Part 1-Complex factors cause recent gasoline price run-ups

Sept. 3, 2007
During 1999-2006, US gasoline prices almost tripled, shocking consumers and spurring public debate about the causes of the increase.

During 1999-2006, US gasoline prices almost tripled, shocking consumers and spurring public debate about the causes of the increase. Simply put, the debate has pitched those who argue that the price reflects the market response to stronger demand and increasing raw material costs against those who see greedy oil companies using the power of monopoly to withhold output and artificially inflate prices. Critics have argued that:

  • Oil companies have consolidated to increase concentration and decrease competition and have deliberately failed to invest in capacity, causing shortages and high gasoline prices.
  • Speculation in futures markets has bid up gasoline futures prices, which in turn bids up current gasoline and crude oil prices.
  • High gasoline prices are out of line with cost increases, allowing excessive profits in refining.
  • US refineries are able to exploit their alleged monopoly power because of low demand price elasticities and because consumers have no alternatives to gasoline.
  • Refineries have deliberately reduced their inventories to increase monopoly power, resulting in increased price volatility.

This article examines, in the light of economic theory and available statistical evidence, these and other factors that are causing high gasoline prices.

Gasoline price history

A review of the history of nominal and real gasoline prices in the US since 1918 finds that recent gasoline price levels are by no means unprecedented. The price increases have been shocking because they followed more than a decade of the lowest real prices US markets have ever enjoyed.

Putting the current price run-up in historical context, Fig. 1 shows nominal US gasoline prices since 1918. Prices were relatively stable during 1918-70, when large multinational oil companies controlled much of the oil flow. However, during 1973-82 prices more than tripled in an era of tight markets, wars, revolutions, and the emergence of powerful national oil companies. An almost equally dramatic increase occurred during 1999 through August 2006, when prices almost tripled. So the current run-up is not unprecedented, and the previous increase of this magnitude was followed by a price decline.

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The nominal gasoline prices shown in Fig. 1 do not take into account that over time generally all prices were rising with inflation. When the price is adjusted with the consumer price index, we isolate the behavior of gasoline prices relative to other prices in the economy. The adjusted historical real gasoline prices in Fig. 1 show a general downward trend in gasoline prices except during the two periods of sharply rising oil prices in 1973-1982 and 1999-2006. Real prices reached an historical low in 1998 during the Asian economic crisis and did not return to their historical average of $2.13/gal (in 2005 dollars) until 2005. The product-weighted average annual price in 2006 was lower, in real terms, than in the 1930s. Rather than being shocked by recent high prices, one might ask why consumers enjoyed such low gasoline prices in the prior decade.

The run-up in gasoline prices is also not unique among commodities. Fig. 1 also shows the combined price for a range of industrial and agricultural nonpetroleum commodities that make up the Commodity Research Bureau’s Commodity Price Index (CPI). This index also rose sharply during 2002-06 to surpass its previous peak of the early 1980s. The similar price increases of nonpetroleum commodities suggest that the recent trend in gasoline prices reflects a strong world economy led by the US, China, and India, rather than specific actions by oil companies.

Demand pull 1999-2007

The demand for gasoline is driven by a steady increase in population and licensed drivers overlaid with short-term fluctuations in gross domestic product (GDP) growth. During 2001-06 GDP showed a positive trend that was not only greater than prior years but also stronger than expected, resulting in demand pressure on the gasoline market.

Statistical studies find that for every 1% increase in income, gasoline consumption increases by about 0.3% in the first year and by even more in the longer term. Unlike changes in population and drivers, however, changes in income tend to be somewhat unpredictable. Since 1973 real US GDP has fluctuated with an average growth rate of 3%/year. Noteworthy are the high rates of growth since 2004. Particularly unexpected were a 3.8 % increase in 2004 and the 5.4% annualized growth rate in first-quarter 2006, a rate that was well above the historical average and higher than in any year since 1984. Refinery managers expecting lower income growth would have planned for slower gasoline consumption growth than actually occurred.

Supply push 1999-2006

To produce and sell gasoline requires a variety of inputs, including crude oil, labor, electricity, catalysts, processing capacity, a normal rate of return on capital investment (ROI), product distribution, marketing, and taxes. In 2005, when refineries were paying about $50/bbl for oil and receiving a $2.27/gal retail price for gasoline, more than half of the retail cost of each gallon of gasoline went to buy the crude oil needed to produce it.

Between 1999 and summer 2006, oil prices to US refiners more than quadrupled, rising from $15.50/bbl to more than $65/bbl. In a competitive market, such increasing costs would necessarily raise gasoline prices.

From 1918 through 2006, the price of gasoline less tax (Pg-t) has closely tracked the price of a barrel of oil. Statistical analysis finds that the crude oil price explains about 97% of the variation in the pretax gasoline price over almost 9 decades and that each $1/bbl increase in the oil price is accompanied by an increase of about 2.7¢/gal in the gasoline price. Fig. 2 compares actual gasoline prices with the prices that were forecast with a regression equation and shows how closely the actual price matches the prediction made from the oil price. The most interesting feature of this figure is that actual prices were higher than the prices forecast over the time that the large multinationals were in control of world oil markets prior to the late 1970s.

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Other purchased items have increased as well. During 2000-05, electric power costs increased about 20%, inorganic chemical costs rose about 25%, and organic chemical costs, about 45%. During the summer of 2006, spiking ethanol prices likely added 20¢/gal to reformulated gasoline prices.

New fuel regulations have strongly affected refiners since 1989. In addition to adding investment costs, tighter environmental regulations effectively reduce available refining capacity by reducing throughput and even causing the closure of refineries that cannot comply. Small refineries, in particular, have been challenged in meeting new fuel standards.

Refiners’ profits

Higher oil prices have brought an era of higher oil company profits, causing some media personnel and policymakers to ask whether these profits are excessive. These profits should be examined in an historical context.

The refining industry viewed the early 1990s as a time of hardship, with low capacity utilization, high environmental compliance costs, and inadequate profits (Fig. 3). As a result, in the second half of the decade, the industry undertook massive restructuring aimed at cutting costs, increasing economies of scale, and improving profit margins. At the same time, the vertically integrated majors were spinning off their refining operations, increasing the number of players in the industry. The refining capacity operated by independents more than tripled to over 25% in 2006 from 8% in 1990. Returning the industry to profitability was especially important for the increasing numbers of independent refiners such as Valero, which did not have producing operations with earnings that could offset low profitability in refining. Refiners viewed the increase in utilization rates in the second half of the 1990s as a major accomplishment that made refining once again a viable industry.

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After September 2001, US economic growth faltered, and refinery product sales fell in 2002. Refinery utilization and profit margins fell, causing net income to drop precipitously to the greatest loss in more than 30 years.

By 2003, however, refiner profits had risen above their historical average and regained their 2000 level. In 2004, unexpectedly high US economic growth drove profits to a record high level.

Hurricane Katrina, in August 2005, shut down oil production and pipelines and damaged ports and refineries so that by the end of August, 11% of US refining capacity was shut down, and 17% of US refineries were operating at reduced capacity. This temporary disruption brought higher net income. The year-on-year net income increase in second-half 2005 was over 50%, compared with less than 12% in the first half of the year.

In the first half of 2006, US GDP growth was the highest in 22 years, and real refining net income rose 30% from the first half of 2005. Some refineries that had delayed maintenance after the 2005 hurricanes were down in the spring. Refineries were phasing out methyl tertiary butyl ether and phasing in ultralow-sulfur diesel-all of which made refining capacity tight and drove prices higher. These pressures were alleviated by the end of the 2006 summer driving season as prices dropped only to rise again in spring 2007. High crude prices and unexpected outages kept real gasoline prices in the spring level with the high prices of 2006.

Higher prices have led to higher profits. However, these higher profits have come after more than a decade of low and negative ROI rates and restructuring aimed at returning refining to viability.

Part 2 of this article, which will run Sept. 10, 2007, will examine whether these high income levels are excessive and will review refining capacity, inventories, and margins; gasoline market concentration; and the role of futures markets.

For complete bibliographic references and statistical support, see (http://dahl.mines.edu/api.pdf).

Acknowledgement

The research for this article was supported by the American Petroleum Institute.

The authors

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Carol Dahl is professor of mineral economics and director of the Colorado School of Mines-French Institute of Petroleum (CSM-IFP) joint international degree program in petroleum economics and management at the Colorado School of Mines. She received her bachelor’s degree from University of Wisconsin and her PhD in economics from University of Minnesota. Dahl has supervised numerous PhD students, published two books and more than 100 articles and conference papers, completed numerous grants and contracts, and traveled to more than 95 countries pursuing her interest in modeling international energy markets.

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Anthony Scott is a graduate student in the CSM-IFP joint degree program working on his MS in mineral economics and an MS in petroleum economic management. He also is an intern with Global Energy Inc. Scott received his BS in economics from the Colorado School of Mines. He previously has worked on projects for the Energy Information Administration and the American Petroleum Institute.

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Rachael Hackney is an energy research assistant at the Colorado School of Mines, where she recently graduated with a BS in economics and business. She has worked on energy projects for the American Petroleum Institute and Bill Barrett Corp. as well as on various design projects for the Colorado School of Mines. In the fall, Hackney will be advancing her language skills in Paris at the Sorbonne in preparation for her MSc in international finance.