How Gas Companies Manipulate Prices
>>> From the Statement of Senator Carl Levin, Chairman, Permanent Subcommittee on Investigations; Hearing on Gas Prices: How Are They Really Set? US Senate, 30 April 2002:
Low inventories have helped to create the conditions for price spikes in the Midwest, which have occurred when demand has increased (near driving holidays) and/or the supply of gasoline was disrupted. Not unlike oil companies nationwide, oil companies in the Midwest have adopted just-in-time inventory practices, resulting in crude oil and product stocks that frequently are just above minimum operating levels. And, in the spring of 2000 and 2001, the conversion from the production and supply of winter-grade gasoline to summer-grade gasoline further contributed to low inventories just prior to a seasonal increase in demand. With the stage set by those two factors, the oil companies took actions over these past two years in accordance with their profit maximizing strategies that significantly contributed to the price spikes when disruptions in supply occurred:
– During the spring of 2000, three major refiners determined it wasn't in their economic self interest to produce any more RFG [reformulated gas] than that required to meet the demands of their own customers, and so in that year they produced 23% less RFG than in the prior year, not enough to supply everyone who wanted to purchase it. That contributed to the short supply in the spot market for RFG, contributing to the price spike of spring 2000. While Marathon did have surplus RFG, it withheld some of it from the market so as to not lower prices.
– In the summer of 2001, major refiners deliberately reduced gasoline production, even in the face of unusually high demand at the end of the summer driving season, contributing significantly to the price spike of 2001.
Nationwide, in the winter of 2001 - 2002, demand fell and inventories rose following the tragic events of September 11, 2001. With reduced demand and higher inventories, prices fell. As a result, refining profits fell and refiners cut back on production in order to obtain higher profits. Along with the increase in the price of crude oil and market speculation, these reductions in production and the increase in industry concentration significantly contributed to the run-up in price in the late winter and continuing into the early spring of this year.
Internal documents from several oil companies confirm that the oil companies view it to be in their economic interest to keep gas inventories low and the supply and demand balance tight.
Several documents from California show that refiners in California sought in the mid-90's to prevent imports into California in order to make the market "tight."
• One internal Exxon memo advises the company to "not do deals that supports other's importing barrels to the West Coast."
• Similarly, an internal Mobil memo counsels against importing gasoline, saying it would depress margins.
•California refiners also sought to limit the overall refinery capacity in the state.
• One Mobil document talks about how to block the proposed startup of the Powerine refinery. "Needless to say," the memo says, "we would all like to see Powerine stay down." It then proposes accomplishing this by buying all its product and marketing it themselves. "Especially," the memo says, "if they start to market below our incremental cost of production." The memo then notes that buying Powerine's product the previous year, when it was below Mobil's "incremental cost of production" had worked and it was "a major reason that the RFG premium . . . went from 1 cent per gallon to 3-5 cents per gallon."
• A Texaco memo discusses how to use changes in fuel specifications to reduce supplies. The memo says, "Significant events need to occur to assist in reducing supplies and/or increasing the demand for gasoline." One example of a significant event, the memo says would be to eliminate the requirement for an oxygenate which, the memo says, would make oxygenate usage go down which reduces total volume of gasoline supplies. The memo says, "Much effort is being exerted to see that this happens in the Pacific Northwest."
California refiners also exported gas – that is, shipped gas out of California – to keep the market in that state tight.
• An ARCO internal document discusses the need to export to prevent supply from building up in the state. The memo indicates that ARCO should export in order to intentionally alter the supply/demand balance within California and not just as a passive response to the prevailing economic conditions. In that same presentation, one strategy discussed is to "exchange and trade selectively to preserve market discipline."
• Another document in the Subcommittee files indicates that one company would export gasoline out of California to the Gulf Coast, even at a loss, with the rationale that such losses "would be more than offset by an incremental improvement in the market price of the much larger volumes of [gas] left behind."
• Another company's plan indicates that exporting gasoline can "improve market conditions," and that the company was willing to "take [a] hit on price to firm up market."
An internal BP document from 1999 reflects similar thinking with respect to the Midwest. The document reflects a discussion amongst senior BP executives of possible strategies to increase refining margins, and it mentions "significant opportunities to influence the crude supply/demand balance." It notes that these "opportunities" can increase Midwestern prices by 1 to 3 cents per gallon." The memo discusses strategies to reduce the supply of gasoline in the Midwest. It lists some possible options, including: shutting down refining capacity, convincing cities to require reformulated gas that is not readily available, exporting product to Canada, lobbying for environmental regulations that would slow down the movement of gasoline in pipelines, shipping products other than gasoline on pipelines that can carry gasoline, and providing incentives to others not to provide gasoline in Chicago. BP officials told the Subcommittee staff that these ideas were only part of a "brainstorming" session and that none of the options for reducing supply were adopted. We'll go through this document in some detail later this morning. In another document from the Midwest, an internal Marathon document, Marathon even called Hurricane George a "helping hand" to oil producers because it "caused some major refinery closures, threatened off-shore oil production and imports, and generally lent some bullishness to the oil futures market."
And that is the heart of the problem with respect to gas prices in the United States today – in certain regions of the country – the refining market is so concentrated, that oil companies can act to limit supply and from time to time spike prices to maximize profits, and because there is insufficient competition, there is little-to-no challenge to that action. That's the major problem as I see it. The ability to control supply allows oil companies to spike prices in a concentrated market without adequate competition to challenge them.
The Majority Staff made some other significant findings. Oil companies do not set wholesale (rack) or retail prices based solely upon the cost to manufacture and sell gasoline; rather wholesale (rack) and retail prices are set on the basis of market conditions, including the prices of competitors. Most oil companies and gasoline stations try to keep their prices at a constant price differential with respect to one or more competitors. For example one company decided that its station in Los Angeles should price the lower of ARCO stations plus 6 cents per gallon, or the average price of major branded stations in the area. Another oil company followed a pricing policy in Baltimore as follows:
We will initiate upward, we will follow Amoco, Shell quickly... we will be slow to come down in a dropping market.
Because many oil companies and gasoline retailers set their retail price on the basis of the prices of their retail competitors, prices in each specific market tend to go up and down together. And oil companies tend to stake out a position in each market vis a vis the competitors and hold that position. Hence, it will often appear that, over time, gasoline prices in that market move together in a "ribbon-like" manner – so that as a brand moves up and down it nonetheless remains at a constant differential with respect to the other brands. Look at this retail pricing chart for Illinois for June 2001, and this one from Maine for January-August 2001. (Exhibits 9 and 10.)
In Michigan and Ohio, we found a clear leader-follower pricing practice. Speedway, owned by Marathon, has a pricing practice that bumps up the price of gasoline on Wednesdays or Thursdays. As the price leader in Michigan, once Speedway goes up, the other brand follows. The typical pattern after that is for Speedway to come down in price pretty quickly, while the other brands follow them down more slowly. You can see this very clearly in these charts from January to August 2001 and April 2001. (Exhibits 11 and 12.)
Oil companies also use a system of what they call "zone pricing" in order to maximize the prices and revenues at each gas station. Since under the antitrust law, they are prohibited from selling wholesale product at a different price to similarly situated retailers, the oil companies have developed a system for differentiating among retailers in the same immediate area. In doing so, they can charge the retailers different wholesale prices for their gasoline. The way they accomplish this is by dividing a state or region into zones. A zone is supposed to represent a particular market, and the stations in that zone are supposed to be in competition with each other. The oil companies use a highly sophisticated combination of factors to identify particular zones. For example, if most people buy their gas on their way home from work instead of on their way to work, a station on one side of a rush hour street may be treated as in one zone and the same brand station on the other side of the street in another zone. The oil company will then charge those two gas stations different prices for their gasoline, because the station on the side of the street with easy access for evening rush hour traffic may be able to get a higher price for its gas than the station on the other side of the street. That's the kind of thinking that goes into the zone pricing system, and it allows the oil companies to charge the highest possible amount for their gas in a given area.
Another pricing practice the Majority Staff uncovered has to do with how gas station owners set their retail prices. The Majority Staff learned that for those stations that lease from a major oil company (about one-fourth of the 117,000 branded stations) the oil company actually recommends to the station dealer a retail price. Now by law, the oil company is prohibited from telling a lessee dealer what it can charge for gasoline, but that doesn't keep oil companies from "recommending" a price. And the Majority Staff was told by several dealers that if they don't charge their retail customers the recommended price, the next delivery of gas from the oil company will reflect any increase instituted by the dealer. These dealers are saying that if they decide to price their gas at $1.40/gallon when the oil company recommends $1.35, the next delivery of gasoline to the station (and deliveries are sometimes daily for busy stations) will have a 5 cent/gallon increase in the price to the retailer. If these allegations are true, then the practical effect would be that the recommended price is subtly or not so subtly being enforced.
[read the entire statement at Senator Levin's Website]
[read the report, Gas Prices: How Are They Really Set?]
|copyright 2002 Russ Kick|