Gas Price Gouging

Gas prices have almost doubled at the pump over the past three years, from an average of $1.60/gallon in April 2003 to $2.74 in April 2006. What would cause such a dramatic increase? Opinions range from vast oil conspiracies to classic supply and demand. However, these perspectives are not mutually exclusive — oil demand is largely inelastic, while oil companies have a significant influence on the supply, and therefore their own profits.

Where Does The Money Go?

Using gas price data from doe.gov, I created an area chart depicting the composition of gas prices. The explanation of terms is basically as follows:

  • Crude — Refiner acquisition cost.
  • Refining — Difference between spot price and crude price. Includes costs and profits.
  • Distribution — Difference between retail price and sum of other three components. Includes costs and profits.
  • Taxes — National average of federal and state taxes.
gas prices area graph

Crude is clearly the biggest reason for the price increase. Big Oil’s refining & distribution show an upward slope as well, while taxes remain almost flat.

The Impact of Oligopoly

Debate over gas prices is not a new phenomenon. In June 2001, Senator Carl Levin (D, Michigan) instructed the Majority Staff of the Permanent Subcommittee on Investigations to pursue the then-large gas price increases — $1.16/gallon in 1999 to $1.51/gallon in 2000. The Executive Summary (PDF warning) outlines the full report “Gas Prices: How Are They Really Set?“. The findings remain relevant to today’s prices:

  • Mergers and refinery closings concentrate the refining industry. “In 1981, 189 firms owned a total of 324 refineries; by 2001 65 firms owned a total of 155 refineries, a decrease of about 52 percent in the number of refineries.
  • Concentrated markets lead to reduced competition and thus higher retail prices.
  • Tightly coupled refiners and retailers have little incentive to reduce wholesale prices, which would in turn reduce profits from their own branded gasoline. Further, integrated refiner-retailers reduce incentive for competition between refiners, and reduce the market strength of unbranded competitors.
  • Lower refining capacity leads to a tight supply-demand balance – supply capacity barely exceeds demand. For example, in 1981 “Just over 68 percent of refining cpacity was being used”. Fast-forward to 2001, where “The average refinery utilization rate [was] regularly greater than 90 percent, which is near maximum capacity.”
  • A tight market lead to spontaneous supply shortages if demand increases. Such shortages require imports and present an opportunity to manipulate supply and increase refining margins.
  • Retail prices often scale in relation to competitors’ prices, independent of costs or demand. If one retailer seeks to increase margins, other retails in the same market systematically follow in unison.

Conspiracies

Closely matching supply to demand is “good business”, so where is the conspiracy? While legal, the above mentioned price matching is arguably a form of collusion. Other legal avenues exist as well. For instance, the executive summary cites a 1999 internal BP memo that presents options for reducing supply in the Midwest, including “shutting down capacity, exporting to Canada, lobbying for environmental regulations that would slow down movement of gasoline in pipelines, shipping product other than gasoline in pipelines, and providing incentives to others not to provide gasoline to Chicago”.

Summary

Supply and demand are not nebulous forces that exist beyond the suppliers’ control. Particularly in a market with inelastic demand, where suppliers have even greater reign — it is difficult to choose not to use oil. While there may never be a smoking gun, the potential for price gouging is clear, as is the impact of consolidation and reduced competition in the oil industry.

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One Response to “Gas Price Gouging”

  1. JonnyRo says:

    Wow, they even considered “lobbying for environmental regulations that would slow down movement of gasoline in pipelines” lobbying for legislation that would hinder the production and movement of gasoline. An industry trying to overregulate itself to keep gas prices high.

    I’ve been feeling the pain with my two Jeeps, spending almost $40 to fill either of them up. Thankfully I live very close to work so I havent felt the pain as hard as others, but it’s definately restricted my ability and desire to travel.

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