The New York Times

July 1, 2004

Parsing California Gas Prices


GASOLINE prices have finally started to fall, with the United States average declining by over 13 percent in the last month.

But California has not been as fortunate as the rest of the country. Prices there are down only 8 cents, and remain the highest in the continental United States.

Why did gas prices go up so sharply in the spring? Why did they subsequently decline? And why do California gasoline prices stay so stubbornly high?

May's surge has been widely attributed to a fear of oil supply disruptions in the Middle East. Skeptics have argued that the possibility of future disruptions should not affect current prices. After all, they argue, the oil used to manufacture the gasoline now being sold at the pump has already been bought and paid for.

But this economic analysis is flawed. Gasoline is easy to store, so if the price is expected to increase, refiners and shippers will keep more in storage, in anticipation of those higher prices. The resulting reduction in current supply will push prices up now, before any actual shortages materialize.

That's the way the market should work. If you believed that gasoline would become scarcer in a few weeks, wouldn't you want to economize on use now to ensure a larger supply in the future?

Luckily, the feared disruptions have not occurred (yet), and prices began to fall at the end of May. In addition to the reduction in worries about oil supply disruptions and the increased oil production from OPEC, increased gasoline imports, particularly from Venezuela, helped drive down prices. According to the Automobile Club of Southern California, "International refiners are like the cavalry, riding to the rescue of overcharged motorists."

Maybe so, but Californians are still getting trampled. Prices in California are 30 cents higher than the national average and much more volatile.

The economics of the California gasoline market are described in a recent study by Severin Borenstein, James Bushnell and Matthew Lewis of the University of California Energy Institute ( /csemwp132.pdf).

The basic problem comes down to supply and demand. California uses a special low-polluting blend of gasoline known as CaRFG (California reformulated gasoline), which is produced by only 13 in-state refineries. In 2003 these refineries produced about 15 billion gallons, a figure almost identical to the 14.8 billion gallons consumed in the state.

California's production capacity is so closely matched to its demand that even sharp increases in price result in little additional production of gasoline.

On the other side of the market, the demand for gasoline is also quite insensitive to price: a 10 percent increase in price typically reduces short-term demand by only 2 to 3 percent.

The result is that even small fluctuations in the demand or supply of CaRFG can lead to large price swings.

The market forces of supply and demand offer a reasonably convincing explanation as to why the California gasoline market is so volatile. But this may not be the entire story.

The market is controlled by seven large suppliers, ranging from ChevronTexaco, with a 27 percent share, down to Exxon Mobil, which supplies 8 percent of the market. With only seven suppliers, price manipulation may also be at work.

When demand is insensitive to price and capacity is more or less fixed, sellers have mixed incentives. When prices rise, a refiner can make an immediate profit by selling more gasoline; if all suppliers sell more, the price is pushed back down. But if a few large companies withhold gasoline supplies, they can keep the price propped up for an extended period.

The authors of the report are quick to point out that they have no evidence that this has occurred. Indeed, they argue that the basic economics of the industry make it difficult to find such evidence in price and quantity movements alone.

However, they also point out that the temptation to manipulate price is certainly present, and a prudent response from Sacramento would be to enact policies that will reduce that temptation as much as possible.

It is important to recognize that it is not illegal under American antitrust laws for a supplier to withhold gasoline or any other commodity. Individual energy companies are free to produce or not produce, store or not store, as they see fit. That is the nature of a free market.

It is illegal for companies to collude to create an artificial scarcity, but collusion is extremely hard to prove.

The California economists examine various policy responses that might help reduce price volatility and mitigate the incentives to exercise market power: maintaining a strategic fuel reserve, regulating seasonal changes in gasoline mix, regulating refinery closures and using state gasoline purchases more strategically.

All these proposals have serious problems. Heavy-handed regulation can easily make supply problems worse rather than better. The goal of policy should be not to displace markets, but to make them work better.

There is one market-based measure that shows considerable promise. This is to allow the importation of non-CaRFG gasoline into the state when CaRFG is in short supply, as long as the importer pays a tax equal to the difference in cost between CaRFG and non-CaRFG (about 15 cents a gallon).

When prices in California rise, sellers would then want to import gasoline from out of state, dampening the price increase. Air pollution might go up slightly for a few weeks, but the revenue from the gas tax could be used to finance other environmental measures, like buying back old, polluting cars.

Not only would this measure help dampen price fluctuations, it would also greatly reduce the temptation to manipulate prices - since any attempt to push up the price would be met with a flood of imported gasoline. Regardless of whether you believe price spikes result from market forces or market manipulation, increasing gasoline supply when prices rise has got to be a good thing for Californians.

Hal R. Varian is a professor of business, economics and information management at the University of California, Berkeley.

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