Gasoline Dynamics
Another great post Chip. And long overdue as our Forum membership has many new faces I am sure.
For those new to our Forum and wish to read another of Chip's literary treatises, I suggest you search out his comments on gasoline. Another of his favorite topics and one which he also has depth of experience.
Bill,
I had almost forgot about that post. Here is a little history about that write up. I have a severe dystonia in my right hand that makes it difficult for me to type, so I bought some voice recognition software called "Dragon Naturally Speaking" and wrote that treatise on gasoline prices while learning to use it. I put it up on the Ford GT Forum and it caused a stir, getting cut and pasted on hundreds of web sites as it spread all over the country. A copy of it found it's way to Chevron Oil Companies top management and they distributed copies of it to their management employees nation wide. Many radio talk show hosts quoted parts of it including Rush Limbaugh who recited a section of it almost word for word on his show (he did not credit me). In any event, I studied Managerial Economics in graduate school and love the subject. My entire life has been spent in the automobile, aviation, and gasoline businesses. For those who have not read it, I've copied it below.
Chip
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“The real reasons for higher than necessary gasoline prices and regional shortages.”
By Chip Beck
This article is long, but if you take the time to read it, perhaps a few things will come to light.
I have read and I have on good authority that one out of four Americans today is functionally illiterate, this means that they cannot read and comprehend a daily newspaper. Worse than that, approximately 50% of all adult Americans are numerically illiterate, meaning they cannot add, subtract, multiply, and divide three digit numbers using a sheet of paper and a pencil. It has also become abundantly clear that at least 95% of adult Americans are economically illiterate. The current national furor over high gasoline prices, with accusations by politicians and citizens alike of conspiracies and gouging by oil companies in collusion with one another are evidence of this. As I have on this forum in the past, I feel compelled here to point out a few basic economic principles, along with a few facts for you to ponder. Fact number one, current oil company profits on a gallon of gas at three dollars per gallon are currently 9% or about $.27 per gallon. Of that $.27, approximately 40% is taken by the government in taxes before the remaining 60% is distributed to shareholders. Thus the after-tax profit distributed to the tens of millions of Americans who own oil company stocks is about $.16 per gallon. There are no greedy oil company owners colluding with one another to gouge American citizens, only shareholders like you and me, our pension funds, our IRAs, and our investment portfolios. The largest American oil company is Exxon Mobil; they are the fifth largest oil company in the world and control less than 5% of the world oil market. The top three US oil companies combined control less than 10% of the world oil market. This is hardly a market dominating monopoly.
Large markets are more efficient than small markets. Any governmental regulation that inhibits the free flow of products or its production will result in either higher prices, product shortages, or both. Essential products like gasoline without readily available substitutes are by definition, inelastic, meaning that large increases in price will have only a small effect upon consumption. Nonessential products with readily available substitutes like apple juice are by definition, elastic, meaning that even small increases in price will have a large effect upon consumption.
Most products including automobiles and gasoline are assembled from multiple components as well as requiring numerous processes to produce the finished product. Any shortage of an essential component or any bottleneck in the manufacturing process will limit total production to the number that may be produced by what ever item is in shortest supply. It matters not a whit how abundant the other components or manufacturing processes are, nor does it matter what the bottleneck is. All that matters is that a bottleneck exists. The six speed transmission in the 2007 Ford Shelby GT500 Mustang is an example of such a bottleneck. Despite enormous demand for the Shelby version, Mustang sales were down 19% that year, the cars were available in large numbers, and Ford Motor Co. would obviously have liked to sell them. But because only 10,000 of the six speed transmissions necessary to build a Shelby GT500 were available to Ford that year, total production (and Shelby sales) were limited to 10,000.
I have not seen in any publication, nor have I heard on any newscasts the actual reason for today's high gasoline prices. There is a reason why gasoline is about $.50 to $.75 per gallon more expensive today than it should be given today's price of oil. And though the reason is not obvious or even readily apparent to those outside the gas & oil business, neither is it particularly difficult to explain or to understand. So here you go.
Up until the 1970s in the United States gasoline was essentially a commodity. Produced in over 150 refineries nationwide gasoline was piped or trucked wherever it was needed. A production disruption or breakdown in any one refinery affected less than 1% of the national supply. The vacuum created by one plant's production stoppage was immediately filled by product flowing in from other areas drawn to the affected region by temporarily higher prices. Much like the scooping of a bucket of water out of the surface of a lake is immediately filled by water rushing in from the rest of the lake, the force of Adam Smith's "invisible hand" sent gasoline quickly and efficiently where ever it was needed. Prices were essentially equal, coast to coast. But in the late 1970s, government and its well meaning yet isolated and economically ignorant bureaucrats got involved. First was the State of California deciding that it needed its own special blend of gasoline. Next high altitude areas decided a special blend would be better for them too. State after state and county after county decided to dictate special fuel blends for their communities as well. Four years ago the number of refineries in the United States had shrunk to about 100 due to environmental regulations and government mandates. At the same time, the total number of regular unleaded gasoline blends had reached the absurd number of 165.
My home here in Scottsdale, Arizona is in the middle of Maricopa County. The Maricopa County Board of Supervisors in their infinite wisdom dictated a blend of regular unleaded gasoline that was not sold or used any other place in the world. This, despite the fact that the entire state of Arizona does not contain a single refinery. Therefore our own little special blend needed to be piped in from Texas or California where it was produced in a total of three refineries. No other blend of unleaded gasoline could legally be sold in Maricopa County. The results of this folly to anyone with even a rudimentary understanding of economics were predictably disastrous. A production disruption at any one of the three refineries producing our boutique blend immediately cut off one third of Maricopa County’s fuel supply. This was brought into sharp focus by the bursting of the Kinder-Morgan pipeline from Texas into Maricopa County two years ago bringing the Valley of the Sun to it's knees for two weeks. While I sat in my Chevron station out of fuel and out of business for four straight days, gasoline was plentiful just 25 miles away and in every other county of Arizona. But I was not allowed to pick up the phone and have a tanker deliver it to me as selling a non-Maricopa County blend fuel would result in fines exceeding $100,000, and most likely jail time as well. Our fuel supply is no longer a lake with Adam Smith's invisible hand sending gasoline quickly and efficiently where it is needed. Blend requirements have turned it into an ice cube tray with solid walls blocking the flow of fuel from the rest of the full tray into the cube that is presently dry. Our Democrat Governor Janet Napolitano, a hard-core liberal and an economic idiot, could have solved this problem with the stroke of a pen, exercising an executive order temporarily eliminating Maricopa Counties fuel blend requirement. Instead of taking this simple step to help all Arizonans, she dithered and did what all good liberals would do, she used this shortage and the hardship created by it to demonize gas station operators like me, my suppliers including Chevron, and to score political points for herself by taking cheap shots at the entire gas and oil industry.
The United States of America has taken a huge step backwards in both the production and distribution of gasoline because of these blend requirements. And it gets even worse as twice a year most municipalities switch from a summer blend to a winter blend and then back to their summer blend. As government regulatory agencies insist on testing these blends in the field at tank farms, each blend changeover results in a draw down of existing fuel stocks to critical levels. That done, it takes a while before the new blend can be shipped or piped in sufficient quantities to restock tank farms all across the country. Instead of just producing fuel 24 hours a day seven days a week, refineries must now constantly gauge individual markets and do their best to estimate how much fuel will be needed, and therefore produced for each little cube in the tray. A miscalculation by refiners or a change in demand of any market results in either a glut or shortage that cannot be shipped to or from another market because fuel produced for one market cannot legally be sold in another market. Instead of the lake we used to have with 150 streams of product flowing into it immediately assessable nationwide we now have this ice cube tray of small individual cubicles, each filled by just a couple refineries. Where a production disruption at an individual refinery used to be invisible to the American public because of its small effect on the total supply, now a production disruption at an individual refinery creates a crisis, eliminating 30% and sometimes as much as 50% of the fuel available for sale in that market. This has led to huge differences in the cost of gasoline from one market to another. And when a production difficulty arises such as a refinery fire is not uncommon for the price of gas in that affected market to spike up more than a dollar a gallon.
Let me add that every single time a refinery needs to change from one blend to another, that refinery needs to be shut down in order for the change to take effect. These constant shutdowns and start ups are eliminating as much as 20% of the capacity of each refinery and adding enormously to the cost of operating that facility. These blend requirements are adding $.50 to $.75 to the cost of each gallon of gasoline that we purchase. In addition to this, taxes at both the federal, state, and local levels totaled nearly $.60 per gallon. After-tax profits to shareholders of oil companies on the sale of a $3 gallon of gasoline will total about $.16. Even if oil companies eliminated 100% of their before tax profit that would only amount to $.27 per gallon. Oh, let me mention that the oil companies have to do 100% of the work to find, transport, refine, and deliver our fuel supply. Our government on the other hand, does none of the work, yet gouges American citizens to the tune of approximately $.60 cents per gallon in direct taxes, plus income tax of approximately $.11 per gallon on distributed oil company profits, plus between $.50 and $.75 per gallon in mandated regulatory costs. Clearly there is some gouging going on by local and state governments that rip our heads off to the tune of over one dollar per gallon! These same economic nitwits tell us that the .16 cent after-tax profit on the Exxon Mobil stock in your IRA is unconscionable!! All of this is possible of course because we run our public school system not for the benefit of our children, but instead for the benefit of the NEA teachers union and their cash campaign contributions to the Democratic Party. The laws of economics are as certain as the law of gravity. Yet economics is not being taught in public schools today. This economic illiteracy combined with the misinformation spewed at us daily by our left wing agenda driven mainstream press has public anger directed at the wrong culprit.
We have taken the world's largest and most efficient market for gasoline and turned it into over 100 little tiny inefficient markets. We have taken the world's best gasoline distribution system and made it irrelevant by making it illegal to ship fuel from its intended market into another market where it is needed. And worst of all, we have not built a new fuel refinery in the United States in over 30 years. Many oil companies have tried yet it is virtually impossible to obtain all of the permits necessary to build one as environmental groups sue time and time again to stop construction and left wing Liberal Democrat appointed judges grant these environmental wackos endless impact studies that stop construction. We have permanently closed down about one third of the refineries that existed 30 years ago however because governmental regulatory requirements have made it impossible to keep them operating profitably. Our current refineries are operating at very close to their maximum capacity. But this is not sufficient as we now need to import 14% of our refined gasoline. The United States of America, the greatest economic power on earth, is incapable of refining its own gasoline supply because we have willingly crippled ourselves with suicidal environmental restrictions. Shipping crude oil is relatively safe as it is fairly inert and not very combustible. Shipping refined gasoline is tricky and dangerous as it gives off explosive fumes and is extremely flammable. We are playing national Russian roulette with our own energy security. We have very little room for error and with our expanding population and economy we are nearing a crisis point. As 20% of our refining capacity has been eliminated through shutdowns and start ups required by continual blend changes, refinery capacity is the bottleneck. Until the United States deals with this issue, and it is not going to deal with it, our gasoline supply will remain restricted and prices will remain high regardless of the price of oil.
These are the real reasons for our fuel prices being higher today than they should be given the price of oil. What baffles me is that President Bush was willing to take the political hit for those high fuel prices yet did not even make an attempt to explain it to the American people. I know President Bush understood that problem because after hurricane Katrina he immediately issued an executive order suspending all fuel blend requirements nationwide. He knew that without taking this decisive action there is no way that America's remaining undamaged fuel refineries could keep up with demand.
Ahhh, I'm sure there's a big environmental payoff for all of the economic pain that these blend requirements have imposed upon us right?? The air is certainly much cleaner than it would be if we all used the same blend, right?? We now have the answer to that question. For about two months after Katrina all gasoline sold in the United States was essentially the same blend. There was no detectable difference in air quality during this time. No detectable benefit for the incredible expense incurred in brewing up 165 different blends of gasoline!!! Yet as soon as refineries came back online these ridiculous blend requirements were put back in place.
And that is where we stand today. This post has been quite lengthy, both for you to read and for me to write. I hope the payoff for those of you patient enough to slog your way through it has been a better understanding of the economics involved, fuel production and its current price, and the real problem and its solution. Cheers.
Chip Beck
