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Thesis & Antithesis

A critical perspective on energy, international politics & current affairs

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greekdefaultwatch@gmail.com Natural gas consultant by day, blogger on the Greek economy by night. Trained as an economist and political scientist. I believe in common sense and in data, and my aim is to offer insight written in language that is clear and convincing.

07 August 2006

Are refiners to blame?

That domestic refining shares the blame for high gasoline prices has been a political accusation for a while now; in April 2006, for example, Senator Charles Schumer (D-NY) accused refiners of keeping plants off-line as they switched to summer fuel blends to keep prices high. Now the attack has come alive again, prompted by a report by Jeff Donn of the Associated Press (link), which claims that gas prices are high because of market power in the refining sector.

The arguments made in the report merit close attention, even though, after close examination, they lose much of their potency. But before turning to the report, here is a graph to get the argument going: it plots the price of gasoline based on where the money goes—crude oil, refineries, distribution & marketing and taxes. Two trends are clear: first is that an ever smaller percentage goes to taxes (since most taxes are unit taxes that do not increase with prices) and second, that more and more money goes to crude oil. Refining and marketing, on the contrary, have retained an almost constant share (a volatile one too) of the final price of gasoline.

What does this say about the AP report? Mr. Donn writes that, “Crude oil [accounts] for just under half the price of gasoline.” Although he writes this to explain the industry position that high crude oil prices lead to high gasoline prices, implicit is the idea that this is not too much (I am reading between the lines here). After all, Mr. Donn writes that, “A big chunk of gas prices -- almost a fifth -- pays refiners who make gasoline from oil,” suggesting that he thinks these numbers important.

The first issue is that how much of the overall gasoline price goes to crude oil is irrelevant; what is important is how much of the change in gas prices can be attributed to changes in the price of crude (in econometrics lingo, how much of the variance in one variable can be explained by variance in other). In a study I did for gasoline prices and crude oil between January 2000 and January 2006, that number was 0.91, meaning that 91% of the change in gasoline prices can be explained by changes in crude oil prices (time series models usually yield very high results anyway, though I did use a control trend variable).

The other interesting number is that the coefficient is 0.80 implying that a 1% change in crude oil prices leads to a 0.8% in gas prices (I used logs; also, I did not test, as the AP did, whether whether prices rise and fall by the same proportions, although I will get to that). These numbers may seem high, but they are consistent both with a look at a graph plotting the two variables (the two really high gas values were September and October 2005 following Hurricanes Katrina and Rita), as well as with other studies (look at the Cato study in the references).

The AP report then goes on to look at refining margins: the difference between input costs (crude oil) and output prices (gasoline and distillate). Below is a graph with that spread, with data taken from the BP Statistical Review of World Energy 2006; one thing to note is that margins have gone up for all three major refining centers, not just the United States (the spike in the US in 2005 is, again, due to Katrina and Rita). If market power alone explained refining margins, there should be a dissimilar pattern in margins (unless we assume that those two centers also have concentrated market power); we would also expect a more consistent upward trend in prices since industry consolidation (in refining) has dated to the early 1980s (after the repeal of the Emergency Petroleum Allocation Act in 1981).

But are there other reasons to expect margins to increase? The AP reports writes, “In a competitive market, when raw material gets more expensive, margins typically shrink, economists say.” This is not necessarily true when demand for the final good is inelastic (as gasoline is). What is more, refineries are capital-intensive industries that exhibit considerable returns to scale. No refinery has been built in the United States since 1976, but overall capacity has increased all the same from 15.2 mbd in 1975 to 17.3 mbd. This has been achieved through capacity expansions at existing refineries and through efficiency gains (for example, by adding catalytic hydrocracking processes that increase the amount of gasoline or diesel that can be extracted from a barrel of oil).

A second reason is that oil coming into the United States is heavier and sourer. The average API gravity of crude oil inputs into US refineries has decreased from 32.64 API in Jan. 1985 to 30.25 in Aug. 2005, and the sulfur content has increased from 0.88 in Jan. 1985 to 1.40 in Aug. 2005. In simple terms, this means that refining is harder because refineries need to make premium content from lower quality inputs. As refining gets harder, it is reasonable to see higher margins, particularly for refiners that can process lower quality crudes. Also, in tight markets, the premium between high and low quality oil increases further given that refiners bid up the price of higher quality crudes much faster than low quality crudes.

Two more points to make: the first is that refining is a separate business, related but not identical to oil. Oil prices reflect the scarcity of oil, and similarly, gasoline prices reflect the scarcity of refining capacity. In 1983, utilization rates were 72% in the United States; in 2004 they were 90.3% in 2005. The scarcer a service becomes, the more valuable it is; no collusion is necessary.

The second is that quality differentials are having a major impact because they limit intra-US trade (the so-called “boutique fuels”). At some point there were 17 different gasoline standards nationwide, although this is set to decrease due to the Energy Policy Act of 2005. But different standards mean that having a surplus in one state and a shortage in another will not necessarily lead to trade. Add to that Congress’ effort to phase out MTBE and replace it with ethanol rather quickly, and this too has created constrains in the refinery market.

What about the idea that prices change asymmetrically: “The Associated Press analysis looked at weekly federal pricing data since September 1999. It found that a gallon of retail gas rose an average of 6 cents for a 10-cent rise in oil, but dropped only 4 cents for a 10-cent decline in oil -- suggesting that gas temporarily resisted downward shifts more strongly than oil.” This is important, but the report offers various reasons that are very persuasive (price stickiness or retailers trying to maximize profits), even though they are dismissed by the author. (Another issue is to examine whether this discrepancy disappears when we use lagged variables—essentially a lower crude oil prices will have an effect after some time given that a refinery still purchased past oil at a higher price and is more inclined to charge more for it.)

In the end, market concentration is surely a concern, although this trend has more to do with the regulatory problems (and adverse economics) involved in building refineries than in any specific design for collusion. It is frustrating to think that an American living in Wyoming will pay more to drive to work because China is buying more oil, or because Kuwait has struggled for ten years to pass a law that will boost foreign investment in its oil sector, or because nearly all of the oil revenues in Mexico go to the government leaving little for re-investment. But it is no less true.

*

Despite my overall criticism, I am glad that the AP did this study. This has been a popular issue for quite some time and the evidence to examine it has been absent from public debate. It is depressing to hear so many politicians discuss this topic without spending some time to study it methodically; it is even more depressing to think that when I did my own study (for a class), all it really took me was some knowledge of statistics and five-six hours on a Thursday afternoon.

References:
Unless otherwise indicated, data comes from the Energy Information Administration; Nick Snow, “Schumer seeks probe of refining capacity utilization,” Oil & Gas Journal Online, 19 April 06;
Peter Van Doren and Jerry Taylor, “Economic Amnesia: The Case against Oil Price Controls and Windfall Profit Taxes,” Cato Institute Policy Analysis (12 Jan 06); Franz B. Ehrhardt, “Refining and price,” Oxford Energy Forum, August 2005; Bob Williams, “Refiners’ future survival hinges on adapting to changing feedstocks, product specs,” Oil & Gas Journal, 11 Aug 2003; “Margins soar,” Petroleum Economist, September 2004; “Attention to refining,” Oil & Gas Journal, 26 Sept, 2005; “Big profits, big decisions,” Petroleum Economist, September 2005; David Nakamura, “Refining industry to sustain strong margins through 2004,” Oil & Gas Journal, 15 Mar, 2004; “Devising a winning strategy,” Petroleum Economist, September 2005

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