Thursday, May 20, 2004

Is the System Broken?
I missed this article from the New York Times last week, describing testimony before the Senate on the influence of environmental regulations on the current high gasoline cost. From the description in the article, the non-industry participants reflected their ignorance of how the industry actually functions to deliver fuel to customers, and the industry representatives did a poor job of explaining the facts.

Let's start with the basics. Contrary to popular opinion, when you pull into an Exxon station, there's a high likelihood the gasoline you are buying on a given day was not refined by Exxon. This would be equally true of any other brand you could name. The reason is that the industry has been optimized over the years though a system of "exchanges" that reduce the cost to the companies and, more importantly, to consumers.

If companies could only market in those areas in which they could guarantee 100% supply from their own facilities, the retail gasoline market would look a lot more like the market for milk: most consumers would only have one or two brands from which to choose, and they would pay prices that were inflated by virtue of those companies having to maintain higher inventories, in order to be able to keep their stations supplied, and by less competition.

Instead, the industry evolved into a system in which each company supplies other companies in the markets served by its refineries, and in turn receives supplies in markets in which it has no refineries in close proximity. In addition, they buy product from third party refineries that produce more gasoline than their own marketing outlets require, or that have no service stations at all.

When a company ran short of product in a given market, either because of a refinery problem, or because sales were higher than anticipated, they would borrow or buy supplies from other companies that have temporary surpluses. The increasing complexity of environmental regulations governing local gasoline specifications across the country confounds this response and ensures that local supply disruptions that previously would have been covered by other companies instead result in outages or price increases.

For example, if Company A has a refinery problem that reduces its gasoline production, it calls Company B to ask to borrow some for a short time. But all of Company B's excess above immediate requirements has been blended for the specifications of other markets, for delivery by pipeline. This product cannot legally be sold in the market in which Company A is short. Result: Company A raises prices to slow sales and avoid running out entirely.

What we are witnessing is the undoing--as an unintended consequence of regulations designed to improve local air quality--of a highly flexible mechanism that for decades promoted both more market competition and higher reliability of supply. Although it is not clear how much impact this is having on prices at the moment, there's an excellent chance that we will see some truly startling price spikes this summer, as the system gets stretched further by higher seasonal demand.

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