Rent Seeking, Strategic Behavior and Gasoline Prices

Not a very exciting sounding topic, but it does deal with something that is close to just about every adult out there, gasoline prices. Changes in gasoline prices affect all of us, and hence it is something most people should, in my view, know more about, but usually don’t. The notion of rent seeking is where a person, a group of people, a corporation, etc. seek to increase their profits via the political process instead of doing things like making and selling their goods/services. For example, you have an industry and the industry association gets together and decides that it would be better for those in the industry if new entrants could be prevented or reduced, but how to do it? Licensing. You go to politicians and point out that there is potential or even real problems in the industry from shoddy work, dishonest operators, etc. The solution is a license after meeting certain requirements. And bingo, now you have fewer entrants because entry into the industry is now costly. If you are already in the industry (and especially if you are grandfathered in) you now improved your market power. Market power translates into an ability to raise prices and hence increase your profits. However, these new profits are not from producing more, being more efficient, etc. These profits are for all intents and purposes unearned, hence they are called rents.

Now that is a nice description of the problem, but does it happen in reality? The answer is yes. The other day the Foundation for Taxpayer and Consumer Rights (FTRC) released a press release claiming that oil companies intentionally limited refining capacity to drive up gasoline prices. To me this is not at all suprising.

The three internal memos from Mobil, Chevron, and Texaco (Click here to read the memos.) show different ways the oil giants closed down refining capacity and drove independent refiners out of business. The confidential memos demonstrate a nationwide effort by American Petroleum Institute, the lobbying and research arm of the oil industry, to encourage the major refiners to close their refineries in the mid-1990s in order to raise the price at the pump.

So oil companies are behaving in a strategic manner to improve their profits. Nothing new here, IMO. In fact, I’d say that anybody who is shocked, surprised, or upset by this is a naive fool. This is what companies do. No company wants competition. Every company would love to be a monopolist. The Mobil memo for instance seems to be nothing more than an appraisal of another competing refinery starting back up. The Texaco memo on the other hand looks like a nice example of rent seeking in that it discusses using proposals about establishing tighter fuel standards to their advantage in terms of reducing supply and thereby driving up prices. Given the description and example of rent seeking in the first paragraph of this post, it looks like nothing other than good old rent seeking.

In short what we have are oil companies using environmental legislation to their benefit. So when the FTCR and their consultant Tim Hamilton say things like the following,

“It’s now obvious to most Americans that we have a refinery shortage,” said petroleum consultant Tim Hamilton, who authored a recent report about oil company price gouging for FTCR. (Click here to read the report.) “To point to the environmental laws as the cause simply misses the fact that it was the major oil companies, not the environmental groups, that used the regulatory process to create artificial shortages and limit competition.”

it strikes me as monumentally naive. Are oil companies to blame? Sure, but at the same time the oil companies used the very same environmental laws to do their dirty work. So this idea that environmental laws and regulations played no part is bordering on the stupid. In reading the report, Promoting $3 at the Pump in California I see some dubious assertions. For example,

Increases in the prices charged for oil by OPEC countries are not primarily responsible for the dramatic increase in gasoline prices in California. Much of California̢۪s crude oil is harvested locally by major refiners who control their own fields. OPEC nations only supply approximately 20% of the oil delivered to refineries in California. Fields controlled by the oil companies in California or Alaska provide the majority (66%) with the remaining 14% coming from non-OPEC foreign locations (Figure 2).

This indicates a complete lack of understanding of economics and the fact that the oil market is a global market. If oil produced in California has a price of say $20 in California, but it could be sold in another part of the world for $50 then you sell in another part of the world. The result is that prices would rise in California and fall the other part of the world producing a global price. This is what we observe today. So noting that oil that is refined in/for the California gasoline market comes mostly from California is pretty much irrelevant.

California consumers will pay an estimated increase of $15.5 billion more at the pump in 2005 than in 2000 because of profiteering by oil companies and government̢۪s failure to act. (Figure 5).

Yes, and there are only two types of gasoline that can be sold in CA, and those types cannot be sold anywhere else. Hence this creates a local market and since retooling a refinery is costly it gives those refiners who produce for the CA market market power (i.e. the ability to raise prices).

No public evidence exists of substantive increases from 2000 to 2005 to oil companies in the cost of a) producing crude oil; b) refining oil into gasoline or diesel; or c) transporting the refined products to market.

Geez, anybody who suffered through an elementary microeconomics class would know that price is not determined just by costs, but by demand and supply (costs). Looking at just the costs and ignoring the possible changes in demand gives only part of the picture. Also, we’d want to look not just at the cost of refining, but the industry composition as well. Are firms shutting down? If this is the case than that also gives the remaining firms market power as well.

And this notion that it is bad for one firm to engage in strategic behavior that drives out other firms is just ridiculous. It is ridiculous in that is what all firms try to do. They want to be the successful firm, get rid of the compeitition and increase their market share if it is percieved as being good for profits.

The basic idea in all of this is that the oil companies like the environmental laws (although they may claim otherwise) in the sense that it can prevent entry into the market. The hostile environment in CA to new refineries helps the oil companies drive up prices. The thing the FTCR and Tim Hamilton have completely missed is that the high profits of the oil companies also invite entry into that industry by competitors who want to cash in on those profits, but these potential competitiors are kept out which insulates the oil companies and hurts consumers.

The naivete is further on display when the FTCR sends letters to Bill Lockyer expecting him to do something about it. Lockyer is a politician and as such probably has hopes of making it to the governorship of CA. Does anybody really think Lockyer wants to reduce tax revenues so that if he does become governor he’ll have an even harder time balancing the budget and may have to raise other taxes?

And the solution suggested by the report, regulating gasoline sales, is just silly. We can look at the electricity market in CA and see how well that worked out. Prior to deregulation one of the big reasons CA had high electricity rates was because the state force utilities to purchase electricity from environmentally friendly sources (solar, wind, geothermal, etc.) called Qualifying Facilities or QFs. The cost of this electricity was very high and pushed up the average rate. This lead to a push for deregulation which proponents aregued would lower prices (never mind getting rid of the high priced QFs or renegotiating those contracts). And in the end energy prices in CA are no higher than ever (and ironically for the big industrial/commericial users–i.e. the biggest proponents of dergulation–got the biggest increases). The idea of allowing for more refining capacity and competition to lower prices just doesn’t enter the picture (which was also part of the problem in CA with deregulation in that there was sufficient generation capacity for the most part, but taking one or two generators offline would cause problems and price spikes…pretty much like what we see with gasoline refining).

In short, the problem is that we need more refining capacity. The people at FTCR know this, after all they did write,

“It’s now obvious to most Americans that we have a refinery shortage,” said petroleum consultant Tim Hamilton, who authored a recent report about oil company price gouging for FTCR.

The obvious long terms solution is to not clamp down harder on the refining situation, but to increase the refining capacity and prefereably with new companies to increase competition. Another lesson that anyone who has suffered through an elementary microeconomics course would know.

Thanks to TangoMan for pointing out the press release to me.

FILED UNDER: Economics and Business
Steve Verdon
About Steve Verdon
Steve has a B.A. in Economics from the University of California, Los Angeles and attended graduate school at The George Washington University, leaving school shortly before staring work on his dissertation when his first child was born. He works in the energy industry and prior to that worked at the Bureau of Labor Statistics in the Division of Price Index and Number Research. He joined the staff at OTB in November 2004.

Comments

  1. RA says:

    Let the oil companies gouge Californians all they want. Those environmental Wackos deserve it.

  2. ken says:

    I went to high school in so cal before the environmental laws came into effect. There were many, many, days when, even for the healthiest of us, our eyes burned, teared up and turned red as soon as we left the house. Taking deep breaths literally hurt so football practice would be shortened or cancelled altogether.

    That doesn’t happen anymore thanks to strict environmental laws. Anyone who complains about these laws is an idiot.

  3. Herb says:

    Congratulations Steve:

    Your article points out what I, in my own way, have been trying to say. Yes, as this article points out so vividly, the oil companies are indeed price gouging the American people. When I heard that the oil companies reported that they had record profits of 33 Billion dollars in the last quarter and that the President of OPEC reported that they are producing 1 Million barrels per day over the present demand, I felt that these facts were very important in my conclusion that the oil companies were price gouging.

    With the information you provided today, the question arises, How much profit is to much? And What can be done to put the skids to price gouging?

    In that the politicians in a way have created this price gouging monster, they should put a stop to it. What should they do? Put a limit on profits, Create an excess profits surtax on oil and gasoline? Or, Charge them with price gouging and take them to court?

    I don’t know the answer, but I do know that something has to be done. In my part of the country, people are not driving as much and they are drastically cutting back on their purchases of most everything. If the price gouging continues, I think everyone will cut dramatically into their Christmas Holiday spending that will hurt many many businesses that depend on the holidays for their total yearly profits. That would really hurt the entire country. Right now, the airlines are hurting bad with the dramatic increases in jet fuel prices.

    While the FTCR press release and report deal mostly with California, It effects the entire country. I don’t know what to say to you folks in Calif. You have an environmental problem that only you can deal with. But for the rest of the country, I do feel that the oil companies should be taken to task for their business practices.

    Let me say again Steve, Congratulations on this article.

  4. Steve Verdon says:

    Let the oil companies gouge Californians all they want. Those environmental Wackos deserve it.

    Unfortunately some of us in CA aren’t enviro-whackos.

    I went to high school in so cal before the environmental laws came into effect. There were many, many, days when, even for the healthiest of us, our eyes burned, teared up and turned red as soon as we left the house. Taking deep breaths literally hurt so football practice would be shortened or cancelled altogether.

    That doesn’t happen anymore thanks to strict environmental laws. Anyone who complains about these laws is an idiot.

    And the consequence is higher gasoline prices. Not necessarily because it raises costs, but because it gives the refiners market power. The cleaner air is great, but is the cost worth it? That is a legitimate question to ask and to rule it out as being idiotic is itself idiotic.

    With the information you provided today, the question arises, How much profit is to much? And What can be done to put the skids to price gouging?

    The thing is Herb, I don’t care about the profits. What I care about is having a competitive market. Ideally a competitive market where air quality is maintained, but that might be asking too much.

    In that the politicians in a way have created this price gouging monster, they should put a stop to it. What should they do? Put a limit on profits, Create an excess profits surtax on oil and gasoline? Or, Charge them with price gouging and take them to court?

    And if this results in less fuel being available? And what is excess profits? Why not allow for more refineries and new companies to get into the mix, or even standardize the gasoline blend into one national standard?

    While the FTCR press release and report deal mostly with California, It effects the entire country. I don’t know what to say to you folks in Calif. You have an environmental problem that only you can deal with. But for the rest of the country, I do feel that the oil companies should be taken to task for their business practices.

    I disagree. While I don’t like the higher gasoline prices, Herb, I also wouldn’t like a company I’m investing in doing anything short of trying to make as much money as possible while still operating within the letter of the law (and no, to best of my knowledge I hold no oil company stocks save maybe via my 401k).

    And in the end, the politicians are basically the people’s representatives. In a sense Herb, we have done this to ourselves.

  5. Josh Cohen says:

    Well, I tried to trackback, but it didn’t work, so… I also wrote about this topic today, although from the market side, not the corporate side:

    Right here.

  6. ken says:

    Steve, eonomic theory is fine for the classroom but in the real world it just doesn’t work out that way. In a hierarchy of desires, your idealogical desire for perfect markets is always going to be less worthy than a desire for clean air to breath.

    Markets need always to submit to sociatal oversight otherwise they tend to destroy the society that permits them to function in the first place.

  7. Herb says:

    Steve, Thank you for your kind reply. I respect you ideas and opinions, but as is stated in the FTCR report, shortage of supply is generated by the oil companies themselves. Supply and demand are one thing, but when a company controls the supply as well as the inventories, that’s another. It hurts everyone when an oil company does it.

    As far as profits are concerned, I agree that everyone who invests in any company should be fully entitled to a profit, however when these profits are excessive as a result of a manufactured shortage of supply and everyone is hurt. The last I heard is that States have a price gouging law that is supposed to protect the consumer. I don’t know how you feel about it, but violations of the law should be pursued.

    I very strongly agree with you on more refineries and the production of one grade of gasoline and only the politicians can change that.

    You are also right on the American people doing this to themselves by electing these self serving politicians, The recourse there is to either wait until the next election or do what they did in California, “Conduct a Recall”

    Again thanks for the great article. While we disagree now in some areas, we are getting there.

  8. Steven Plunk says:

    Through implementation of environmental regulations the federal and state governments have created de facto public utilities to supply gas, diesel and natural gas. The natural gas segment is regulated as a public utility while the other segments are not.

    It is time to examine this situation in more detail. I am not a fan of non-freemarket interventions but if regulations have already broken the market’s ability to work properly then it could be justified and reasonable.

    The great privilege enjoyed by the large oil companies needs to have the accompanying responsibilities.

  9. Herb says:

    Steven Plunk;

    Wow That was a powerful statement, I wish I would have thought of it. You are RIGHT ON TARGET

  10. Steve Verdon says:

    Steve, eonomic theory is fine for the classroom but in the real world it just doesn’t work out that way. In a hierarchy of desires, your idealogical desire for perfect markets is always going to be less worthy than a desire for clean air to breath.

    Ding, ding, ding. Strawman alert!

    I didn’t say a perfectly competitive or perfect market, but a competitive one. And breathing clean air is great, but you make it sound like there is only two possibilities:

    1. Clean air and an ologopolistic oil/gasoline market.

    2. Filthy air and a competitive oil/gasoline market.

    There is a continuum between the extremes here.

    Markets need always to submit to sociatal oversight otherwise they tend to destroy the society that permits them to function in the first place.

    In a sense, sure, but you don’t want to set up your oversight in such a way as to result in perverse outcomes.

    Herb,

    Steve, Thank you for your kind reply. I respect you ideas and opinions, but as is stated in the FTCR report, shortage of supply is generated by the oil companies themselves.

    Sure it is, but the point is that the oil companies/refiners are in this situation because we gave them this situation. People like Ken who apparently want clean air irrespective of the cost, and those who don’t know better but mean well don’t think through the consequences of various pieces of legislation. So we end up with a fixed number of refineries and an industry becoming more and more concentrated. This allows for market power and increasing prices. Feel free to damn the oil companies all you want, but the only real long term solution is to increase competition, IMO.

    As far as profits are concerned, I agree that everyone who invests in any company should be fully entitled to a profit, however when these profits are excessive as a result of a manufactured shortage of supply and everyone is hurt. The last I heard is that States have a price gouging law that is supposed to protect the consumer. I don’t know how you feel about it, but violations of the law should be pursued.

    Yes, I’m aware of this, but I don’t like such laws. The problem is that laws have isolated the oil companies/refineries from competition. Using the laws to hold down prices artificially will do nothing except result in a shortage. Thus, instead of paying via the wallet you’ll pay by not being able to drive as much.

    I very strongly agree with you on more refineries and the production of one grade of gasoline and only the politicians can change that.

    Unfortunately the oil companies and the environmentalists will probably oppose this.

    Steve Plunk,

    Through implementation of environmental regulations the federal and state governments have created de facto public utilities to supply gas, diesel and natural gas. The natural gas segment is regulated as a public utility while the other segments are not.

    It is time to examine this situation in more detail. I am not a fan of non-freemarket interventions but if regulations have already broken the market’s ability to work properly then it could be justified and reasonable.

    The great privilege enjoyed by the large oil companies needs to have the accompanying responsibilities.

    As somebody who works for a regulated company I’m reluctant to go this route. With regards to electricity and the transmission/distribution system I can see some justification. The transmission/distribution systems do exhibit the conditions of a natural monopoly. Electricity generation does not, but was traditionally lumped in with the transmission/distribution side of the business so deregulation for generation while I think possible is very difficult.

    Gasoline on the other hand is not a natural monopoly (this is a technical definition in that costs have to be subadditive and there has to be a price that precludes entry, but allows the monopolist to earn a positive profit). Standardizing gasoline blends would, IMO, go a long way to solve the problem you have noted without burdening society with all the regulatory costs (i.e., oil companies hiring people like me to handle regulatory matters which would show up in the price).

    Also, there is the issue of the various regulatory agencies being “captured” by special interests. Here in CA that has resulted in high energy prices due to “green/renewable” power which is typically very expensive. And if you go down the regulatory road then decide you don’t like it, going back can be very, very hard (look at the CA electricity crisis).

    Or in short, you observation that government caused the problem, hence we need more of it to solve the problem strikes me as a dubious proposition.

  11. TangoMan says:

    Steve,

    I knew you’d make a good post out of this. You must have missed the other e-mail I sent you:

    In a thoroughly misguided attempt to stem the rising price of gas, Hawaii is set to impose Nixon-style price caps on all the islands’ pumps. The law, set to take effect Sept. 1, ties the price of gas to the wholesale price of gasoline at three price points on the U.S. mainland.

    The Democrats in control of Hawaii’s Legislature admitted back in 2002 when they passed the legislation capping the retail price of gasoline, and again when they revised it in 2004 to cap the wholesale price, that regulatory measures might not lower gas prices when implemented this fall. . .

    So why bring back price controls more than 30 years after Nixon tried them and failed miserably, causing shortages, rationing, inflation and an economic crisis? It’s hard to find a reason, other than to retaliate against the big oil companies, namely Chevron, which many Democrats tried to punish unsuccessfully in court.

    Made up primarily of liberal Democrats with no economics training, no business background, an open disdain for the free market, and a lust for price caps (except on state taxes), lawmakers say they have to “do something” about the high price of gasoline.

    I suppose this is another way of regulating the market.

  12. Herb says:

    Steve:
    While you may not like the price gouging laws, the law is the law and you, I and everyone must obey the law. Maybe I didn’t make it clear enough, If any company indulges in price gouging in violation of the law, then they must be prosecuted and we are a nation of laws.
    At this point of time, I could care less what the environ(Mental) people think. They as individuals and as a group have done more damage to this country that the Russians ever thought of and for the oil companies, Steven Plunk put it best ” the oil companies have responsibilities”, not only to the stockholders, but also to America and Every American.
    And thanks Steve, this is a very good exchange of thoughts and ideas.

  13. Steve Verdon says:

    While you may not like the price gouging laws, the law is the law and you, I and everyone must obey the law.

    True to a certain extent Herb, but there are also dumb laws that should either be repealed or ignored, and I feel this is one of them. It may sound good, but in the end it will likely mean less gasoline as it implicitly puts a price cap on gasoline. I know you remember the gasoline lines when Nixon tried explicit price caps, so you should know what I’m talking about.

    At this point of time, I could care less what the environ(Mental) people think. They as individuals and as a group have done more damage to this country that the Russians ever thought of and for the oil companies, Steven Plunk put it best ” the oil companies have responsibilities”, not only to the stockholders, but also to America and Every American.

    While I think it would be nice if firms behaved this way, I think a firms only responsibility is fiduciary in nature. It isn’t nice, but then I’m never disappoited when a firm turns out to be nothing other than greedy.

  14. ken says:

    Herb, you are an idiot. Without strong environmental laws the land, the air and the water would still be poisoneous. I can tell by your attitude that you are too young to remember the days before environmental laws were enacted.

    The Cayahoga River in Cleveland caught fire due to industrial pollution and nearly burned down a bridge. Lake Erie was so polluted that fish could not be eaten from it and it was rapidly losing its ability to support aquatic life. Mine tailings poisened entire watersheds throughout the Appalachans. Smog hid bridle veil falls in Yosemite from sight, caused misiry for anyone who breathed and ate away at the marble features of the the stature of Lincoln in the Lincoln Memorial in Washington DC. This is just a small sample of the problems unregulated industrial polluters were causing America. Remember Love Canal killing children,leaded paint causing mental retardation, asbestos particles ripping apart lung tissue and mercury poisened tuna fish sold in cans?

    If you don’t face any of those problems today it is because of the environmental laws passed well before your time.

  15. Herb says:

    Ken:

    You really have all the answers, Yes, I do remember the long gas lines in the 70’s, and perhaps I remember to well. I was a very frequent traveler with my work and I, during the 70’s long lines, have seen with my eyes barge after barge after barge, full of gasoline parked on the Ohio River in Midland PA. waiting for the price to rise, I also remember to well in the 80’s when there was a shortage of jet fuel forcing the airlines to tank fuel to the western part of the country. And all during the shortage, I personally knew a guy that was buying up jet fuel by the barge full in Memphis TN, then trucking the fuel to places like Denver CO and selling it at a handsome profit. Greedy, yes he was. but the shortages of gas in the 70’s and the jet fuel shortage in the 80,s was not due to the environment, it was contrived.

    I also remember when the bridge in the cuyahoga river burned due to the sludge dumped there by the steel mills. I also can tell you a lot about the coal sludge in W.VA, dumped there by the coal companies.

    I fail to see the correlation you seem to have between air pollution and industrial waste that does not effect the air.

    You don’t need to tell me a thing about the past misdeeds of industry, I was there, you young yuppie whipper snapper.

    You see Ken, I lived those times in real time, before you were born, I am 72 YO.

    So there!!!!

  16. DL says:

    Two of the main providers of our great way of life-oil and drug companies- are also the most assaulted by the left. Why is that? Perhaps we should just do without them -or, to use the left’s perpetual solution – have the Government take them over-Chavez style!

  17. Herb says:

    DL:

    First of all, I am not and will never be a lefty.

    The answer to your question is easy,

    Because the Drug Companies and the Oil Companies are GREEDY.

    Greed will be the eventual downfall of our country. For me, I strongly feel that if anyone takes from me to enhance their own wealth at my expense, with total disregard to my basic needs, that is the same a theft. I sure hope you don’t feel differently.

  18. Steve Verdon says:

    Herb, you are an idiot. Without strong environmental laws the land, the air and the water would still be poisoneous. I can tell by your attitude that you are too young to remember the days before environmental laws were enacted.

    Ken are you a parody bot or something? While environmental laws have done quite a bit of good, you can’t be serious that there is no way in which things can be improved?

    Also, Herb is retired so he is probably older than you.

  19. frankr says:

    Boutique formulations of gasoline within California have not done anything to eliminate pollution anymore so than changes to gasoline formulation in any of the other 49 states. Gasoline is a hodpodge mixture of different hydrocarbons. Changing the formulation only changes the ratio of the lighter to heaver hydrocarbons. The real problem for southern california is the fact that we live in a big bowl, otherwise known as the LA basin. Before there were cars there was smog in the basin. The indians saw this haze hundreds of years before any cars traveled on any roads. If you limit the formulation of gasoline sold in Southern California, then you have a captive market, with limited production as your only answer. If you regulate gasoline, as they are proposing to do in Hawaii, you will limit availability. I think it is time to have one type of unleaded, with three different octane levels, available for 50 states. Then gasoline becomes a commodity, not a microbrew.