Rising gas prices: collusion or competition?

The signs are all around us, literally — gasoline prices are on the rise again. The latest
Weekly Pump Price Survey from MJ Ervin & Associates, a Calgary-based industry consultant, shows that gas prices in Canada averaged $1.16 per litre last week, ranging from $1.28 in Kelowna, B.C., to $1.03 in Thunder Bay, Ont. Prices that were once considered off the charts are now commonplace, and
fuel-efficient cars are touted as much for their economic benefits as their environmental ones.

Still, we’re a fuel-hungry nation, consuming more than 36.6 billion litres of gasoline in 2006. Perhaps surprisingly, smashing the dollar-per-litre price barrier hasn’t slowed demand: SUVs are still guzzling and 75 percent of Canadians still drive to work. Meanwhile, Imperial Oil Ltd., Canada’s largest oil company, recently reported a 31 percent increase in profits.

So when does healthy competition stop and price gouging start? A
recent report released by the Canadian Centre for Policy Alternatives (CCPA) says Canadians have been paying too much for gas for almost two years. Since August 2005, prices have consistently exceeded levels that would be justified on the basis of costs and normal profits, suggests Hugh Mackenzie, author of the report.

He argues that the oil industry’s explanations for high pump prices — rising crude oil prices, refinery problems and geopolitical events — are merely “after the fact rationalizations for the price-gouging opportunities.”

The Canadian Petroleum Products Institute (CPPI), which represents the gas industry, categorically rejects
the report on the grounds that it was “simplistic” and “ignored market realities.” A
recent investigation by the federal Competition Bureau concluded that there’s no national conspiracy by retailers for price fixing after Hurricane Katrina.

And yet, the
Consumers’ Association of Canada recently dismissed industry explanations as “trite” excuses and called for a new government investigation of gasoline prices.

“Part of the difficulty, why there is a lot of suspicion over prices, is that it’s a very complicated market to explain,” says Michael J. Ervin, of MJ Ervin & Associates.

Making sense of the oil and gas market
Most consumers understand that the price of crude oil fluctuates on the world market due to increasing demand from Asia or events that compromise or reduce supply, such as the U.S. invasion of Iraq in 2003 or Hurricane Katrina in 2005, but it’s not always in tandem with changing pump prices: Crude oil prices are actually 5 cents per litre lower this year than they were in 2006. To complicate matters further, wholesale gasoline prices (the price marketers pay to refiners for the finished or refined product) are tied to U.S. prices because of NAFTA and the nature of the North American marketplace.

“If an oil company in Canada was to arbitrarily reduce the wholesale price of gasoline to be nice or in response to political pressure, the simple consequence is that all the cheap gasoline would flow into the States,” says Ervin. Pump prices would be at 85 cents, but there’d be no gas to pump.

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What’s more, regional prices are affected by variables such as taxes (for example, provincial taxes vary from 6.2 cents per litre in the Yukon to 20.4 cents per litre in P.E.I.), inventory levels (the eastern provinces can import wholesale gasoline from Europe when supplies get low) and volume of sales (smaller markets often require a higher markup to maintain a viable level of revenue).

On a local level, gasoline price wars are fairly common and their intensity contributes to local pump price volatility: When one retailer lowers the price to boost sales and attract new customers, others must follow or lose volume until prices become so low that gasoline sells for less than cost. Prices then rebound, and customers are left questioning whether this is competition or collusion.

Where are gas prices going?
To look at the bigger picture, the price problem right now is threefold: Wholesale prices are high due to concerns over low U.S. inventory levels, larger-than-usual refinery maintenance has further reduced supply and the demand for gasoline is expected to grow with the arrival of summer. So where does that leave pump prices?

“I expect to see a modest decrease in pump prices going forward into the summertime,” says Ervin, “but fundamentally they will remain high because of the very tight, if not non-existent, gap between demand for gasoline and North American supply capacity.”

He explains that around the year 2000, the gap between supply and demand lessened until there ceased to be any practical spare production capacity. While there are 19 refineries operating across Canada, that’s 25 fewer than in 1970 and the newest Canadian refinery, in Alberta, started production in 1984. Older refineries require more maintenance and upgrades, which translates to more downtime and a pinched supply.

It is at the refineries, not the retail outlets, says the CCPA’s Mackenzie, where oil companies aren’t playing fair. It’s a classic oligopoly, he argues, where industry members have recognized that it’s in their collective interest to keep capacity down.

“The tightness of refinery capacity has given enormous market power to a small number of companies. They have huge pricing power,” he says. “The fundamental problem is that none of the major companies has any economic incentive to build a refinery.” He argues that if normal refinery margins are 10 to 12 cents per litre with a 2-cent profit, why would any company want to increase its capacity when margins are between 30 and 40 cents per litre?

Increasing capacity, counters Ervin, isn’t easy. The CPPI states that building a new refinery would cost about $2 billion and the refinery would have to meet rigorous environmental standards and public scrutiny. Because fixed costs are high and prices are set on regional and international markets, larger refineries that operate at a higher throughput (the amount of oil refined in a given period) and efficiency are more profitable than smaller refineries. These large refineries are already operating at near or full capacity, leaving prices very susceptible to price volatility.

One thing is clear — gas prices will remain a contentious topic, as much a political issue as a consumer one. Until more cars run on biodiesel or Canadians become less dependent on this liquid gold, demand will remain inelastic, supply tight and prices high. Perhaps the best suggestion is the simplest one: shop around, walk when you can and hope that an alternative to gasoline comes sooner rather than later.

To see whether driving farther to a cheaper gas station will save you money, check out Bankrate.ca’s
gas price calculator.

Fiona Wagner is a freelance writer in Georgetown, Ont.

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