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Tuesday, June 06, 2006

Refining Monopoly Power

As the demand for gasoline has grown, why hasn't refining capacity expanded at a faster rate, and how can the rate be increased in the future?:

Pumped Up, by James Surowiecki, The New Yorker: At first glance, there’s nothing unusual about the refinery that Marathon Oil owns in Garyville, Louisiana. ... Indeed, the only thing that’s special about the Garyville facility is that it was opened in 1976. That makes it the last refinery ever built in the United States.

Until recently, this didn’t seem like a problem. Gasoline was cheap, and no one was clamoring to live next to a highly combustible chemical plant. So, over the past twenty-five years, the number of refineries in the U.S. has been cut in half, and although the remaining ones have expanded, they haven’t kept up with the growing demand for gasoline. But now, with voters furious about three-dollar-a-gallon gas, Washington has decided that this trend must change. Samuel Bodman, the Energy Secretary, has exhorted oil companies to use some of their hefty profits to expand refining capacity, and Congress is considering streamlining the environmental regulations that add to the expense of building new refineries...

There are so few refineries in the U.S. now that they are run tight to the bone, typically using about ninety per cent of their total capacity. The result is that refining—which, until recently, was a tough, low-margin business—has become tremendously lucrative. Last year, refiners’ profits jumped thirty-nine per cent, to twenty-four billion dollars, and this year should be even better...

In a normal marketplace, of course, high prices and profits would drive companies to expand, in an attempt to capture more of the market, or else new players would emerge, hoping to outmaneuver a risk-averse establishment. But the refining industry isn’t a normal marketplace. For one thing, refineries are huge investments—a new one costs at least two billion dollars—and they take a long time to open. This means that although refiners might make more money by opening new facilities and thus serving more customers, they’d rather take the sure money than gamble. It also means it’s hard for new competitors to raise enough capital to enter the market at all.

What’s more, over the past fifteen years refiners have been buying each other up, creating an industry that’s highly consolidated. In 1993, the five biggest refiners in the U.S. controlled thirty-five per cent of the market. By 2004, they controlled fifty-six per cent. And refining is primarily a regional business. The government allows different states to use different formulations of gasoline—some formulations burn cleaner than others—and in some urban areas a federal requirement determines what formula can be used, depending on the quality of their air. That makes it hard to ship gas across state lines, and shrinks the number of refiners that provide a particular blend of gas, giving each refiner more power. As a result, in many areas the refinery business is more like an oligopoly than like a competitive market. In 2002, a Senate report identified “tight oligopolies” operating in twenty-eight states; in California in 2003, ninety-five per cent of the refining market was in the hands of just seven companies. ...

Some have suggested that the lack of new refineries points to collusion on the part of refiners—an agreement to reduce capacity... But in refining today there’s no need for a cartel; the investment decisions that the companies make have such a direct impact on prices that it’s rational for each of them individually to limit capacity.

And if Washington wants a scapegoat it might take a look at itself. By not vetting mergers more carefully, government regulators allowed many refiners to achieve “market power”..., and other regulators enhanced that power by mandating gasoline standards without considering competition...

In general, monopoly power is associated with prices that are too high and a level of production that is too low relative to the competitive or socially optimal outcome. In competitive markets, when price is above the cost of production, the resulting profit attracts new capacity to the industry, but when monopoly power exists this mechanism breaks down.

Policymakers should take steps to make these "tight oligopolies" more competitive as a means of encouraging additional investment and lower prices before considering tax cuts, the easing of environmental restrictions, and other government incentives that increase profit with no guarantee of subsequent increases in refining capacity.

In addition, reductions in the demand for gasoline through conservation and other programs can also reduce the need for additional capacity and this is an area that has not received enough attention from policymakers (see Feldstein's proposal for tradeable gas credits for one idea).

Sorry for the outburst of supposedly conservative values, advocating competitive markets and all that, but somebody has to do it and besides, as I've argued before conservatives do not have a monopoly on this idea. Democrats are also strong advocates of well-functioning markets.

    Posted by on Tuesday, June 6, 2006 at 01:17 AM in Environment, Oil, Policy | Permalink  TrackBack (0)  Comments (39)

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