Sacramento's Role in California's Gasoline Price Spike

How much higher were gasoline prices in California last week than elsewhere?  Enough to raise the national average price for unleaded regular by about $0.10 per gallon.  So while the rest of us were paying an average of $3.75/gal., down slightly from the previous week, gas prices in the Golden State went up by 48 cents, leaving Californians paying nearly a dollar a gallon more than other Americans.  In general the media have done a good job of explaining the direct causes for this spike: a pair of unexpected outages at large refineries in the Bay Area and L.A., combined with the difficulties of supplying the state's unique gasoline blend when local refiners fall short.  Robert Rapier does an even better job of explaining the intricacies of that blend.  But what's missing from all this commentary is an explanation for why the supply for the nation's largest gasoline market, with more than 11% of US sales, should be so tightly balanced that such disruptions would lead to economic hardship for consumers.

As I've indicated before, California is effectively a gasoline island. The product pipelines connecting it with neighboring Arizona and Nevada run out, not in, and the only routes between California and the other West Coast refining center north of Seattle travel over water.  So the principal refineries serving the California market are in California, and obtaining supply from elsewhere that hasn't been prearranged takes time for special batches of fuel to be blended up, tankers to be chartered, and for those vessels to complete their voyages from ports as far away as the Gulf Coast or Singapore.  That entails at least a couple of weeks.

In a posting I wrote in 2007 during a similar price spike in California, I referred to a 2003 study by the Energy Information Agency of the US Department of Energy, looking at an earlier California gasoline spike. (This is a recurring problem.) Among the major factors explaining the higher prices and volatility of the California gasoline market, they found,

"The California refinery system runs near its capacity limits, which means there is little excess capability in the region to respond to unexpected shortfalls."

That also means that there is typically no local surplus from which to rebuild inventories once refinery production returns to normal.  That's a crucial factor in the speed at which prices return to normal.

So much for the diagnosis, but what about the cause?  Tackling the local pollution from large, stationary sources like oil refineries, and from the tailpipes of the state's 31million cars and other vehicles has been a top priority for the state's Air Resources Board (CARB) since the 1970s, for good reason.  However, over the years, CARB's increasingly strict regulations made it harder and less attractive to operate refineries in the state, and more difficult to blend the fuel it allowed to be sold there.  As it happens, I saw much of this first-hand when I worked as an engineer in Texaco's Los Angeles refinery and later when I traded refined products, crude and feedstocks for the company's West Coast operations in the 1980s and early '90s.  I watched one small refinery after another go out of business, and the magnitude of periodic price spikes grow, as the market became more constrained and isolated. I also saw refining margins for the survivors improve relative to those on the Gulf Coast and other parts of the country.  These trends seemed related, since the state, by its actions, was turning California gasoline into a boutique product and effectively blocking competition from outside the state.

The normal response of companies operating in a market such as that, with growing demand and healthy margins, would have been to invest in more capacity--new refineries or major refinery expansions--and collectively to overshoot somewhat.  But by then the prospect of obtaining the permits necessary to build a new refinery in California had gone from difficult to impossible, and most refining investment was focused on the substantial upgrades required to keep up with the state's periodic tightening of product specifications.  And since those investments generally did little to increase output or improve product quality in ways a consumer might notice and pay a premium for, they had awful returns and dragged down the total return on investment for the entire facility. This contributed to refineries shutting down or being sold to independents with less capacity to make further such investments in the future. 

The net result of all these factors is a California refining system that today is 21% smaller than in 1982, at least in terms of crude processing capacity, but must meet gasoline demand that has grown by a third in the meantime, even after shrinking from its 2006 peak.  Now, when an unplanned refinery outage occurs, the result provides as classic and dramatic a demonstration as you'll ever see of the price response to a shift in the supply curve for a good with inelastic demand.

As an ex-Californian and ex-Angeleno there's no doubt in my mind that air quality, especially in Southern California, has improved as a result of many of the regulations imposed on industry and on fuels.  However, you'd have to ask the state's current residents whether that result is worth the high price they periodically pay at the gas pump, or whether some degree of compromise that would have allowed refineries to expand to keep pace with demand, while cleaning up the air almost as much, would have been preferable.