Testimony

The Effect of Federal Regulations on Gasoline Prices in the Milwaukee/Chicago Area

By Jerry Taylor
July 7, 2000
Subcommittee On National Economic Growth, Natural Resources, and Regulatory Affairs
Committee on Government Reform
The United States House of Representatives

I’d like to thank the members of the Subcommittee on National Economic Growth, Natural Resources, and Regulatory Affairs for the opportunity to testify today on the effect that federal regulations have had on gasoline prices in the Milwaukee/Chicago area.

There is no mystery as to why gasoline prices have spiked here but nowhere else: the Milwaukee/Chicago market is suffering from a shortage of gasoline and this shortage is entirely responsible for the surge in prices. My testimony today will examine the factors that have contributed to this shortfall as well as the economic laws that govern gasoline markets. In short, the June spike in Milwaukee/Chicago gasoline prices was largely caused by federal and state regulations mandating the use of ethanol blended reformulated gasoline in this market.

The only other explanation for the price spike that’s been offered - the contention that oil companies are colluding to gouge consumers - is also examined and dismissed as extremely unlikely. No single oil company has enough market power to significantly affect retail prices and there is absolutely no evidence of collusion. A basic understanding of the gasoline markets strongly suggests that, if prices had not gone up dramatically in May/June, 1970-style gasoline lines at the pump would have been the inevitable result.

I conclude by suggesting some policy steps that would reduce the likelihood of such disruptions in the future. Less - not more - regulation is in order.

The National Gasoline Market

A gallon of gasoline in the United States today is - on average - 60 cents more expensive than it was a year ago. This represents about a 50 percent increase in price. Gasoline prices in the Milwaukee/Chicago area, however, peaked at about double the price of a year ago.

So about half the price increase experienced in the Milwaukee/Chicago area was due to the general increase in world oil prices. The Congressional Research Service, for instance, reports that refiners’ crude acquisition costs have risen by the equivalent of 48 cents per gallon of gasoline over the past year and a half. That price increase is explained by three factors; OPEC production restraint, low domestic inventories of oil, and surging demand for oil products. About this there is little dispute, so I will not dwell upon it this morning.

As an aside, the price increase appears more dramatic than it actually is. First, it was preceded by the lowest inflation-adjusted oil prices in recent history: less than $10 a barrel in December 1998, a price that allowed gasoline to sell at $1.05 a gallon. Price increases were virtually inevitable, and given the historic lows of December 1998, they were bound to appear dramatic by comparison. Second, real prices even in the Milwaukee/Chicago area still don’t approach the historic peak price of $2.67 a gallon, which was set nationally in March 1981 after adjusting for inflation.

Nevertheless, why are prices higher in the Milwaukee/Chicago area than elsewhere? Simply put, the imbalance between gasoline supply and demand is greater here than elsewhere in the country.

Imbalances in Supply & Demand

Disruptions in the transportation network are primarily responsible for limiting the supply of gasoline in the Milwaukee/Chicago area. An inability on the part of refiners to produce enough gasoline to keep up with surging demand has also contributed to the problem. Given the inelasticities of the gasoline market, those two factors alone explain the disparity between regional and national prices.

Gasoline demand has increased by 4 percent since last year according to the American Automobile Association but supply has remained unchanged. This imbalance is complicated by a shrinkage in inventory stocks: mid-June national inventories of reformulated gasoline were 6 percent below the June 1999 level and 16 percent below those of June 1998.

While this disparity between the supply and demand of reformulated gasoline has affected all markets that rely on the reformulated gasoline equally, the Milwaukee/Chicago market has been additionally hit by a production shortfall of the specific blend of reformulated gasoline that is required there and nowhere else. Going into the spring, only six refineries (all located in Illinois) were producing RBOB that could be sold in the Milwaukee/Chicago market. But production at those and the other facilities making gasoline dedicated to the Milwaukee/Chicago market is running about 7 percent below production a year ago and stockpiles are unusually low.

The cheapest and easiest way to supplement the production at those Illinois facilities is to ship gasoline via pipelines from Gulf Coast refineries. Unfortunately, the main pipeline that services the Milwaukee/Chicago area - the Explorer pipeline, which ships gasoline from refineries on the Gulf Coast to Chicago - experienced a major fire near St. Louis in March. Although the damage was repaired quickly and the pipeline opened for business ten days later, the owners of the pipeline and the U.S. Department of Transportation entered into a joint agreement to reduce the operating pressure of the pipeline by 20 percent, which reduced the volume of gasoline moving through the pipeline by 10 percent. A rupture in the Wolverine Pipeline on June 8 - the one dedicated reformulated gasoline pipeline from Chicago to Detroit that serves the Milwaukee region — has further reduced pipeline traffic by 20 percent although it returned to full operation by the end of the month.

While trucks and barges are an alternative means of delivering gasoline to the Chicago/Milwaukee market, it’s a far more expensive method of delivery and a limited delivery alternative given the paucity of unused truck and barge capacity. The upshot is that trucks and barges have not been able to make up the shortfall in deliveries caused by the pipeline problems and the use of trucks and barges has added expense.

An imbalance of only a few percent between supply and demand seems at first blush to be a minor problem, but given the nature of gasoline markets, it is quite serious.

Gasoline Economics 101

The demand for gasoline is inelastic in the short run. That is, it takes a large increase in price to reduce consumer demand even a little in the near term. Economists calculate that short-term price elasticity for gasoline is about -0.05. That is, if prices go up 1 percent, consumer demand will decrease in the short term by only one-twentieth of 1 percent.

Accordingly, when the demand for gasoline outstrips the available supply (even by just a little), prices have to go up a lot in order to keep the gasoline pumps from literally running dry. Thus, if local gasoline supplies are 2-3 percent below where they need to be to meet unmoderated consumer demand - the figure most market analysts believe to be correct for the Milwaukee/Chicago area - price would have to jump by more than 50 percent in order to prevent spot shortages.

Prices, remember, are used to allocate scarce goods. Although demand for gasoline is far more elastic in the long run, in the short run, small disparities in supply and demand (in either direction) will always by necessity have a large impact on prices.

Thus, we know all we need to know to explain the supposed mystery of retail gasoline prices in the Milwaukee/Chicago area. OPEC production cutbacks and surging world oil demand have driven the price of oil from around $10 a barrel in the winter of 1998/99 to around $30 a barrel today, adding 50-60 cents to the price of gasoline per gallon. Pipeline ruptures and production shortfalls have further reduced Milwaukee/Chicago supplies by 2-3 percent, which — given the inelasticities of demand - explains the 50 cent difference between peak regional gasoline prices and national average gasoline prices.

Why the Production Shortfall?

What role have politicians played in all of this? Approximately three-quarters of the price hike in the Milwaukee/Chicago area can be explained by circumstances largely outside of government’s control; the OPEC production restraint and the pipeline ruptures. This is also the conclusion of economist Lawrence Kumins in his June 16 report on midwestern gasoline prices for the Congressional Research Service.

One-quarter of the price spike, however, can be laid directly at the doorstep of government. Refineries have had a hard time keeping up with the demand for reformulated gasoline in the Milwaukee/Chicago market, and that production shortfall is a logical consequence of poorly designed federal and state policies. Refinery production has been limited by the reformulated gasoline mandate passed as part of the 1990 Clean Air Act, unnecessarily burdensome environmental regulations promulgated by the EPA, and the continued demagogic nature of Congress, which deters investment in the refining industry.

Reformulated Gasoline Mandate

As a consequence of the Clean Air Act Amendments of 1990, areas that violated federal air quality standards were required to sell only specially reformulated gasoline beginning June 1, 2000. This new gasoline is blended with various oxygenates (primarily methyl tertiary butyl ether - MTBE, or ethanol) in order to reduce the emission of carbon monoxide, a significant contributor to wintertime smog, and to reduce the amount of toxic chemicals, such as benzene, in the fuel. This reformulated gasoline now serves 30 percent of the country.

While today’s reformulated gasoline (known in the regulated community as “Phase II” reformulated gasoline, or RFG-2) is 1-2 cents more expensive per gallon than last year’s “Phase I” reformulated gasoline and 5-8 cents more expensive than conventional gasoline, the real consumer impact of reformulated gasoline is related to the rigidity it imposes on national gasoline markets.

The accompanying map of the United States shows the different federal requirements for retail gasoline. As of October 1999, there were essentially seven separate gasoline markets. As of today, there are eight; gasoline is reformulated with ethanol in Milwaukee and Chicago but with MTBE elsewhere.

This is a crucial point. As noted earlier, gasoline intended for ethanol reformulation requires a unique blendstock known in the trade as “RBOB.” That’s because ethanol evaporates easily and unburned evaporated fuel is a major contributor to smog. Gasoline intended for ethanol blending must, accordingly, be specially made in order to minimize ethanol evaporation rates.

Because of RBOB’s unique characteristics, it must be segregated from other gasoline all the way up the transportation system until the point just before it is mingled with ethanol and delivered to the service station. Accordingly, it cannot move through normal distribution channels and requires an entirely separate, dedicated transportation network.

This congressionally mandated balkanization of the gasoline market has seriously hampered the flexibility that refiners would otherwise have to react to spot shortages (and the related opportunity for profit making). Because it is inefficient to segment refining operations to produce multiple fuel blends, refiners generally dedicate their facilities to the production of one particular gasoline blend. Going into the spring, most of the RBOB for the Milwaukee/Chicago market was produced by six refineries in Illinois. Unfortunately, shifting production from one blend to another is costly and time consuming. Accordingly, refiners cannot react quickly to profit-making opportunities.

Why did the refining industry initially underproduce RBOB? Two reasons. First, whenever new gasoline blends are introduced to the market, an adjustment period almost always takes place that is frequently characterized by temporary supply and transportation dislocations. Refiners and merchant facilities need time to figure out the marketplace, their place in it, and to learn the most efficient way to deliver the new product to consumers. This shakeout is temporary but inevitable. As even the EPA acknowledged in its November 1999 “Fact Sheet on Reformulated Gasoline”:

It is not possible to accurately predict the retail price of Phase II RFG [reformulated gasoline] in the year 2000 because it will be influenced by many factors including production costs, weather, crude oil prices, taxes, and local and regional market conditions. It is important to note that, at the start of the Phase II RFG program, retail prices may be higher or fluctuate more.

Accordingly, there should be no surprise that the introduction of this fuel in the Milwaukee/Chicago area on June 1 led to problems as the industry adjusted to new market conditions. Government mandates will always produce such periods of temporary dislocation.

Second, a federal appeals court ruled in March that Unocal legitimately held a patent on the most efficient method of producing RBOB. Refiners were forced to either pay Unocal royalties on RBOB production (imposing a 1-5 cent per gallon tariff on the cost of RBOB) or use a less efficient means of producing the blend. While the direct cost of the Unocal patent is thus minor, the indirect cost has been a reduction in RBOB production. Given the low profit margin that refiners typically operate under, many refiners simply chose to dedicate their facilities to the production of other blends.

Environmental Regulatory Burdens

As noted a moment ago, the refining business is not a particularly profitable one. Its profit margins, in fact, are smaller than the industrial average and no new refinery has been built in over thirty years. Refining capacity is shrinking annually due to plant shutdowns despite continually increasing demand.

The lack of profitability within this industry can be easily traced to several causes.

First, air pollution and hazardous waste regulations hit this particular industry harder than almost most any other. While such regulatory burdens might be justified as the price society must pay for a cleaner environment, that is unfortunately not the case. A 1990 joint study by the U.S. EPA and Amoco found that a typical refinery could meet all of EPA’s emission mandates at only 20 percent of the cost if only the federal government would allow the plant managers flexibility in how they go about controlling emissions.

Second, delays in permit review and issuance seriously constrain a refiner’s ability to react to profitable market opportunities such as the one presented today by high prices in the Milwaukee/Chicago area. Retooling a plant to produce a different gasoline blend requires federal permits to ensure that no additional air pollutants would result from the change. Often, these permit reviews take so long that windows of market opportunity close before refiners are capable of taking advantage of them.

Third, the federal government is constantly issuing new orders regarding how gasoline can be made. Those orders, which require constant retooling and reinvestment in facilities, not only impose steep up-front costs but curtail a plant’s ability to capture profits from previous mandated retoolings and reinvestments. The refining industry is today facing 12 major regulatory actions over the next 10 years, all of which will require major capital investments. Many of those regulatory actions concern additional mandated changes in gasoline blends such as the reduction of sulfur in gasoline and diesel fuel, total elimination of MTBE from reformulated gasoline, and the reduction of various toxic substances. These changes alone will cost between $1.8 billion and $5 billion depending upon how the regulations are promulgated by EPA.

As long as government is insensitive to the regulatory costs it’s imposing on this industry, it cannot legitimately complain when the industry occasionally stumbles under the weight of its regulatory burdens. In short, the government has made certain that there is little profit to be made in the business of refining gasoline, capacity is naturally dwindling, and the industry’s ability to quickly and efficiently adjust to dislocations caused by new mandates is disappearing.

Regulatory Uncertainty

The final contributing factor to the shortfall of gasoline this summer is the constant threat of regulatory and policy change that deters companies from entering the market, investing in efficient practices and technologies, or stockpiling supplies. If businessmen are uncertain about whether new regulations will be imposed that might prevent them from recouping the cost of plant investments, less plant investment will be made. Similarly, if politicians threaten to impose windfall profit taxes or other forms of regulatory intervention to ensure that occasional shortages never present the opportunity for significant profit, then companies will refrain from investing in stockpiling and other activities that only prove profitable under such conditions.

It is a cardinal rule of economics that stable rules are good rules. Even poorly drafted, inefficient regulations can be mitigated and overcome in time by market actors. Constant change, however, spawns uncertainty, and uncertainty in the marketplace restricts corporate time horizons in ways that often prove disastrous for consumers.

The “Price Gouging” Charade

The foregoing analysis should put to rest the charge that oil companies are “gouging” the public. Price increases in the Milwaukee/Chicago region were necessitated by a shortfall in supply, a shortfall that was caused by a number of factors. Moreover, there is no dispute about the fact that there has been a shortfall. The fault line is between those who understand that, given the inelasticities of demand, such a shortfall will have major pricing implications and those who simply do not understand the basic economics of this industry.

Even so, the logic of the “price gouging” charge is threadbare. Federal regulatory officials deny the possibility of shortages by pointing out that reformulated fuel stocks are just as plentiful today as they were last year when no such price shock occurred. But demand is about 4 percent higher today than last year, a disparity that is great enough to trigger the spike. Moreover, such assertions about overall reformulated fuel stocks ignore the fact that the particular reformulated fuel stock relied upon by the Milwaukee/Chicago market — RBOB — is undeniably in shorter supply.

Spectacularly high industry profits are not evidence of gouging. Given the inelasticities of consumer demand for gasoline, prices had to go up substantially to bring demand in balance with supply. If they had not, then the Milwaukee/Chicago area would have undergone a replay of the 1970s when long gasoline lines and dry service station pumps traumatized the nation. Suppliers who had gasoline for the Milwaukee/Chicago market on hand and who were able to deliver it cheaply to market (inframarginal suppliers) are indeed making a substantial profit. Those who had to retool their refineries this spring to make RBOB for the Milwaukee/Chicago market and those who had to secure special truck or barge service to get that gasoline to market (extramarginal suppliers) are making significantly less.

Regardless, those high prices were necessary not only to ration a scarce good; they were also necessary to signal to other refiners that a valuable commodity was in short supply. If prices had somehow been kept down by government action, refiners would have been even less likely to help mitigate the shortage and the supply crisis would have been even worse.

Finally, the charge of price gouging has little internal consistency. If oil companies have enough market power to gouge consumers at will, why have they waited until this year to exercise that power? Why did they not “gouge” in 1999, or in 1998 (when industry profits were at their lowest point in years), on anytime over the last several decades? Moreover, why would oil companies gouge the Milwaukee/Chicago area but nowhere else?

The answer some give is that the industry needed an “excuse” to gouge, and the introduction of Phase II ethanol-blended reformulated gasoline this June was the excuse they needed and an excuse that was not available in any other market. But what critics miss is that businesses do not need an “excuse” to raise prices if that’s what they want to do. This is, after all, a relatively free market and companies are free to charge whatever they think the market will bear anytime they chose.

Oil companies should not have to apologize for their profits this year. Given the short-term inelasticies of both supply and demand in this industry, minor imbalances in either direction will dramatically move prices either up or down. Massive but temporary transfers of wealth are just as likely to benefit consumers as they are to benefit producers in the oil business because temporary periods of excess supply are as likely as are temporary shortfalls of supply. Nobody shed a tear when consumers were “gouging” oil companies in 1998 when the short-term inelasticities of the gasoline markets crashed prices through the floor. Nobody should shed a tear now when those same market inelasticities produce windfall profits for producers.

Finally, for a charge of price gouging to have credence, federal investigators will have to find evidence of collusion between oil companies. That’s because no one company has enough market power to unilaterally drive up prices. But absolutely no evidence of collusion has been unearthed so far, and 30 years of on-again, off-again public witch-hunts have yet to produce even a shred of evidence that oil companies have ever colluded to fix prices.

The belief that oil companies get together to profit at the expense of consumers appears to be genetically hard-wired into our heads. But much like the belief in extraterrestials, it has yet to be substantiated. Given the perfectly understandable nature of the current price spike in the Milwaukee/Chicago area, it’s a pretty safe bet that this particular investigation by the Federal Trade Commission — like all investigations that have come before it — will turn up empty. It is my hope, however, that those who are so demagogically accusing the industry of unjustified profiteering without any evidence will just as loudly and energetically apologize to it once the FTC investigation concludes with its inevitable findings.

Conclusion

Of the approximately $1 per gallon increase in gasoline prices that Milwaukee/Chicago area drivers have experienced over the past year, about 50 cents can be attributed to OPEC production decisions, 25 cents can be attributed to unfortunate pipeline breaks during particularly inopportune times, and 25 cents can be attributed to the market complications imposed by the reformulated gasoline mandate originally imposed in the 1990 Clean Air Act and put into place this June.

Congress would be best advised to eliminate the reformulated gasoline mandate in its entirety. Not only has it been responsible for an (albeit largely temporary) 25 cent per gallon increase in gasoline prices, it accomplishes absolutely nothing in the way of air quality. The fuel injection systems that replaced conventional carburetors in cars built since 1983 include computerized oxygen sensors to determine when the fuel-air mix is optimized from an emissions perspective. By automatically mixing gasoline in such a way as to minimize carbon monoxide emissions, fuel injectors accomplishing through technology what the mandated reformulated gasoline attempts to accomplish via fuel design. Eric Stork, the head of EPA’s Mobile Source Air Pollution Control Program from 1970 till 1978, told the New York Times recently that reformulated gasoline was a good idea 30 years ago, but in cars built in 1983 or later, the fuel is “obsolete and pointless.”

Congress should also demand that environmental regulations shift from a command-and-control basis to a “performance” based regime. Federal agencies might still require that no more than x amount of this or that pollutant come from a facility or gasoline blend but should allow plant managers to undertake whatever actions they wish to meet the standard. As long as companies are required to verify their emissions (and allow public verification of their findings), such a regulatory reform would dramatically reduce regulatory burdens on refiners while maintaining current strict air quality standards.

Finally, congress should force regulatory changes to expedite the issuance of federal air emission permits and reconsider the onslaught of new fuel recipe mandates that are in the hopper. As a recent report by the National Petroleum Council (an official advisory body to the secretary of the Department of Energy) warned, those mandates threaten to replay the dislocations that have hit the Milwaukee/Chicago market in other markets on and off for years to come.

Thank you for your patience, and I look forward to answering any questions you may have.