Statement for the Record of the American Petroleum Institute for the Senate Judiciary Committee
API is a national trade association representing more than 400 companies involved in all aspects of the oil and natural gas industry, including exploration and production, refining, marketing and transportation, as well as the service companies that support our industry.
The oil and natural gas industry recognizes the concerns across the country over the higher energy costs American consumers and businesses have been facing this year. It is also aware of contentions that the consolidation that has occurred in the industry over the last decade has led to higher prices. This statement will attempt to address those concerns and to offer the proper context in which to view both energy prices and company mergers.
A brief overview of the industry's status is in order. With the hurricane season past and much, but not all, of the lost Gulf of Mexico production and refining back on line, oil and natural gas prices have receded. But no one should conclude that we aren't facing some tremendous energy challenges ahead.The most recent forecasts of the United States Department of Energy’s Energy Information Administration (EIA) indicate we still haven't escaped our energy predicament. Its sobering message to consumers: Strong demand, hurricane affected production and infrastructure limitations could help keep markets tight and prices volatile for the foreseeable future.
Complicating the overall supply/demand situation are numerous contributing factors. The new federal energy law eliminates the reformulated gasoline oxygen requirement in May, and ultra-low sulfur diesel will be introduced starting June 1.The industry is working hard to meet these new requirements, but they are major transitions and will present a challenge that could decrease supplies.
America's oil and natural gas industry is an industry that has undergone great transformations in recent decades. Whereas once it produced two types of gasoline – leaded and unleaded, it now has 17 formulations. Twenty years ago there were 200 refineries producing about 250 billion gallons of product. Today there are just 148 making 330 billion gallons per year (Chart 1).
It should be noted at the outset that the Federal Trade Commission did a thorough analysis of the potential effects of each large oil company merger – 16 since 1981. In 12 of those cases, the agency mandated significant divestitures of assets before it approved the merger and in the other four, the parties abandoned the proposed transaction altogether. In addition, the FTC has continued to monitor the industry and – in its own words – “remain vigilant” regarding potential anticompetitive conduct. Again, to quote the FTC: “In no other industry does the FTC maintain a price monitoring project such as its project to monitor retail gasoline and diesel prices.” Any allegation that the federal government has been lax in its oversight of oil company mergers is simply not credible.
Economic Factors Led to Mergers
The oil company mergers we saw during the 1990s occurred in response to economic pressures and regulatory requirements. These pressures and requirements were the catalysts of change. During the 1990s, the oil industry earned relatively poor rates of return on their investments. This was especially true in the refining sector, which was hard hit with the need for new investment in technology and equipment to produce cleaner-burning fuels to meet clean air standards set by the Clean Air Act of 1990. This Act had a major impact on the operation of refineries in the United States and the return on investment realized at the time (Chart 2).
Technological advancements have helped refineries produce more from existing facilities than they did in the past. In addition, the elimination of subsidies under the government regulations after 1981 led to the closure of many smaller, less-efficient refineries throughout the1980s and 1990s. Those refineries left standing did a better job of bringing product to market for less. The further consolidation benefited consumers. We can see this in the gradual decline in the refiner/marketer margin, measured as the difference between the refiner’s composite crude oil acquisition cost and the retail price of gasoline minus gasoline taxes (Chart 3). The margin represents the cost of doing business. It includes operating costs, capital expenditures, labor, rent and all the other expenses associated with running a business, including the profits earned from the business
Back in 1980 the cost to refine, distribute and retail gasoline, or the refiner/marketer margin, averaged about 99 cents per gallon (in inflation-adjusted terms). By 1990 it averaged more than 63 cents per gallon, and by 2000 the margin had declined to 54 cents per gallon. It increased briefly in 2001 as a result of colder than normal weather over the 2000-2001 winter and supply disruptions due to pipeline outages and the introduction of new blends of gasoline as required under the Clean Air Act. The refiner/marketer margin has since come down to an average of 48 cents per gallon in 2005. Multiplying these reductions by the 330 billion gallons of petroleum products consumed translates into billions of dollars of savings for consumers. American consumers benefit every day from these improvements and efficiency gains.
The consolidation in the refining sector has increased measurements of industry concentration, but according to the FTC, “despite some increases over time, concentration for most levels of the petroleum industry has remained low to moderate.” This is illustrated in (Chart 4) which shows that even though concentration in the refining sector has increased since 1997, the concentration ratio is still less than it is for many other industries.
A Worldwide Market for Crude Oil
This information relates only to the downstream sector of the market – the refining and marketing sector. When we look at the upstream sector – exploration and production we must recognize we are tied to a worldwide market for crude oil. The price of oil is set on the global market by the forces of supply and demand. When demand is growing rapidly and supplies are tight, buyers typically bid the price up in order to secure supplies for their customers. The higher price acts as a magnet for supplies. It encourages more production and discourages consumption. The market is always looking for a new balance.
The price of crude is the consequence of thousands upon thousands of individual decisions made on the world market every day. No one company or group of companies has control over that price. In terms of market power, large international oil companies own less than 10 percent of the world's oil resources. According to the FTC, “recent large major oil companies have had little impact on concentration in world crude oil production and reserves.” And, as noted by the FTC in their June 2005 report on gasoline price changes “The world price of crude oil is the most important factor in the price of gasoline. Over the last 20 years, changes in crude oil prices have explained 85 percent of the changes in the price of gasoline in the U.S.”
So, when consumers pull up at the gasoline pump, they should know that the price they pay reflects not just the costs to refine and distribute and retail gasoline – costs which have been trending downward - but also a world market for crude and the competition for supplies in that market.
The GAO Report
With this backdrop in mind, let's turn to the report of the General Accounting Office regarding mergers, issued in 2004. The GAO was asked examine the price effect of the wave of mergers that occurred in the U.S. oil and natural gas industry in the 1990s. They found that “increased market concentration generally led to higher whole gasoline prices in the U.S. from the mid-1990s through 2000.”
GAO’s results are measured to within fractions of a cent. It found, for example, that wholesale prices for “conventional gasoline increased by less than one-half cent per gallon, on average from 1994 through 2000. The increases were larger in the West than in the East—the increases were between one-half cent adone cent per gallon in the West, and about one-quarter cent in the East (for branded gasoline only) on average.” (p.11). Given the number of mergers GAO attempted to analyze at once, and the limitations of the data available to it, as well as the approach it used in its analysis, there is simply no way it could trace price effects with sufficient credibility.
The FTC, in a statement issued by Chair Timothy J. Muris shortly after its release, had this to say about the GAO report:
“In 30 years as an antitrust enforcer, academic, and consultant on antitrust issues, I have rarely seen a report so fundamentally flawed as the GAO study of several oil mergers that the Federal Trade Commission investigated under by predecessor, Robert Pitofsky. As the Commission unanimously said in its August 2003 letter to the GAO, this report has major methodological mistakes that make its quantitative analyses wholly unreliable; relies on critical factual assumptions that are both unstated and unjustified; and present conclusions that lack any quantitative foundation. As a result, the report does not meet GAO’s own high standards of “accountability, integrity, and reliability” that one expects from its reports and publications.”
At the heart of the problem with the GAO's approach is the idea of causality. Essentially, GAO arrived at its conclusion that the mergers that occurred during the 1990s increased the wholesale price of gasoline by measuring the difference between the price a refiner pays for crude oil and the price of the gasoline sold at the refiners rack. It measured this price for a period before the mergers took place and for a period after the mergers, and saw an increase after the merger and concluded the merger was the cause.
This approach is surprisingly simplistic and misguided. It only accounts for a refiner's crude costs; it leaves out all the costs incurred by a refinery, such as capital costs, energy costs, and labor costs. And it does this at a critical juncture in the history of U.S. refineries – just when massive investments in capital expenditures were being made by refineries to comply with the 1990 Clean Air Act. Between 1994 and 2003, for example, the refining sector spent $47 billion on environmental expenditures alone. Furthermore, GAO dismissed the need to examine these other costs because, it said, “these inputs comprise a small share of the inputs used to produce gasoline” since “crude oil costs constitute about 66 percent of total refining costs.” (GAO, p.1 15). When results are measured in pennies and fractions of pennies, as GAO's are, leaving out 34 percent of the equation is a stunning omission. (Chart 5)
The GAO also completely ignored the introduction of new types of gasoline. Over the period studied, the first two phases of the Clean Air Act provisions were introduced that required two new more costly blends of reformulated gasoline. Also, over the period several new higher cost “boutique” blends of gasoline were introduced. GAO ignored this cost increase and simply attributed the rise in price due to the mergers.
In addition, the cost of crude oil will vary as a share of the cost to refiners. It is not always 66 percent. It depends, in large measure, on the price of the crude, as well as capital costs, energy cost and labor costs. This can and does vary quite a bit. There was a lot of volatility in the price of crude oil at exactly the time of the mergers. In 1998, for example, the price of crude dropped to just $10 a barrel, from around $20 a barrel. Anytime you have sharp changes in crude prices, you'll see price adjustments being made at varying speeds and heights throughout the wholesale and retail market. (Chart 6) offers an idea of the complexity of the distribution chain.
Also, there are a number of different kinds of crude oil and different prices for these crudes. The GAO used the price of West Texas Intermediate crude for its analysis. This is a reference spot market price. A better measure of what U.S. refiners actually pay for their crude oil is to use the refiner's composite acquisition cost. This is a volume- weighted average of the price of domestic crude oil and imported crude oil. Domestic crude oil is more expensive, on average, than the heavier imported crudes. That differential was growing in the 1990s. At the same time, refineries were becoming more technologically sophisticated in order to produce cleaner-burning fuels. The most advanced of them were able to take advantage of the growing difference in price between the lighter crude and the heavier imports and process more of the heavier cheaper imports (Chart 7 and Chart 8). We can see from these charts that if we are measuring changes in the difference between a refiner's rack and the WTI price, we'll get a different answer than if we use one of the other crude prices. The results vary by several cents per gallon. This is important to note because the GAO's results are measured to within fractions of a cent. This kind of precision, given the variables the GAO measured, is simply not credible.
Refinery Utilization Rates
This isn't the only problem with its analysis. GAO's interpretation of inventory information and refinery utilization rates is uninformed. For example, it correlates national refinery utilization rates with city rack prices. It does this because it said that regional data was not available. This is inaccurate. The national utilization rate is an inadequate choice for studying local markets. GAO was apparently unaware that weekly regional utilization rates are available for the 12 refining districts from both API and the Energy Information Administration.
Refinery utilization rates are high. Typically, they average over 90 percent of their capacity. For most industries, utilization rates are in the 80 percentile. Refinery utilization rates peaked in the late 1990s because capacity additions and imports took some pressure off the need to run refineries so hard. They have since climbed back up to 93 percent in 2004, and even with the devastation from hurricanes Katrina and Rita, managed to averaged 90.4 percent in 2005. (Chart 9).
Refinery utilization rates will fluctuate widely during the year and in different parts of the country for different reasons. In a typical year, refineries shut down for routine maintenance before they gear up to produce a new slate of products. So, for example, refiners will shut their operations down in the fall in advance of the winter season and will start producing more distillate for heating oil and less gasoline than they will in the spring and summer months when the demand for gasoline is at its peak. This process became increasingly complicated during the 1990s because of the number and variety of new fuel specifications being introduced during that time in response to the Clean Air Act. Different cities, counties, and states adopted different fuel specifications with different implementation dates. This added to the volatility of gasoline prices during that time. It truly complicates the job of discerning merger price impacts from fuel specification impacts.
Even if the GAO had used the refining districts for its analysis, rather than national averages, its analysis would not account for such things as "formulation changes, supply disruptions, refinery outages, and changes in imports." (FTC to GAO, p.178). It is not enough to have a utilization rate and a price and from that infer some relationship. We really need to know the information behind that rate or the correlation is meaningless.
Inventories
Another variable the GAO relied on to explain the availability and price of gasoline at the wholesale level is an inventory ratio, which the GAO defined as “the ratio of gasoline inventories to expected demand.” (p.115) GAO apparently intended inventory levels as a proxy for “supply” or the supply curve, but in reality the supply curve includes not just the potential to draw from inventories, but the potential for refineries to produce gasoline and the potential for imports.
The ratio does not account for something as simple as the summer/winter blend difference for gasoline. Summer blends tend to be more costly to produce because evaporation must be reduced, which leads to more costly inputs to keep octane levels up. That doesn't have anything to do with the inventory ratio used by GAO, and strongly suggests there may be a type of seasonal price variation that would not be captured by that variable.
In addition, changes in inventory holding costs can affect inventory levels. For example, when oil prices are high, a refiner might decide to hold a smaller inventory and rely more on producing gasoline when needed. This might be more a reflection of the prices and not have any direct relationship to the tightness or slackness in the gasoline market. Also, there has been a steady decline in privately held inventories for many years, reflecting growing efficiencies of operations and the steady decline in the market share of several products with high seasonal fluctuation (residual fuel for electricity generation and distillate for home heating, for example). In short, GAO's simplistic assumption that “prices will increase if inventories are low relative to demand and decrease if inventories are high relative to demand” (p.115) does not sufficiently capture the reasons for changes in inventories and has the causality of the relationship backward.
GAO Silent on Retail Price Effects of Mergers
Finally, we find it surprising that GAO never once mentions the retail price of gasoline in the areas it measured wholesale prices. That would be one of the first things most analysts would check wholesale price results against. GAO's silence on this is telling. No doubt a spot check would show results all over the board.
The bottom line is that the consolidation that occurred in the oil and natural gas industry in the 1990s took place as a consequence of economic pressures and regulatory requirements. These catalysts for change forced companies to realize economies of scale and to cut costs further. Evidence of the savings from this effort can be found in measurements of the downward trend in refining and marketing margins. These savings have been passed along to consumers. The market is healthy and very competitive.
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