Fundamentals of Spring Gasoline Price Increases

Lynne Kiesling

The following is a post I wrote in March 2004 about the regular, annual, seasonal rise in gasoline prices that always occurs at this time of year. I am reposting it here because it generally still applies, and I am inserting some updated comments in bold below.

Being systematic, here are the primary reasons for the rise in gasoline prices in March 2004:

1. High world crude oil prices. These prices are partly the consequence of conscious OPEC supply constriction to raise price. OPEC�s ability to do so is typically constrained by three interrelated factors: the world demand for oil, cheating on the part of smaller OPEC members, and production from non-OPEC countries like Russia, Norway and Mexico. Economic growth, particularly in Asia, is shifting out the demand for oil according to this Ft. Worth Star-Telegram article:

Strong demand for oil in Asia is one reason for higher crude prices in recent months, although analysts also said that aggressive bets by large commodity speculators have contributed to the recent run-up in oil markets. Much of the attention on Asian oil supplies is related to the fast-growing economies of China and India.

Sales of diesel fuel in India, which account for about 40 percent of the oil sold in that country, soared 10 percent in February from the same month a year earlier; automobile sales in India grew 31 percent in the last year. India’s oil imports are forecast to continue to climb as its economy grows 8 percent this year.

This Investor’s Business Daily article points to the other two aspects of this dynamic: Saudi Arabia is still the “swing producer” because of the scale of its reserves relative to other producers, and some OPEC members have not curtailed production to meet the targets OPEC set in their 1 February meeting. Saudi Arabia�s production is the primary determininant of the world price, and with rising demand the growth in production in Russia and in Iraq has not been sufficient to change that fact. And small OPEC producers are riding the crest of this high price, not restricting their output.

No current discussion of OPEC is complete without reference to the horrendous state of affairs in Venezuela. Their low production adds substantially to the high prices we are currently experiencing.

OPEC is currently discussing whether or not to continue its output restrictions at the end of the month, and today�s news suggests that they are fighting internal battles over whether to pursue output restrictions when their benchmark price is $4 above the high end of their usual benchmark range.

2007 update: Economic growth in Asia has continued, although it might slow somewhat. The horrendous state of affairs in Venezuela has gotten worse, including the nationalization of the oil industry and expropriation of foreign assets. Russia has given in to the “natural resource curse”, nationalized some of its oil assets, expropriated foreign investment, and now gets most of its government revenue from the sale of oil and natural gas. It has moved from oligarchy backward to autocracy.

2. Existing environmental regulations making supply more inelastic. Petroleum refiners in the US must meet the EPA’s federal fuel oxygenate requirement from Title II of the Clean Air Act Amendments of 1990, which mandates a 2% oxygen content in fuel in ozone non-attainment urban areas. Furthermore, refiners are required to drain all of the winter fuel from their tanks before replacing it with summer fuel, which in most markets must have inventory built up to start sales on 1 April. On top of that, states can choose to implement their own fuel formulation requirements to address their specific geographic and climatologic conditions that lead to different local air quality conditions. As a result, the US now has over 40 fuel formulation requirements at different times and places.

Think about what this does physically and economically. People continue driving in March, and continue to use winter-blend fuel while the inventory of winter-blend fuel falls, ideally to zero at midnight on 31 March. Inventory storage costs are very high for petroleum, so keeping a buffer of winter fuel through March and over the summer is very expensive (this point is in response to a question from Virginia Postrel on storage). Not only do people generally not want new refineries built near them, they also do not want new tank farms built near them. So storage capacity is a binding constraint.

So of course the seasonal fragmentation that the oxygenate requirement introduces into fuel supply would cause prices to rise in March, all other things equal. This temporal fragmentation exacerbates the balkanization of fuel markets, because of the 40+ fuel formulations in effect. Note especially that this fragmentation across both time and place makes the supply of gasoline more inelastic. Confront that with an inelastic demand for gasoline, and one that shifts out and becomes more inelastic in the spring and summer months, and you have a policy-driven exacerbation of the potential for price spikes.

The California prices are also driven by the switch from MTBE as fuel oxygenate to ethanol, a switch that is taking full effect for the first time in 2004. Ethanol, a corn-based additive, is not produced in California, cannot be shipped from the Midwest to California in oil pipelines, and is highly water soluble, so it can only be added to the fuel at the rack (basically, right before it ships out to gas stations). And Senator Boxer wonders why the price of gasoline in California has gone up to $2.18/gallon? I suggest that she review Title II, Section 211 of the Clean Air Act Amendments of 1990. You can also read my testimony to a Congressional hearing on the MTBE/ethanol transition in California from July 2003 for more background.

2007 update: EPAct 2005 eliminated the use of MTBE as an oxygenate nationally. The increased demand for ethanol from this and other ethanol-favoring policy is increasing corn prices, which in turn increase the prices of beef and chicken (because corn is an input in livestock production) and soybeans (because corn and soybeans compete for arable acreage). Boutique fuels and fuel market balkanization continues, notwithstanding attempts to “rationalize” it.

3. New air quality regulations taking effect in 2004. The EPA’s Tier 2 sulfur control regulations, leading to the co-development of low-sulfur fuels and vehicles optimized to the use of low-sulfur fuel, took effect in January 2004. This program to reduce sulfur content in fuel will be phased in over three years, and 2004 is the first year in which refiners will be required to meet overall sulfur content regulations, according to this EPA fact sheet on the Tier 2 regulations:

Beginning in 2004, the nation’s refiners and importers of gasoline will have the flexibility to manufacture gasoline with a range of sulfur levels as long as all of their production is capped at 300 parts per million (ppm) and their annual corporate average sulfur levels are 120 ppm.

More information on the regulations is available at the EPA OTAG Tier 2 website. The Tier 2 regulations can be found in the Federal Register from 2000.

These new regulations, while likely to deliver improvements in air quality, are going to increase gas prices, at least in the short run. Refiners are having to engage in research, in reconfiguration of their production processes, and in equipment installation to meet the new low-sulfur requirements. For example, Valero is building a new desulfurization unit in one of its Louisiana refineries, precisely to aid compliance with the Tier 2 sulfur regulations.

These factors have combined to raise the current, and expected future, prices of gasoline. The new low-sulfur requirements are not likely to exacerbate the seasonality/inelasticity problem, but they will increase fuel prices.

4 thoughts on “Fundamentals of Spring Gasoline Price Increases

  1. Request for Prediction — Will Sen. Durbin make his annual pilgrimage to suburban gas stations to denounce high gas prices?

  2. Well, I heard the first news report on higher gas prices today. Of course, the reporter was standing in front of some Citgo on the north side, interviewing SUV drivers who were insane with rage over gas prices. Nevermind that they’re getting ripped off ($2.75) only because of Cook county and Chicago gas taxes and sales taxes.

    The reporter was better than most. He noted that refiners are doing a lot of upgrades and maintenance now, and were at 73% capacity, and that this was the reason prices were rising. Good answer.

    Interestingly, my gas station is an island of reasonableness in a sea of ripoffness. I paid $2.39 today in Bartlett. I drive by this station twice a day, and in the last week the price has decreased by 6 cents. Weird.

    I think the difference in price station to station is more interesting that the average price. Driving around yesterday, I noticed a 10 cent difference between two stations that were kitty corner across North Ave and 59. Again, weird.

  3. Isn’t it true that gas is the one thing that has not kept pace with inflation and therefore is still pretty cheap for us? If it had kept up, wouldn’t we be seeing European type prices? Shouldn’t we be thanking the oil companies for keeping it so low for so long – in spite of OPEC? The media and some in Congress just love to cook up whacko conspiracy theories about how big oil is ripping us off at the pump. But each time it’s investigated it turns out to be supply and demand, and not dubya and his veep, those dastardly oil men, lining their pockets. OPEC sets the price, not dubya and Dick.

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