire U.S. refining industry. … Significant events need to occur to assist in reducing supplies and/or increasing the demand for gasoline.”
In 2001, the Wall Street Journal reported that Marathon Ashland Petroleum intentionally withheld reformulated gasoline supply in the Midwest in a contrived effort to keep prices–and profits–artificially high, and documents suggest that other companies have done the same. Industry consultant Tim Hamilton, who authored a telling report on the causes of California’s high gas prices, documented that refineries in California and Washington have been increasingly exporting gas to Mexico and elsewhere at prices lower than they could get on the U.S. market. That’s because limiting the domestic supply means that prices will inflate higher than they would have otherwise.
That rationale extends to building new refineries despite record profit margins in the refining sector. “Why would an oil company today invest $2 billion [to build a new facility] and lower the profit of their other refineries?” Hamilton asks rhetorically.
And while environmental regulations did contribute to the refinery decline, it’s beyond naive to think that the oil companies sat idly by when the regs were being formulated. When was the last time that a major federal or state government initiative did not include industry as the most influential player at the table? The Bush administration energy policy is but one screaming example–the policy includes billions in tax breaks and environmental waivers for Big Oil to increase refining capacity. That will only happen, of course, to the extent that oil profits can increase.
As for just-in-time storage inventories, Hamilton points out the fallacy of that argument. If General Motors were to keep an inadequate supply of vehicles or parts on hand and suddenly had to raise prices to meet demand, he says, the company’s competitors would make a killing at GM’s expense. In the oil industry, no such competitive balance exists. “In the oil business, if you fail to meet the needs of your customers, you make a windfall,” Hamilton says. “Nowhere else in the free market does that situation exist.”
The lack of competitiveness that characterizes the industry extends to the retailers, as well. The notion that gas station owners are taking advantage of Katrina and Rita or any other disaster ignores the fact that dealers don’t really have the freedom to set their own prices as they once did. This, too, is by design–as numerous lawsuits and media investigations have chronicled, the major oil companies have effectively taken control of the pump price since the mid-1980s by driving their own independent service station dealers out of business en masse (especially in high-volume urban areas) and replacing many of them with company-owned stations that set the base pump price for everyone else. The few remaining independents often pay higher-than-average wholesale costs yet must still keep their prices in line with the BPs, Exxons and Shells, or lose customers. “There’s not a lot of money to be made on this end of the gas business,” says Randy Spencer, who owns the Farm and Garden country store outside Hillsborough. “All the money is made somewhere else.”
And when supplies are short, the independents are the last to get a delivery. One distributor, who declined to be identified, says that terminal operators in Greensboro shut off supplies last week in anticipation of higher prices in the aftermath of Rita. Not surprisingly, the major branded stations had no trouble getting gas.
To further illustrate the power that the majors have to set retail prices, consider that stations sell gas at different rates from one neighborhood to another within a given market. This phenomenon, known as zone pricing, is dismissed by the companies as reflecting different levels of competition from street to street. But that doesn’t explain why the wholesale price to dealers varies to the same degree, as the cost to produce and deliver the product is exactly the same. Gas is often more expensive in urban areas closer to terminals than in more remote locations, where increased transportation costs ought to result in the opposite outcome. In fact, sophisticated computer software allows the major oil companies to know precisely how much they can charge per gallon to maximize their return on a station-by-station basis.
This badly skewed market model has yielded reliable rewards. ExxonMobil earned more than $15 billion in profits the first half of 2005, a new record for the world’s largest energy giant. The other majors registered impressive billion-dollar profits as well. Analysts predict equally if not more bloated returns in the future.
In a free market, new competitors would enter the marketplace to capture some of this profit, thereby increasing competition and eventually driving prices down. But the barriers to entry at every level are virtually insurmountable, and the existing players are content to split the huge pie while avoiding scrutiny from antitrust regulators by continuing the merger mania of the last decade–flush with cash and nowhere to spend it, ExxonMobil, BP Amoco or Shell would certainly swallow the remaining independents–and each other–if they thought they could get away with it.
Economists, industry insiders and conservative politicians are dead-on in one important respect: Price controls are no solution and would only exacerbate the problems, though not just because they would interfere with market forces. Rather, the companies have the ability to retaliate and would not hesitate to do so, a power that Hamilton calls “Try to intervene and we’ll put you in gas lines.” The only remedy to the current state of affairs is to reduce demand, which will require acts of will from those at the bottom of the food chain, the consumers. Whether or not we choose to do so, that’s the one factor oil companies can’t control.
Contact Burtman at burtman@indyweek.com.
