How the refiners are profiting from your pain
ASK THIS | May 05, 2005
Are reduced gasoline inventories a sign of efficiency – or a clever way to gouge consumers?
By Peter K. Ashton and Henry M. Banta
Q. Could reduced gasoline inventories be contributing to sharp spikes in the price at the pump?
Q. Who profits from the consumer pain that these spikes cause?
Q. Could there be collusion at work here?
Q. What could or should the government do?
Gasoline is made from crude oil, and the price of crude oil accounts for about 60 percent of the price of gasoline. Our questions are about the other 40 percent, and the role of gasoline inventories.
Throughout the 1990s and into this decade, the major oil companies have continually reduced their working inventory levels for gasoline – even while the demand for gasoline has risen. In 1990 the supply level was about 30 days. In 2000 it fell to 23.8 days and more recently to about 22.7 days. This is precariously close to the 20 days of supply considered a bare minimum. Much of this inventory isn't even available to meet demand, but is needed to keep gasoline flowing through the refinery into the wholesale and retail system to the consumer: it's line fill in pipelines, tank bottoms, in-transit flow, etc. The companies explain that their inventory reduction improves efficiency and lowers costs. No doubt this is true, but even assuming all of these cost savings are passed through to the consumer, is the consumer better off?
Most analysts see a direct, causal link between gasoline inventories and wholesale and retail gasoline prices. This means that as inventories fall, prices tend to rise. Research shows that as inventories fall to low levels, prices and margins also tend to increase. That price effect has gotten much stronger as the system has moved closer and closer to the bare minimum necessary to operate the system. Now, any little "hiccup" that curtails supply, even one that lasts only a couple of days, can cause precipitous price spikes.
This was not the case when the companies carried larger inventories. Refinery outages, pipeline and barge accidents, and other unanticipated supply disruptions are not unusual. And companies generally carried sufficient inventories to act as a buffer to prevent price spikes when such incidents occurred.
But now, the lower inventories have shifted the cost of such disruptions to the consumer. Since 2000, when supply first went below 25 days for any extended period, there have been five price-spike periods. These spikes have lasted almost three months each on average and resulted in price spikes of about 16 cents per gallon. Lower inventories may be saving the oil companies a bit of money, but they're costing the consumer a lot.
All of this additional revenue represented a wealth transfer from consumers to oil companies. These were also times when the oil companies reported significant increases in profits. And the evidence suggests that this problem is going to get worse for the consumer rather than better.
A very troubling part of this reduction of inventory is that there is more than a hint of collusion about it. It seems most unlikely that normal market forces would have caused a group of competitive firms to collectively reduce inventory to the point where it caused a significant transfer of wealth from consumers. In a truly competitive market, refiners will make differing assessments about the amount of inventory they need. It would be a very risky thing for one refiner to reduce its inventory without some confidence that all others will do the same. Otherwise, one or more of its competitors would take advantage of the situation. In a time of shortage, a firm with a larger inventory could, for instance, take market-share away from its competitors. In fact, the whole inventory reduction game would seem to require at least the tacit acquiescence of all.
It is worth noting that in California, where the refining capacity is concentrated in the fewest hands, refining margins are also the highest. In fact, California has the lowest crude oil cost and the highest gasoline prices in the nation. It seems that the amount of competition matters.
So either there is actual illegal collusion in the refining market, or concentration of ownership in refining has reached a point where explicit collusion is not necessary, and the small number of firms can recognize their common interests without actually conspiring with each other. In either case, what we have is a failure of competition in the market, and the Federal Trade Commission and the Justice Department's Antitrust Division have some explaining to do. The current high concentration of ownership in petroleum refining is largely a result of mergers, all of which were reviewed by the antitrust agencies. At an absolute minimum, one would expect the antitrust agencies to revisit the issues raised by these mergers and at least conduct an investigation. If the president is concerned about gasoline prices, why doesn't he ask for an investigation?
The same may be said for Congress. When the Senate Permanent Subcommittee on Investigations was under the leadership of Senator Carl Levin (D-Mich.) a good start was made on looking into competition in the petroleum industry and the gasoline market in particular. In fact, much of what is being written here is in the report of his subcommittee. But lately, what passes for energy policy in the Congress and the Administration consists of throwing money at the industry in the form of tax breaks and subsidies. There are no serious investigations into the industry's behavior.
The myopia of the antitrust agencies and the Congress should not be reinforced by the media. Responsible journalism requires a clear understanding of the role of competition. It is useful to remember how quickly the New York Times columnist, Paul Krugman, a distinguished economist, spotted the role of collusion among the power companies in the California energy crisis and how long it took the rest of the media to catch up.