High Gas Prices: Chapter Three Excerpts

Chapter 3

Competition or Collusion
Is there a competitive market with a level playing field?

Government allowed mergers in the oil industry have created five of the largest
companies in the world. Since 1991 the United States oil industry has seen 2600
acquisitions, buy-outs, joint ventures, alliances and mergers.1 These mergers have
resulted in greater market power for five companies and allowed them to control 62%
of the market.

A report by the United States General Accounting Office (Congressional Investigative
Agency) shows that oil industry mergers have lead to higher wholesale and retail fuel
prices, and higher prices for conventional and RFG fuels. Reformulated gasoline
(RFG) is gasoline that is blended to burn cleaner and reduces smog-forming and
toxic pollutants.

The Big 5 oil companies easily control the price and flow of oil in this country. The
largest five oil companies operating in the US (Exxon Mobil, Chevron Texaco, Conoco
Philips, BP Arco and Royal Dutch Shell) now control:
-48% of the United States oil production
- 52% of the United States refinery capacity*
- 62% of the Unites States retail gasoline market
* Refineries with over 30,000 bpd
Source: Public Citizen, March 31, 2004

These companies control a product that virtually every American needs to get to
work, to the store, to the hospital, to schools, churches and even to enjoy recreation.
Nearly every business depends on oil and gas products to provide merchandise to
manufacturers, wholesalers and retailers. Furthermore, they control oil that is used to
keep Americans warm in winter. It is therefore little wonder why these top companies
enjoyed after-tax profits of $61 billion in 2003 and $81 billion in 2004. Record
numbers also appear to be on pace for 2005.These figures are in stark contrast to
just over a decade ago, when the top five oil companies controlled only:
- 7.7% of global crude oil production
- 33.4% of domestic refinery capacity
- 27% of retail market
Source: Public Citizen

The major difference between 1993 and 2004 is that the largest oil companies have
merged with one another, creating a few companies that control large chunks of the
American oil and gas markets. In 1993, the largest five oil companies operating in the
US controlled one third (33.5%) of domestic oil refinery capacity; the top ten
companies controlled 55.6%. In just ten years, because of mergers, the largest five oil
companies now control over half (52%) of domestic oil refinery capacity, while the top
ten control 80%. This dramatic increase of control for the top five companies (to over
half the refining capacity in 2003) makes it easier for oil companies to manipulate
gasoline supplies and intentionally withhold supplies in order to drive up prices.

With this significant market share and power, these mammoth companies can easily
pursue uncompetitive activities. Forecast analysts said that gas prices would reach
historic highs the summer of 2004 with the national average exceeding $1.80 a
gallon, the highest prices in our national history - and they did. The graph below
(exhibit 3A) illustrates how the national gas prices have risen since November of 2002.

(Graph is available in book.)

Exhibit 3A
Although gasoline prices typically reflect the price of crude oil, oil still must be refined
into gasoline at one of the 145 refineries located in the US. In 1981 there were 189
firms that owned 324 refineries. By 2003 there were 65 firms that owned 146
refineries and out of these 65 refining firms, only 11 companies also explore for oil.
Again, 2600 mergers have occurred in the oil industry since 1991 and as a result
market concentration has increased dramatically especially in the refining and
marketing sectors.

The Department of Justice and the Federal Trade Commission measure market
concentration in two ways. One way is the Herfindahl-Hirshman Index (HHI), which is
obtained by summing up the squares of the market shares of each firm in the market.
For example, if four firms have 10%, 20%, 30%, and 40% of the market, then the HHI
for this market would be 10x10+20x20+30x30=40x40=3000.The DOJ / Federal Trade
Commission guidelines consider markets with HHI below 1000 to be “unconcentrated,”
HHI between 1000 and 1800 to be “moderately concentrated,” and HHI above 1800 to
be “highly concentrated.” According to the guidelines, “where the post merger HHI
exceeds 1800, it will be presumed that mergers producing an increase in the HHI of
more than 100 points are likely to create or enhance market power or facilitate its
exercise.”There are many states and markets (discussed more in chapter 6) in the US
that are considered “highly concentrated” which means they have HHI above 1800.

The second way market concentration is measured is the 4-firm concentration ratio.
This can be obtained by calculating the total market share of the four leading
companies in the market. Economists characterize a market with a four firm
concentration ratio of more than 60% as a “tight oligopoly.”Remember, nationally the
Big 5 control 62% of the retail market. What type of market would you call this? In the
Department of Justice / Federal Trade Commission guidelines it is noted that to have
an oligopoly market, it is not necessary, and I repeat not necessary for firms to
explicitly collude to raise prices above competitive levels.

Individual firms with a degree of market power in a concentrated market can act in
“conscious parallelism” with other firms to raise prices. This is what you see with oil
companies when there are very few competitors in the marketplace. They make their
pricing decisions by anticipating what their competitors will do, usually it is to raise the
price and watch the others follow. This is also known as parallel pricing and the result
is to avoid price competition. This pricing practice is what you see in the West Coast,
Midwest, Northwest, Northeast and other regions in the US where there are four firms
that control 60% of the market. One firm raises their price either at the production,
refining, wholesaling or retail level, so the other firms see this and wants to avoid a
competitive market, knowing they can increase profits and not lose market share, and
decide to follow. It is that simple.

At the request of a bipartisan congressional group, the United States Federal Trade
Commission was asked to investigate gasoline price spikes in the Midwestern United
States. In June of 2001, Senator Carl Levin, Chairman of the Senate Permanent
Subcommittee on investigations, directed the Majority Staff of the Subcommittee to
investigate the reasons for historic price increases. Specifically, the subcommittee
was to look at whether increased concentration within the refining industry had
contributed to these price spikes and increase. Here are some of their findings:

- High concentration exacerbates the factors that allow price spikes and increases, a
key one of which is the tightness of supply
- In concentrated markets refiners can affect the price of gasoline by their decisions
on the amount of supply. In a number of instances, refiners have sought to increase
prices by reducing supply.
- Markets in which there is a high degree of vertical integration between refiners and
marketers have higher wholesale and retail prices.

The FTC also concluded in March 2001 that oil companies had intentionally withheld
supplies of gasoline from the market as a tactic to drive up prices – all as a “profit-
maximizing strategy.”These actions, while costing consumers billions of dollars, have
not been challenged by the Federal Trade Commission, the Department of Justice, or
any other United States government agency including Congress. This report is
included at the end of the chapter for your review and is referred to as exhibit 3B.
What is the Federal Trade Commission telling the oil industry? It is okay to
intentionally withhold supplies to make more money!How can this be? But, this is
exactly what happened in 2004 and is likely to remain unchecked in the future as well.
Four of the Big 5 oil companies have and are intentionally withholding oil production
or supply all as a profit-maximizing strategy.

The completed Federal Trade Commission investigation report stated the Federal
Trade Commission uncovered no hard evidence of collusion or any other antitrust
violation. In fact the Federal Trade Commission states, “Prices rose both because of
factors beyond the industry’s immediate control and because of conscious (but
independent) choices by industry participants.”The Federal Trade Commission
further states, “each industry participant acted unilaterally and followed individual
profit maximization strategies”. This Federal Trade Commission reports will tell you it
is not their purpose to criticize the choices made by the investment decisions of three
firms. One firm increased its summer-grade RFG (reformulated gasoline) production
substantially and, as a result, had excess supplies of RFG available and had
additional capacity to produce more RFG at a time of the price spike. This firm did sell
off some inventoried RFG, but it limited its response because selling extra supply
would have pushed down prices and thereby reduced the profitability of its existing
RFG sales. An executive of this company made clear that he would rather sell less
gasoline and earn a higher margin on each gallon sold than sell more gasoline and
earn a lower margin. The VP of Operations Planning and Supply wrote in e-mail, that
he would rather have “$0.40 a gallon margin of 40,000 barrels per day, than $0.10 a
gallon margin on 50,000 barrels per day.” Another employee of this firm raised
concerns about oversupplying the market and thereby reducing the high market
prices. The Federal Trade Commission states, “A decision to limit supply does not
violate the antitrust laws, absent some agreement among firms. Firms that withheld or
delayed shipping additional supply in the face of a price spike did not violate the
antitrust laws. In each instance, the firms chose strategies they thought would
maximize their profits.”The Federal Trade Commission sites there were “no credible
evidence of collusion, no anticompetitive conduct and factors beyond their control.”
(Credits for these statements are in the book.)

The Federal Trade Commission is talking out both sides of their mouth! Take a look
at the following statements from the Federal Trade Commission’s Facts for the
Consumer:

“The Federal Trade Commission works to ensure that the nation’s markets are
vigorous, efficient and free of restrictions that harm consumers. Experience
demonstrates that competition among firms, yields products at the lowest prices,
spurs innovation and strengthens the economy. Markets also best work when
consumers can make informed choices based on accurate information. To ensure the
smooth operation of our free market system, the Federal Trade Commission enforces
federal consumer protection laws that prevent fraud, deception and unfair business
practices. The Commission also enforces federal antitrust laws that prohibit
anticompetitive mergers and other business practices that restrict competition and
harm consumers. Whether combating telemarketing fraud, Internet scams or price-
fixing schemes, the Federal Trade Commission’s primary mission is to protect
consumers.”

Does it look like they are protecting the consumer? Are there vigorous and efficient
marketplaces that are free of restrictions in the petroleum industry?Is there room for
healthy competition? When was the last time a competitor entered this industry?
There are simply too many barriers inhibiting entry into this marketplace. Imported oil
is the number one reason our national debt is so high. We do not have competition
among firms that produce the lowest possible prices because it’s virtually impossible
to compete. Is this strengthening our economy?

If firms are not violating the law when they “intentionally withhold or limit supply” then
we need to do two things. We need more regulation that makes it illegal to
intentionally withhold or limit supply; and we need laws that will allow aggressive
competitors into the petroleum industry. We do have a marketplace where
anticompetitive actions and business practices restrict competition, harm consumers,
and have forced tens of thousands of independent oil companies and gas dealers out
of business.

So how does the Federal Trade Commission explain the Midwest Gasoline Price
Spike?What do they mean by “no credible evidence of collusion?”All the states in the
Midwest are considered highly or moderately concentrated under the DOJ-Federal
Trade Commission guidelines using the HHI. Remember in a highly concentrated
market, it is not necessary for firms to explicitly collude to raise prices above
competitive levels. The moderately concentrated states are Illinois, Michigan,
Minnesota, Tennessee, Wisconsin and Oklahoma. The highly concentrated states
are Indiana, Kentucky, North Dakota and Ohio. Consider first, Michigan and Ohio:In
Michigan there are four firms providing more than 67% of the fuel for this state.
These firms are Marathon, BP, Mobil and Equilon (Shell).Three additional firms are
providing 20% of the fuel. In Ohio there are four firms Marathon, BP, Equilon (Shell)
and Sun providing 82%. Three of the four firms are the same in both states,
qualifying them as highly concentrated states and a tight oligopoly.

Each of these firms know what the others pay for crude, at what price refineries sell
the fuel, and what the street price is. When one company decides to go up, all the
other firms have to do is follow the leader. The few smaller firms that are left follow the
larger firms knowing that if they do not follow, the larger firms could start a price war
and bury them. Does this sound like competition to you?In a perfectly competitive
market where firms sell the same product or service, if one firm reduces his
production or service other firms step in to make up the difference, therefore
increasing their market share, revenue and profit. In markets where there are too few
competitors, as in the oil industry, firms can adversely affects the price by decreasing
supply or limiting production and still maintain their market share, revenue and profits.

Revisiting our example of the home building industry, remember the homebuilders?
Not only did the homebuilder build the home, but they also owned the timber
company, the mill and the lumber company as well. Let’s say that the homebuilder
had four competitors that shared 62% of the market, instead of twenty competitors
that had 62% of the market share. Don’t you think the consumer would get a better
price from one of the twenty firms’ verses a price from the one of the four firms?
The Federal Trade Commission makes several references to “oil industry practices.”
For example, the Federal Trade Commission sites the oil industries “just-in-time
inventory practice”, which is the practice of intentionally keeping inventory tight. The
Federal Trade Commission found that the industry as a whole made errors in supply
forecasts and underestimated the potential for supply shortages in the Midwest for
the Spring and early Summer of 2000.How can an entire industry make a mistake in
supply forecasting?The oil companies have records dating back years regarding how
much fuel they sell by the day, week, month and year. They know exactly what their
demand will be and how much they need to supply. This following graph by the
Energy Information Administration (EIA) shows the inventory gasoline stock in January
for a six-year period.

(Graph is available in book.)

* Midwest gasoline stocks (including blending components which are used to make
RFG) are very low. Total gasoline stocks at the end of May are about 13% lower than
the five year average for this time of year, and the lowest ever since 1981 when EIA
began collecting this data.
* With the addition of a new RFG region, St. Louis, into Midwest, one would expect
RFG and blending component stocks to increase in total. But they did not. They are
at about the same levels as we saw in 1998 and 1999 at this time of year. St. Louis
added about 18% demand to the RFG market in Midwest, but without a
corresponding increase in overall inventory levels.
* Source: EIA

(Graph is available in book.)

This graph shows January 2000 had the lowest total gasoline stock levels for the six-
year history. Oil companies knew in January they had a summer inventory problem
brewing. The EIA comments that total gasoline stock levels at the end of May 2000
were about 13% lower than the five-year average and the lowest since 1981. Even
with the addition of St. Louis to the Reformulated Gas Region (RFG), blending
component stocks with which to make the RFG did not increase. St. Louis added 18%
demand to the RFG market in the Midwest, but without any lateral increase in the
overall inventory levels. So the whole industry made a mistake in forecasting?These
oil companies knew exactly what they were doing!

The Federal Trade Commission also states that a significant part of the reduction in
the supply of RFG was caused by the investment decisions of three firms. These
three firms produced enough RFG to meet their branded needs, but produced 23%
less summer grade RFG to sell on the spot market as they had the previous year.
The “spot market” refers to a market where an agreement is reached to buy and sell
one shipment of oil at a negotiated price. Rising prices on the spot market indicate
that supply is tight. This decision effectively shut down independent and unbranded
retailers needing RFG to sell for the summer, thus eliminating this class of
competition. Is this not ANTICOMPETITIVE?...