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

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I'd like to thank the members of the Subcommittee onNational Economic Growth, Natural Resources, and Regulatory Affairsfor the opportunity to testify today on the effect that federalregulations have had on gasoline prices in the Milwaukee/Chicagoarea.

There is no mystery as to why gasoline prices have spiked herebut nowhere else: the Milwaukee/Chicago market is suffering from ashortage of gasoline and this shortage is entirely responsible forthe surge in prices. My testimony today will examine the factorsthat have contributed to this shortfall as well as the economiclaws that govern gasoline markets. In short, the June spike inMilwaukee/Chicago gasoline prices was largely caused by federal andstate regulations mandating the use of ethanol blended reformulatedgasoline in this market.

The only other explanation for the price spike that's beenoffered - the contention that oil companies are colluding to gougeconsumers - is also examined and dismissed as extremely unlikely.No single oil company has enough market power to significantlyaffect retail prices and there is absolutely no evidence ofcollusion. A basic understanding of the gasoline markets stronglysuggests that, if prices had not gone up dramatically in May/June,1970-style gasoline lines at the pump would have been theinevitable result.

I conclude by suggesting some policy steps that would reduce thelikelihood 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 representsabout a 50 percent increase in price. Gasoline prices in theMilwaukee/Chicago area, however, peaked at about double the priceof a year ago.

So about half the price increase experienced in theMilwaukee/Chicago area was due to the general increase in world oilprices. The Congressional Research Service, for instance, reportsthat refiners' crude acquisition costs have risen by the equivalentof 48 cents per gallon of gasoline over the past year and a half.That price increase is explained by three factors; OPEC productionrestraint, low domestic inventories of oil, and surging demand foroil products. About this there is little dispute, so I will notdwell upon it this morning.

As an aside, the price increase appears more dramatic than itactually is. First, it was preceded by the lowestinflation-adjusted oil prices in recent history: less than $10 abarrel in December 1998, a price that allowed gasoline to sell at$1.05 a gallon. Price increases were virtually inevitable, andgiven the historic lows of December 1998, they were bound to appeardramatic by comparison. Second, real prices even in theMilwaukee/Chicago area still don't approach the historic peak priceof $2.67 a gallon, which was set nationally in March 1981 afteradjusting for inflation.

Nevertheless, why are prices higher in the Milwaukee/Chicagoarea than elsewhere? Simply put, the imbalance between gasolinesupply and demand is greater here than elsewhere in thecountry.

Imbalances in Supply & Demand

Disruptions in the transportation network are primarilyresponsible for limiting the supply of gasoline in theMilwaukee/Chicago area. An inability on the part of refiners toproduce enough gasoline to keep up with surging demand has alsocontributed to the problem. Given the inelasticities of thegasoline market, those two factors alone explain the disparitybetween regional and national prices.

Gasoline demand has increased by 4 percent since last yearaccording to the American Automobile Association but supply hasremained unchanged. This imbalance is complicated by a shrinkage ininventory stocks: mid-June national inventories of reformulatedgasoline were 6 percent below the June 1999 level and 16 percentbelow those of June 1998.

While this disparity between the supply and demand ofreformulated gasoline has affected all markets that rely on thereformulated gasoline equally, the Milwaukee/Chicago market hasbeen additionally hit by a production shortfall of the specificblend of reformulated gasoline that is required there and nowhereelse. Going into the spring, only six refineries (all located inIllinois) were producing RBOB that could be sold in theMilwaukee/Chicago market. But production at those and the otherfacilities making gasoline dedicated to the Milwaukee/Chicagomarket is running about 7 percent below production a year ago andstockpiles are unusually low.

The cheapest and easiest way to supplement the production atthose Illinois facilities is to ship gasoline via pipelines fromGulf Coast refineries. Unfortunately, the main pipeline thatservices the Milwaukee/Chicago area - the Explorer pipeline, whichships gasoline from refineries on the Gulf Coast to Chicago -experienced a major fire near St. Louis in March. Although thedamage was repaired quickly and the pipeline opened for businessten days later, the owners of the pipeline and the U.S. Departmentof Transportation entered into a joint agreement to reduce theoperating pressure of the pipeline by 20 percent, which reduced thevolume of gasoline moving through the pipeline by 10 percent. Arupture in the Wolverine Pipeline on June 8 - the one dedicatedreformulated gasoline pipeline from Chicago to Detroit that servesthe Milwaukee region -- has further reduced pipeline traffic by 20percent although it returned to full operation by the end of themonth.

While trucks and barges are an alternative means of deliveringgasoline to the Chicago/Milwaukee market, it's a far more expensivemethod of delivery and a limited delivery alternative given thepaucity of unused truck and barge capacity. The upshot is thattrucks and barges have not been able to make up the shortfall indeliveries caused by the pipeline problems and the use of trucksand barges has added expense.

An imbalance of only a few percent between supply and demandseems at first blush to be a minor problem, but given the nature ofgasoline 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 alittle in the near term. Economists calculate that short-term priceelasticity for gasoline is about -0.05. That is, if prices go up 1percent, consumer demand will decrease in the short term by onlyone-twentieth of 1 percent.

Accordingly, when the demand for gasoline outstrips theavailable supply (even by just a little), prices have to go up alot in order to keep the gasoline pumps from literally running dry.Thus, if local gasoline supplies are 2-3 percent below where theyneed to be to meet unmoderated consumer demand - the figure mostmarket analysts believe to be correct for the Milwaukee/Chicagoarea - price would have to jump by more than 50 percent in order toprevent spot shortages.

Prices, remember, are used to allocate scarce goods. Althoughdemand for gasoline is far more elastic in the long run, in theshort run, small disparities in supply and demand (in eitherdirection) will always by necessity have a large impact onprices.

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

Why the Production Shortfall?

What role have politicians played in all of this? Approximatelythree-quarters of the price hike in the Milwaukee/Chicago area canbe explained by circumstances largely outside of government'scontrol; the OPEC production restraint and the pipeline ruptures.This is also the conclusion of economist Lawrence Kumins in hisJune 16 report on midwestern gasoline prices for the CongressionalResearch Service.

One-quarter of the price spike, however, can be laid directly atthe doorstep of government. Refineries have had a hard time keepingup with the demand for reformulated gasoline in theMilwaukee/Chicago market, and that production shortfall is alogical consequence of poorly designed federal and state policies.Refinery production has been limited by the reformulated gasolinemandate passed as part of the 1990 Clean Air Act, unnecessarilyburdensome environmental regulations promulgated by the EPA, andthe continued demagogic nature of Congress, which deters investmentin the refining industry.

Reformulated Gasoline Mandate

As a consequence of the Clean Air Act Amendments of 1990, areasthat violated federal air quality standards were required to sellonly specially reformulated gasoline beginning June 1, 2000. Thisnew gasoline is blended with various oxygenates (primarily methyltertiary butyl ether - MTBE, or ethanol) in order to reduce theemission of carbon monoxide, a significant contributor towintertime smog, and to reduce the amount of toxic chemicals, suchas benzene, in the fuel. This reformulated gasoline now serves 30percent of the country.

While today's reformulated gasoline (known in the regulatedcommunity as "Phase II" reformulated gasoline, or RFG-2) is 1-2cents more expensive per gallon than last year's "Phase I"reformulated gasoline and 5-8 cents more expensive thanconventional gasoline, the real consumer impact of reformulatedgasoline is related to the rigidity it imposes on national gasolinemarkets.

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

This is a crucial point. As noted earlier, gasoline intended forethanol reformulation requires a unique blendstock known in thetrade as "RBOB." That's because ethanol evaporates easily andunburned evaporated fuel is a major contributor to smog. Gasolineintended for ethanol blending must, accordingly, be specially madein order to minimize ethanol evaporation rates.

Because of RBOB's unique characteristics, it must be segregatedfrom other gasoline all the way up the transportation system untilthe point just before it is mingled with ethanol and delivered tothe service station. Accordingly, it cannot move through normaldistribution channels and requires an entirely separate, dedicatedtransportation network.

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

Why did the refining industry initially underproduce RBOB? Tworeasons. First, whenever new gasoline blends are introduced to themarket, an adjustment period almost always takes place that isfrequently characterized by temporary supply and transportationdislocations. Refiners and merchant facilities need time to figureout the marketplace, their place in it, and to learn the mostefficient way to deliver the new product to consumers. Thisshakeout is temporary but inevitable. As even the EPA acknowledgedin its November 1999 "Fact Sheet on Reformulated Gasoline":

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

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

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

Environmental Regulatory Burdens

As noted a moment ago, the refining business is not aparticularly profitable one. Its profit margins, in fact, aresmaller than the industrial average and no new refinery has beenbuilt in over thirty years. Refining capacity is shrinking annuallydue to plant shutdowns despite continually increasing demand.

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

First, air pollution and hazardous waste regulations hit thisparticular industry harder than almost most any other. While suchregulatory burdens might be justified as the price society must payfor a cleaner environment, that is unfortunately not the case. A1990 joint study by the U.S. EPA and Amoco found that a typicalrefinery could meet all of EPA's emission mandates at only 20percent of the cost if only the federal government would allow theplant managers flexibility in how they go about controllingemissions.

Second, delays in permit review and issuance seriously constraina refiner's ability to react to profitable market opportunitiessuch as the one presented today by high prices in theMilwaukee/Chicago area. Retooling a plant to produce a differentgasoline blend requires federal permits to ensure that noadditional air pollutants would result from the change. Often,these permit reviews take so long that windows of marketopportunity close before refiners are capable of taking advantageof them.

Third, the federal government is constantly issuing new ordersregarding how gasoline can be made. Those orders, which requireconstant retooling and reinvestment in facilities, not only imposesteep up-front costs but curtail a plant's ability to captureprofits from previous mandated retoolings and reinvestments. Therefining industry is today facing 12 major regulatory actions overthe next 10 years, all of which will require major capitalinvestments. Many of those regulatory actions concern additionalmandated changes in gasoline blends such as the reduction of sulfurin gasoline and diesel fuel, total elimination of MTBE fromreformulated gasoline, and the reduction of various toxicsubstances. These changes alone will cost between $1.8 billion and$5 billion depending upon how the regulations are promulgated byEPA.

As long as government is insensitive to the regulatory costsit's imposing on this industry, it cannot legitimately complainwhen the industry occasionally stumbles under the weight of itsregulatory burdens. In short, the government has made certain thatthere is little profit to be made in the business of refininggasoline, capacity is naturally dwindling, and the industry'sability to quickly and efficiently adjust to dislocations caused bynew mandates is disappearing.

Regulatory Uncertainty

The final contributing factor to the shortfall of gasoline thissummer is the constant threat of regulatory and policy change thatdeters companies from entering the market, investing in efficientpractices and technologies, or stockpiling supplies. If businessmenare uncertain about whether new regulations will be imposed thatmight prevent them from recouping the cost of plant investments,less plant investment will be made. Similarly, if politiciansthreaten to impose windfall profit taxes or other forms ofregulatory intervention to ensure that occasional shortages neverpresent the opportunity for significant profit, then companies willrefrain from investing in stockpiling and other activities thatonly prove profitable under such conditions.

It is a cardinal rule of economics that stable rules are goodrules. Even poorly drafted, inefficient regulations can bemitigated and overcome in time by market actors. Constant change,however, spawns uncertainty, and uncertainty in the marketplacerestricts corporate time horizons in ways that often provedisastrous for consumers.

The "Price Gouging" Charade

The foregoing analysis should put to rest the charge that oilcompanies are "gouging" the public. Price increases in theMilwaukee/Chicago region were necessitated by a shortfall insupply, a shortfall that was caused by a number of factors.Moreover, there is no dispute about the fact that there hasbeen a shortfall. The fault line is between those whounderstand that, given the inelasticities of demand, such ashortfall will have major pricing implications and those who simplydo 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 bypointing out that reformulated fuel stocks are just as plentifultoday as they were last year when no such price shock occurred. Butdemand is about 4 percent higher today than last year, a disparitythat is great enough to trigger the spike. Moreover, suchassertions about overall reformulated fuel stocks ignore the factthat the particular reformulated fuel stock relied upon by theMilwaukee/Chicago market -- RBOB -- is undeniably in shortersupply.

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

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

Finally, the charge of price gouging has little internalconsistency. If oil companies have enough market power to gougeconsumers at will, why have they waited until this year to exercisethat power? Why did they not "gouge" in 1999, or in 1998 (whenindustry profits were at their lowest point in years), on anytimeover the last several decades? Moreover, why would oil companiesgouge the Milwaukee/Chicago area but nowhere else?

The answer some give is that the industry needed an "excuse" togouge, and the introduction of Phase II ethanol-blendedreformulated gasoline this June was the excuse they needed and anexcuse that was not available in any other market. But what criticsmiss is that businesses do not need an "excuse" to raise prices ifthat's what they want to do. This is, after all, a relatively freemarket and companies are free to charge whatever they think themarket will bear anytime they chose.

Oil companies should not have to apologize for their profitsthis year. Given the short-term inelasticies of both supply anddemand in this industry, minor imbalances in eitherdirection will dramatically move prices either up or down. Massivebut temporary transfers of wealth are just as likely to benefitconsumers as they are to benefit producers in the oil businessbecause temporary periods of excess supply are as likely as aretemporary shortfalls of supply. Nobody shed a tear when consumerswere "gouging" oil companies in 1998 when the short-terminelasticities of the gasoline markets crashed prices through thefloor. Nobody should shed a tear now when those same marketinelasticities produce windfall profits for producers.

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

The belief that oil companies get together to profit at theexpense of consumers appears to be genetically hard-wired into ourheads. But much like the belief in extraterrestials, it has yet tobe substantiated. Given the perfectly understandable nature of thecurrent price spike in the Milwaukee/Chicago area, it's a prettysafe bet that this particular investigation by the Federal TradeCommission -- like all investigations that have come before it --will turn up empty. It is my hope, however, that those who are sodemagogically accusing the industry of unjustified profiteeringwithout any evidence will just as loudly and energeticallyapologize to it once the FTC investigation concludes with itsinevitable findings.

Conclusion

Of the approximately $1 per gallon increase in gasoline pricesthat Milwaukee/Chicago area drivers have experienced over the pastyear, about 50 cents can be attributed to OPEC productiondecisions, 25 cents can be attributed to unfortunate pipelinebreaks during particularly inopportune times, and 25 cents can beattributed to the market complications imposed by the reformulatedgasoline mandate originally imposed in the 1990 Clean Air Act andput into place this June.

Congress would be best advised to eliminate the reformulatedgasoline mandate in its entirety. Not only has it been responsiblefor an (albeit largely temporary) 25 cent per gallon increase ingasoline prices, it accomplishes absolutely nothing in the way ofair quality. The fuel injection systems that replaced conventionalcarburetors in cars built since 1983 include computerized oxygensensors to determine when the fuel-air mix is optimized from anemissions perspective. By automatically mixing gasoline in such away as to minimize carbon monoxide emissions, fuel injectorsaccomplishing through technology what the mandated reformulatedgasoline attempts to accomplish via fuel design. Eric Stork, thehead of EPA's Mobile Source Air Pollution Control Program from 1970till 1978, told the New York Times recently thatreformulated gasoline was a good idea 30 years ago, but in carsbuilt in 1983 or later, the fuel is "obsolete and pointless."

Congress should also demand that environmental regulations shiftfrom a command-and-control basis to a "performance" based regime.Federal agencies might still require that no more than xamount of this or that pollutant come from a facility or gasolineblend but should allow plant managers to undertake whatever actionsthey wish to meet the standard. As long as companies are requiredto verify their emissions (and allow public verification of theirfindings), such a regulatory reform would dramatically reduceregulatory burdens on refiners while maintaining current strict airquality standards.

Finally, congress should force regulatory changes to expeditethe issuance of federal air emission permits and reconsider theonslaught of new fuel recipe mandates that are in the hopper. As arecent report by the National Petroleum Council (an officialadvisory body to the secretary of the Department of Energy) warned,those mandates threaten to replay the dislocations that have hitthe Milwaukee/Chicago market in other markets on and off for yearsto come.

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

Jerry Taylor

Subcommittee On National Economic Growth, Natural Resources, and Regulatory Affairs
Committee on Government Reform
The United States House of Representatives