Lotterman: The ins and outs of high gas prices

June 7, 2013 

Tim Lancaster puts $10 worth of gas in his car at the Stinker station at Five Mile and Emerald in February 2011.

JOE JASZEWSKI / JJASZEWSKI@IDAHOSTATESMAN.COM

Few things cause more generalized public anger than a spike in gasoline prices, as we saw in many areas of the country in late May, but particularly in the Midwest.

Prices have retreated from the highs. But the run-up made many people angry. Their questions and charges remain: Why are prices so volatile? Isn't this just an abuse of monopoly power by the big oil companies? Why do prices tend to spike each year right around holidays, when people are most likely to travel? How can the petroleum industry get away with this year after year?

Like prices, the questions and theories rise every year, as if they're working together.

I have learned that this is an issue on which I am unlikely to change many minds. So let's just go over a few arguments for and against abusive practices by gasoline producers and let readers decide which they believe.

The first observation is that while recent prices hit new records for the nation, they are back in a range that has been common in recent years. Adjusted for inflation, national average prices are about 5 percent above the average for all of 2008.

Second, the "big oil companies" don't have the same market power across all levels of the industry they once did. In exploration and drilling, the majors are losing share to the nationally owned oil companies such as the Saudi's ARAMCO, Gazprom from Russia and ChinaPetro. Private investor-owned companies such as Exxon now control only 30 percent of the world's crude reserves, and none of them fall in the world's top 10 in terms of reserves or production.

True, U.S.- and European-based majors still include enormous firms such as ExxonMobil and BP, with annual sales of more than $480 billion. But collusion with the nationalized firms that have the market share would be very difficult.

Third, retail selling of gasoline is extremely competitive, not particularly profitable and no longer dominated by big, fully-integrated oil companies. Don't think that your local station owner is getting rich from price spikes. Retailer's margins are extremely thin. That is why classic standalone gas stations are a disappearing breed. Stations sell gas to bring customers who will buy groceries and convenience items or auto repairs. Believe it or not, they don't make a lot of money on gas itself.

Fourth, though refining has been more profitable since 2008, over the past 30 years it has not been a great money-maker. That is why in the 1990s and early 2000s, the majors were selling off refineries to midsize or specialized non-production firms.

Fifth, in the short run, both the supply of and demand for gasoline is quite inelastic - meaning even with large price swings, the amounts consumed and produced don't change much. Put another way, slight changes in production due to natural disasters, refinery maintenance or overt monopolistic manipulation can cause large changes in price.

Then there are arguments on the other side.

True, the majors don't have the market share they once did globally. There are many more large producing firms than a generation ago. And refining may be more competitive over the long run than people believe. But, region by region in our country, competition could be very limited, and someone in the chain might have considerable monopolistic power in the short run.

Over the medium term, higher prices from one refinery can cause more product to flow from other refineries. The pipeline and terminal system is largely a common carrier, with tariffs for moving crude regulated by the Federal Energy Regulatory Commission. But to the extent that any single refinery or distributor is closer than its competitors or has established business relationships and transport arrangements, it has pricing power, especially in short runs like holiday weeks when demand is higher.

Moreover, while successive investigations mandated by Congress over the years have failed to find evidence of overt collusion to fix prices, such open abuse is not necessary. In an oligopoly like gas production and distribution, the "price leader" model often prevails.

This was common in U.S. auto and steel production in the first decades after World War II. A large firm like General Motors or U.S. Steel would act as the price leader. When it announced a price change, other firms would announce near-identical price changes a day or two later. No executives had to get together clandestinely, but there was tacit cooperation.

There was competition in terms of auto styling and features or the breadth of range of steel products, and there was some price competition around the edges. But on the whole it was a comfortable situation within a small set of companies. Everyone knew the implicit rules and there was no need for anyone to do anything explicit that violated the Sherman Anti-Trust Act. That well might be the case for gasoline supply in many areas.

Oligopolies are not necessarily stable, and that is why you see periods of sharp drops, as in the late 1980s, late 1990s and from 2008 to 2009, although global political factors played large roles, too.

Finally, there are significant "barriers to entry" at most levels of the petroleum industry that make it difficult for new firms to get established and compete. Some of these stem from the large amount of capital needed to buy or build a refinery or pipeline. Difficult permitting processes and NIMBY opposition to any new project amplify these barriers. Unfortunately, the larger the barriers to entry, the greater the pricing power of companies already in the game, and the greater the scope for abuse.

Economist Edward Lotterman teaches and writes in St. Paul, Minn. Write him at ed@edlotterman.com.

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