Last week while I was off philosophizing, the Federal Trade Commission released a new report on the factors that influence retail gasoline prices (hat tip to Todd Zywicki). The FTC watches retail gasoline prices carefully, and every spring like clockwork when prices go up and my Senator (that would be Dick Durbin) rails against “greedy, price gouging refiners”, the FTC releases an analysis showing the complex set of factors that contribute to the increase in retail prices in the spring.
This year is a little different; prices have been the highest (in nominal terms) that we’ve seen in a while, driven largely by persistently high crude oil prices. If you look at the FTC report, which I recommend, you will find their argument that 85% of the magnitude of price increases has been due to changes in crude oil prices, with the other 15% due to increases in demand and what I’ll call policy variables (boutique fuels fracturing markets, taxes, etc.). A couple of the most interesting details in the report are on p. 11; Figure 3-6 shows a consistent increase in consumption since 1992, while real gasoline prices have not increased with the same pattern. Why this increase? Another interesting fact: average real prices over the last 20 years have been lower than they have been since 1919.
The report also finds that increased environmental regulation since the Clean Air Act Amendments were implemented in 1992 have increased prices by a few cents per gallon, and that the price effect is concentrated in urban areas (duh, that’s where the federal fuel oxygenate requirements are binding).
One of my favorite statements in the report is that profits serve a useful purpose in capitalist economies, in contrast to the typical populist anti-profit rhetoric often used against oil companies:
Profits Play Necessary and Important Roles in a Well-Functioning Market Economy. Recent Oil Company Profits Are High but Have Varied Widely over Time, over Industry Segments, and Among Firms.
Profits compensate owners of capital for the use of the funds they have invested in a firm. Profits also compensate firms for taking risks, such as the risks in the oil industry that war or terrorism may destroy crude production assets or that new environmental requirements may require substantial new refinery capital investments. EIA’s Financial Reporting System (FRS) tracks the financial performance of the 28 major energy producers currently operating in the U.S. In 2003, these firms had a return on capital employed of 12.8 percent as compared to the return on capital employed for the overall S&P Industrials, which was 10.0 percent. Between 1973 and 2003, the annual average return on equity for FRS companies was 12.6 percent, while it was 13.1 percent for the S&P Industrials.
The rates of return on equity for FRS companies have varied widely over the years, ranging from 1.1 percent to 21.1 percent between 1974 and 2003. Returns on equity vary across firms as well.
In the little research that I have done on petroleum refinining companies, I have also seen evidence of this.
The FTC report also discusses the role that boutique fuels can play in exacerbating price variability, a pattern seen in particular in California and Chicago. That finding corroborates those of a GAO report released in June 2005 on boutique fuels.
The proliferation of special gasoline blends has made it more complicated to supply gasoline and has raised costs, significantly affecting operations at refineries, pipelines, and storage terminals. At refineries, making these blends can require additional investment such as installing new processing equipment and the use of larger amounts of valuable components in the blending process-making it more costly to produce special gasoline blends. Once produced, different blends of gasoline must be kept separate throughout the shipping and delivery process, and the increased number of gasoline blends has reduced the capacity of pipelines and storage terminal facilities, which were originally designed to handle fewer products. For example, several pipeline companies reported that the capacity of their systems has been reduced because they have had to slow the speed of products through the pipelines in order to off-load special blends at specific locations, which raises the average cost of shipping gasoline.
Similarly, storage terminals have not been able to fully utilize the volume of
their storage tanks because the tanks were designed to handle fewer types
of fuel and are often larger in size and fewer in number than necessary for handling smaller batches of special gasoline blends. Further, the proliferation of special blends has, according to several buyers from these wholesale markets, limited the number of suppliers of some of these fuels, posing challenges when traditional supplies are disrupted, such as during a refinery outage or pipeline delay. In the past, local supply disruptions could be addressed relatively quickly by bringing fuel from nearby locations; now, however, additional supplies of special gasoline blends may be hundreds of miles away.
GAO evaluated pretax, wholesale price data and found that while oxygenate requirements did improve air quality, they did so at a cost of fragmenting retail markets and increasing prices differentially to customers.
I also want to thank James Hamilton for his post with an updated map of the boutique fuel formulas. This map rocks, and I’ve been using it for years, so I am glad to get an updated, electronic copy:
I also testified at a House Subcommittee on Energy Policy hearing on the transition from MTBE to ethanol in July 2003.
Bottom line: this is a very complex industry, and the factors that affect retail gasoline prices are similarly complex and interwoven. But it’s largely market forces that shape retail prices, not market power, although regulatory and policy variables affect retail prices too.
See also Matt’s comments at The Reconstruction, informed by his extensive research into the topic.