The Price of Gasoline: Trends and Open Research Questions

1. The Price of Gasoline:Trends and Open Research Questions Chris Decker, PhD University of Nebraska Omaha MBAA – March 31, 2006

2. Gasoline prices and consumer expenditures

3. Components of the retail price of gasoline

4. The price of crude oil is determined in a world market of which the US is a major consumer

5. With such a tight market, and a low elasticity of supply, good energy (crude oil, natural gas, etc.) demand projections are critical

6. Crude oil demand projections vs. actual off as well…

7. Also, with such a tight market, any crude oil supply disruptions will impact the market • Geo-political events • 2004 – Basra Oil Terminal bombed (90% of Iraq’s crude oil exports ship through here). • February 2006 – attempted bombing of Saudi Arabia oil facilities sent crude oil price up $2.00 to $63.00. • Labor stoppages • 2004 Norway (a major oil exporter) experienced labor strikes, shutting down 375,000 bpd of production in June and another 300,000 bpd in October. • 2004-2005 – Strikes in Venezuela disrupted oil flows to US (particularly Texas). • Natural disasters • 2004 Hurricanes Charlie, Frances and Ivan. • 2005 Hurricanes Katrina, Rita. • Stopped shipping of crude extracted in the gulf coast and destroyed refinery and inland shipping capacity. • Strains on shipping capacity • (according to Federal Trade Commission) Tanker fleets have not kept up with increased demand for oil worldwide. • Significant amount of (environmental) regulation linked to tanker construction.

8. Given such conditions, futures traders are able to bid up prices for future deliveries of crude • Entering the hurricane season again. • Increased international political instability. • Spot prices tend to closely track futures prices.

9. Gasoline demand in the United States

10. Refinery capacity utilization in the United States

11. Utilization rate • Averaged 93 % since 1995. • Averaged 91 % since 2000. • Capacity may not be the main issue with rising prices.

12. Increases in crude oil prices and refinery markups are the major contributors to gas price increases

13. Why the increased refinery markup? • Increased gasoline demand • Benefited crude oil markets as well as refinery markups. • Substantial merger and acquisition in the petroleum refining industry • GAO reports 2,600 mergers have occurred in the industry since 1990. • Most vertical in nature but some large horizontal ones: • 1996 – Shell and Motiva, Ultramar and Diamond Shamrock • 1997 – Tosco and Unocal, UltramarDiamondShamrock and Total (Valero) • 1998 – BP and Amaco, Marathon and Ashland Petroleum • 1999 - Exxon and Mobil • 2000 – BPAmaco and Arco • 2001 – Chevron and Texaco, Phillips and Tosco, UDS and Valero • 2002 - Conoco and Phillips • GAO estimates this may account for a 2-7 cent increase per gallon on average (wholesale price). • Caution: mergers may increase prices but can also lead to scale economies • FTC ruled in a few cases that the merger would be allowed if the new company divested substantial amts of its combined capital assets.

14. Available fuel inventories declining • Inventories can be costly to hold. • Industry has made efforts over time to reduce inventories. • But inventories smooth unanticipated supply and demand shocks.

15. Inventories down across a number of fuel types • Gasoline: down 17.4% from 2001 levels • Reformulated Gasoline: down 58.8% from 2001 levels • Diesel fuel: down 7.2% from 2001 levels • Home heating fuel: down 10.3% from 2001 levels

16. Energy & Environmental Policy and Regulation • Since last year’s energy bill (July 2005) did not grant liability protection against MTBE lawsuits, US refiners will halt the use of MTBE. • Increased demand on other oxygen fuel additives, notably ethanol. • Note: MTBE has already been phased down or banned in many states – inventories have been down substantially (down 75 % from 1993 levels).

17. Ethanol • Good news • ethanol inventories have been increasing, from 4.3 mbd in 2000 to 6.0 mbd in 2005 (39 % increase). • existing production has kept pace with state demands as these states have phased out MTBE. • Bad news • substantial increases in demand will likely strain existing ethanol productive capacity. • Proposed production of FLEX FUELS (E85) by Ford and GM could substantially strain ethanol capacity. • Transportation of ethanol must be done by tanker truck, barge and/or rail (not pipeline) which tends to 1) be more expensive and 2) takes more time to get to refinery destination. Also, ethanol must be stored separately and blended just prior to final product distribution. • More corn used to make ethanol means less corn for live-stock feed, suggesting beef prices could increase as well. • Net effect • not immediately obvious however, there is good reason for concern.

18. Why the general and sustained increase in gasoline prices? • Current crude oil “spike” unlike previous price spikes: • 1973 – OPEC oil embargo – supply side. • 1980 – Iran/Iraq war – supply side. • 1990 – Gulf war – supply side. • 2000 – sustained increase in world demand. • Greater than anticipated world demand for crude oil and refined energy products. • The “miss” on Asian (Chinese) demand likely resulted in fewer refinery capacity additions and lower exploration and development rates. • Strains on existing world productive capacity.

19. Why the general and sustained increase in gasoline prices? • Refinery markups increasing • More consolidation, less competition. • US Energy policy and regulations. • MTBE phase out at the national level. Increased reliance on ethanol. • Relatively tight refinery capacity combined with dwindling fuel inventories. • More susceptible to planned inventory maintenance (usually in the fall and spring). • Greater price increases when refineries switch productive mix to special (cleaner burning) fuel blends (usually in the spring). • More susceptible to unplanned production/distribution disruptions. • Texas, March 25, 2005 – major supply disruption. • 2005 Hurricanes – Gulf coast accounts for 30-40 % of gasoline production in the US.

20. A number of puzzles remain… • Why the poor demand projections, particularly for Asia and China? • China’s economy has been growing for years now. • Historically strong statistical link between GDP growth and energy demand. • Improvement in demand forecasts critical for more accurate crude oil price forecasts. • Guides exploration, production, refining, and alternative fuels planning and investment.

21. Puzzles… • Prices tend to increase much more quickly than they fall, leading to average increases in prices. Why? • Inventories build and decline, as do crude oil prices. Why then don’t gas prices fall as quickly and to the same extent as they increase. • Oligopoly behavior • Search behavior

22. Puzzles… • Why has the volatility of gasoline prices increased so much recently? • Major puzzle – oligopolies are usually characterized by relatively stable prices! • Geo-political uncertainty, fear of unanticipated supply disruptions • Tightening inventories. • To meet unanticipated increases in demand or to counter unexpected supply disruptions, firms may draw down inventories rather than increase price. However, if inventories are low and falling, price changes may be more frequent.

23. Preliminary Regression… Preliminary results suggest inventory levels play a major role in stabilizing prices: