Gas Lines and Bank Runs

What do the recent runs on banks such as IndyMac and Washington Mutual have in common with the gas lines that have appeared in the Southeast in the aftermath of hurricanes Gustav and Ike? The correct answer, in my view, is that both reflect consumer behavior that might be rational at the individual level, but is highly counterproductive in the aggregate. Moreover, rather than demonstrating the failure of unregulated markets to protect consumers, the gas shortage in Georgia and the Carolinas has been compounded by consumer-protection, or "price gouging" laws that prevent the market from reducing demand and encourage hoarding when supply is constrained.

Bank runs and gas lines both begin with a perception that there isn't enough of the desired commodity to go around: cash in the former case, fuel in the latter. In the Southeast, that perception is grounded in the reality that two weeks after Hurricane Ike made landfall in Texas, a number of Gulf Coast refineries were still operating at reduced rates. For the week ending September 19th, the average utilization rate for refineries in the region was approximately half that for the same period last year. Most of the petroleum product supply for Georgia and the Carolinas originates at Gulf Coast refineries and is transported along the Colonial and Plantation pipelines, which only this week resumed shipping at pre-hurricane flow rates. Since the transit time from Houston to Atlanta is around eight days, it could take another week for supplies to return to normal--and longer still for normal inventories to be re-established.

In the meantime, with a significant shortfall in deliveries along these pipelines, and US gasoline inventories that were already extremely low going into the storms, local prices should have risen dramatically, in order to balance supply and demand. Yet although an internet search revealed many stations in the Atlanta, GA and Charlotte, NC metro areas pricing above $4.00 per gallon for unleaded regular, the region only averaged 15 cents per gallon above the national average in this Monday's DOE price report. Although lower prices in surrounding states with access to other sources of supply may contribute to that low differential, regulations have also kept a lid on prices. Following the hurricanes, the Georgia and North Carolina state governments triggered their anti-gouging laws, subjecting retailers to strict penalties for increasing their margins over the cost charged by their suppliers.

There are two problems with this well-intended approach. First, it impedes the price signal to consumers that would otherwise alert them to sharply-reduced availability and promote conservation. We've learned a lot about the price elasticity of demand for gasoline in the last couple of years. It took an increase of approximately $1 per gallon to reduce average US demand by 5%, and the storm-related disruptions cut supplies to the Southeast by a much larger fraction than that. No one knows how high gas prices would have had to go to constrain demand without gas lines, transaction limits, or other non-price controls, but it is reasonable to conclude that the necessary level would be a lot higher than that allowed by law in these states. By imposing price limits, government makes an explicit choice in favor of gas lines, in order to keep the price of whatever gas is available within reach of lower-income consumers. That may be a popular decision, but it is hardly a market failure.

The other drawback of these "soft" price controls is that they encourage a feedback loop that fosters panic and amplifies scarcity. High prices discourage hoarding, while artificially-low prices amid vanishing availability egg consumers on to get theirs, before it's all gone. And as I've noted before, a shift in psychology concerning how low to let our gas gauges get before refueling can drain even a well-supplied service station network. If every American decided to buy a half-tank of gasoline on the same day, demand would spike to more than four times average. That is the last thing you want when product is already tight. Moreover, uncertainty about how price gouging laws will be interpreted leaves retailers perceiving an unpleasant choice between running out and being fined or imprisoned. That's a lot of extra grief for a business that usually only clears a few cents per gallon, after expenses.

Perhaps this situation offers some lessons about our present financial crisis, as well. The most pertinent one bolsters the idea of increasing FDIC insurance levels, to avoid the kind of depositor flight that contributed to my waking up on Monday with my primary bank in the hands of a new and possibly much less customer-focused owner. At the very least, the Southeast gas lines serve as a reminder of the unintended consequences associated with most regulations arising from our populist instincts, rather than sound economics. As we enter a new era that will almost certainly include much greater oversight and regulation of a smaller and more risk-averse financial sector, that bears keeping in mind.

The Storm Spike - Updated

If you're wondering why the price of gasoline at your local stations has suddenly spiked, despite little movement in crude oil prices, and even if you don't live anywhere near Texas or the path of Hurricane Ike, here are a few factors to keep in mind:

1. Although the price of oil is a major component of the cost of a gallon of gasoline, the crude and refined product markets are separate and distinct, and if there aren't enough refineries to turn it into transportation fuel, the price of oil isn't very relevant to the price at the pump. In the short term, refineries without electricity matter more than damaged oil platforms.


2. US gasoline inventories were already extremely low, before Ike made landfall, both in absolute terms and in days of supply. That's the result of months of high oil prices and weak gasoline demand, which together have crushed refining margins and made producing gasoline a break-even proposition.


3. Prices are set by supply and demand. For the moment, with many Gulf Coast refineries shut down or running at reduced rates, we are a nation that uses 9 million barrels per day of gasoline but has less than 8 million barrels per day of supply, including the million barrels or so we routinely import. Extra supplies from Europe and elsewhere are at least 10 days away. When supply and demand are so mismatched and inventory so low, the only choices for rationing supply are higher prices or gas lines and run-outs, which we may yet see in some areas. In general, our gut instincts about "gouging"--fed by misinformed or cynical politicians--are deeply unhelpful in such circumstances. Panic buying is even worse, because it can create a shortage by itself.


4. Service station owners have also been squeezed between weak demand and high prices this year. When they saw spot wholesale gasoline prices spike over $4/gal. on Friday, they knew their next deliveries were likely to cost them a lot more. Stretched by months of weak retail margins, they are in no position to absorb that hit without raising prices in anticipation of it.

As of Monday morning, it appears that the Texas refineries have not sustained major damage. Most should be able to restart within a week or two. Imports will increase in the meantime, and refineries not affected by the storm can run at higher rates, to make up for lost production and rebuild inventories, allowing prices to come back down pretty quickly.

The Storm Spike

If you're wondering why the price of gasoline at your local stations has suddenly spiked, despite little movement in crude oil prices, and even if you don't live anywhere near Texas and the path of Hurricane Ike, here are a few factors to keep in mind:

1. Although the price of oil is a major component of the cost of a gallon of gasoline, the crude and refined product markets are separate and distinct, and if there aren't enough refineries to turn it into transportation fuel, the price of oil isn't very relevant to the price at the pump.

2. US gasoline inventories were already extremely low, before Ike made landfall, both in absolute terms and in days of supply. That's the result of months of high oil prices and weak gasoline demand, which together have crushed refining margins and made producing gasoline a break-even proposition.

3. Prices are set by supply and demand. At the moment, with many of the Gulf Coast refineries shut down, we are a nation that uses 9 million barrels per day of gasoline but has less than 8 million barrels per day of supply, including the million barrels or so we import every day, with any extra supplies from Europe and elsewhere at least 10 days away. When supply and demand are so mismatched and inventory so low, the only choices for rationing supply are rapid and significant price increases, or gas lines and run-outs, which we may yet see in some areas. Our gut instincts about "gouging"--fed by misinformed or cynical politicians--are deeply unhelpful right now.

4. Service station owners have also been squeezed between weak demand and high prices. When they saw spot wholesale gasoline prices spike over $4/gal. yesterday, they knew their next delivery was going to cost them a lot more. Stretched by months of weak retail margins, they are in no position to absorb that hit without raising prices in anticipation of it.

If the Texas refineries haven't sustained major damage, most should be able to restart within a week or two. Imports will increase in the meantime, and refineries not damaged by the storm can run at higher rates, to make up for lost production and rebuild inventories, allowing prices to come back down pretty quickly. If the damage turns out to be significant, however, we're going to be paying a lot more for gasoline and diesel fuel for a while, no matter what happens to crude oil prices.