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”: