I greatly appreciate the opportunity to appear before you today to discuss the problem of rising gasoline prices and gasoline price spikes, and the impact that environmental regulations may have on these increases. Over the past two years, our organizations have looked in detail at the oil industry and the broad range of factors that have affected rising oil and gasoline prices. We submit two major studies conducted by the Consumer Federation of America on this topic for the record.

Three years ago, the analysis we provided in one of these reports, Ending the Gasoline Price Spiral, showed that the explanation given by the oil industry and the Administration for the high and volatile price of gasoline is oversimplified and incomplete. This explanation points to policies that do not address important underlying causes of the problem and, therefore, will not provide a solution.

· Blaming high gasoline prices on high crude oil prices ignores the fact that over the past few years, the domestic refining and marketing sector has imposed larger increases on consumers at the pump than crude price increases would warrant.

· Blaming tight refinery markets on Clean Air Act requirements to reformulate gasoline ignores the fact that in the mid-1990s the industry adopted a business strategy of mergers and acquisitions to increase profits that was intended to tighten refinery markets and reduce competition at the pump.

· Claiming that the antitrust laws have not been violated in recent price spikes ignores the fact that forces of supply and demand are weak in energy markets and that local gasoline markets have become sufficiently concentrated to allow unilateral actions by oil companies to push prices up faster and keep them higher longer than they would be in vigorously competitive markets.

· Eliminating the small gasoline markets that result from efforts to tailor gasoline to the micro-environments of individual cities will not increase refinery capacity or improve stockpile policy to ensure lower and less volatile prices, if the same handful of companies dominate the regional markets.

Thus, the causes of record energy prices involve a complex mix of domestic and international factors. The solution must recognize both sets of factors, but the domestic factors must play an especially large part in the solution, not only because they are directly within the control of public policy, but also because careful consideration of what can and cannot be done leads to a very different set of policy recommendations than the Administration and the industry have been pushing, or the Congress is considering in the pending energy legislation.

Because domestic resources represent a very small share of the global resources base and are relatively expensive to develop, it is folly to exclusively pursue a supply-side solution to the energy problem. The increase in the amount of oil and gas produced in America will not be sufficient to put downward pressure on world prices; it will only increase oil company profits, especially if large subsidies are provided, as contemplated in pending energy legislation. Moreover, even if the U.S. could affect the market price of basic energy resources, which is very unlikely, that would not solve the larger structural problem in domestic markets.

THE UNDERLYING STRUCTURAL PROBLEM IN DOMESTIC PETROLEUM MARKETS

Our analysis shows that energy markets have become tight in America because supply has become concentrated and demand growth has put pressure on energy markets. This gave a handful of large companies pricing power and rendered the energy markets vulnerable to price shocks. While the operation of the domestic energy market is complex and many factors contribute to pricing problems, one central characteristic of the industry stands out – it has become so concentrated in several parts of the country that competitive market forces are weak. Long-term strategic decisions by the industry about production capacity interact with short-term (mis)management of stocks to create a tight supply situation that provides ample opportunities to push prices up quickly. Because there are few firms in the market and because consumers cannot easily cut back on energy consumption, prices hold above competitive levels for significant periods of time.

The problem is not a conspiracy, but the rational action of large companies with market power. With weak competitive market forces, individual companies have flexibility for strategic actions that raise prices and profits. Individual companies can let supplies become tight in their area and keep stocks low, since there are few competitors who might counter this strategy. Companies can simply push prices up when demand increases because they have no fear that competitors will not raise prices to steal customers. Individual companies do not feel compelled to quickly increase supplies with imports, because their control of refining and distribution ensures that competitors will not be able to deliver supplies to the market in their area. Because there are so few suppliers and capacity is so tight, it is easy to keep track of potential threats to this profit maximizing strategy. Every accident or blip in the market triggers a price shock and profits mount. Moreover, operating the complex system at very high levels of capacity places strains on the physical infrastructure and renders it susceptible to accidents.

It has become evident that stocks of product are the key variables that determine price shocks. In other words, stocks are not only the key variable; they are also a strategic variable. The industry does a miserable job of managing stocks and supplying product from the consumer point of view. Policymakers have done nothing to force them to do a better job. If the industry were vigorously competitive, each firm would have to worry a great deal more about being caught with short supplies or inadequate capacity and they would hesitate to raise prices for fear of losing sales to competitors. Oil companies do not behave this way because they have power over price and can control supply. Mergers and acquisitions have created a concentrated industry in several sections of the country and segments of the industry. The amount of capacity and stocks and product on hand are no longer dictated by market forces, they can be manipulated by the oil industry oligopoly to maximize profits. Much of this increase in industry profits, of course, has been caused by an intentional withholding of gasoline supplies by the oil industry. In a March 2001 report, the Federal Trade Commission (FTC) noted that by withholding supply, industry was able to drive prices up, and thereby maximize profits. The FTC identified the complex factors in the spike and issued a warning.

The spike appears to have been caused by a mixture of structural and operating decisions made previously (high capacity utilization, low inventory levels, the choice of ethanol as an oxygenate), unexpected occurrences (pipeline breaks, production difficulties), errors by refiners in forecasting industry supply (misestimating supply, slow reactions), and decisions by firms to maximize their profits (curtailing production, keeping available supply off the market). The damage was ultimately limited by the ability of the industry to respond to the price spike within three or four weeks with increased supply of products. However, if the problem was short-term, so too was the resolution, and similar price spikes are capable of replication. Unless gasoline demand abates or refining capacity grows, price spikes are likely to occur in the future in the Midwest and other areas of the country.

A 2003 Rand study of the refinery sector reaffirmed the importance of the decisions to restrict supply. It pointed out a change in attitude in the industry, wherein “[i]ncreasing capacity and output to gain market share or to offset the cost of regulatory upgrades is now frowned upon.” In its place we find a “more discriminating approach to investment and supplying the market that emphasized maximizing margins and returns on investment rather than product output or market share.” The central tactic is to allow markets to become tight. Relying on… existing plants and equipment to the greatest possible extent, even if that ultimately meant curtailing output of certain refined product… openly questioned the once-universal imperative of a refinery not “going short” – that is not having enough product to meet market demand. Rather than investing in and operating refineries to ensure that markets are fully supplied all the time, refiners suggested that they were focusing first on ensuring that their branded retailers are adequately supply by curtaining sales to wholesale market if needed. The Rand study drew a direct link between long-term structural changes and the behavioral changes in the industry, drawing the connection between the business strategies to increase profitability and the pricing volatility. It issued the same warning that the FTC had offered two years earlier.

For operating companies, the elimination of excess capacity represents a significant business accomplishment: low profits in the 1980s and 1990s were blamed in part on overcapacity in the sector. Since the mid-1990s, economic performance industry-wide has recovered and reached record levels in 2001. On the other hand, for consumers, the elimination of spare capacity generates upward pressure on prices at the pump and produces short-term market vulnerabilities. Disruptions in refinery operations resulting from scheduled maintenance and overhauls or unscheduled breakdowns are more likely to lead to acute (i.e., measured in weeks) supply shortfalls and price spikes. The spikes in the refiner and marketer take at the pump in 2002, 2003, and early 2004, were larger than the 2000 spike that was studied by the FTC. The weeks of elevated prices now stretch into months. The market does not correct itself. The roller coaster has become a ratchet. The combination of structural changes and business strategies has ended up costing consumers billions of dollars. Until the Federal government is willing to step in to stop oil companies from employing this anti-consumer strategy, there is no reason to believe that they will abandon this practice on their own.

A COMPREHENSIVE DOMESTIC SOLUTION

As we demonstrated in a report last year, Spring Break In the U.S. Oil Industry: Price Spikes, Excess Profits and Excuses, the structural conditions in the domestic gasoline industry have only gotten worse as demand continues to grow and mergers have been consummated. The increases in prices and industry profits should come as no surprise.

We all would like immediate, short-term relief from the current high prices, but what we need is an end to the roller coaster and the ratchet of energy prices. That demands a balanced, long-term solution. Breaking OPEC’s pricing power would relieve a great deal of pressure from consumers’ energy bills, but the short-term prospects are not promising in that regard either. There, too, we need a long-term strategy that works on market fundamentals.

Three years ago, we outlined a comprehensive policy to implement permanent institutional changes that would reduce the chances that markets will be tight and reduce the exposure of consumers to the opportunistic exploitation of markets when they become tight. Those policies made sense then; they make even more sense today. The Federal government has done little to move policy in that direction since it declared an energy crisis in early 2001.

To achieve this reduction of risk, public policy should be focused on achieving four primary goals:

· Restore reserve margins by increasing both fuel efficiency (demand-side) and production capacity (supply-side).
· Increase market flexibility through stock and storage policy.
· Discourage private actions that make markets tight and/or exploit market disruptions by countering the tendency to profiteer by withholding of supply.
· Promote a more competitive industry. Expand Reserve Margins by Striking a Balance Between Demand Reduction and Supply Increases Improving vehicle efficiency (reduction in fleet average miles per gallon) equal to economy wide productivity over the past decade (when the fleet failed to progress) would have a major impact on demand. It would require the fleet average to improve at the same rate it did in the 1980s. It would raise average fuel efficiency by five miles per gallon, or 20 percent over a decade. This is a mid-term target. This rate of improvement should be sustainable for several decades. This would reduce demand by 1.5 million barrels per day and return consumption to the level of the mid-1980s.

Expanding refinery capacity by ten percent equals approximately 1.5 million barrels per day. This would require 15 new refineries, if the average size equals the refineries currently in use. This is less than one-third the number shut down in the past ten years and less than one-quarter of the number shut down in the past fifteen years. Alternatively, a ten percent increase in the size of existing refineries, which is the rate at which they increased over the 1990s, would do the trick, as long as no additional refineries were shut down.

Placed in the context of redevelopment of recently abandoned facilities or expansion of existing facilities, the task of adding refinery capacity does not appear daunting. Such an expansion of capacity has not been in the interest of the businesses making the capacity decisions. Therefore, public policies to identify sites, study why so many facilities have been shut down, and establish programs to expand capacity should be pursued.

Expanding Storage and Stocks
It has become more and more evident that private decisions on the holding of crude and product in storage will maximize short-term private profits to the detriment of the public. Increasing concentration and inadequate competition allows stocks to be drawn down to levels that send markets into price spirals.

The Strategic Petroleum Reserve is a crude oil stockpile that has been developed as a strategic developed for dire emergencies that would result in severe shortfalls of crude. It could be viewed and used differently, but it has never been used as an economic reserve to respond to price increases. Given its history, draw-down of the SPR is at best a short-term response. Private oil companies generally take care of storage of crude oil and product to meet the ebb and flow of demand. The experience of the past four years indicates that the marketplace is not attending to economic stockpiles. Companies do not willingly hold excess capacity for the express purpose of preventing price increases. They will only do so if they fear that a lack of supply or an increase in brand price would cause them to lose business to competitors who have available stocks. Regional gasoline markets appear to lack sufficient competition to discipline anti-consumer private storage policies.

Public policy must expand economic stocks of crude and product. Gasoline distributors (wholesale and/retail) can be required to hold stocks as a percentage of retail sales. Public policy could also either directly support or give incentives for private parties to have sufficient storage of product. It could lower the cost of storage through tax incentives when drawing down stocks during seasonal peaks. Finally, public policy could directly underwrite stockpiles. We now have a small Northeast heating oil reserve. It should be continued and sized to discipline price shocks, not just prevent shortages. Similarly, a Midwest gasoline stockpile should be considered.

Reducing Incentives for Market Manipulation In the short term, government must turn the spotlight on business decisions that make markets tight or exploit them. Withholding of supply should draw immediate and intense public scrutiny, backed up with investigations. Since the federal government is likely to be subject to political pressures not to take action, state government should be authorized and supported in market monitoring efforts. A joint task force of federal and state attorneys general could be established on a continuing basis. The task force should develop databases and information to analyze the structure, conduct and performance of gasoline and natural gas markets.

As long as huge windfall profits can be made, private sector market participants will have a strong incentive to keep markets tight. The pattern of repeated price spikes and volatility has now become an enduring problem. Because the elasticity of demand is so low – because gasoline and natural gas are so important to economic and social life – this type of profiteering should be discouraged. A windfall profits tax that kicks in under specific circumstances would take the fun and profit out of market manipulation. Ultimately, market manipulation, including the deliberate withholding of supply, should be made illegal. This is particularly important for commodity and derivative markets.

Promoting a Workably Competitive Market Further concentration of these industries is quite problematic. The Department of Justice Merger Guidelines should be rigorously enforced. Moreover, the efficiency defense of consolidation should be viewed skeptically, since inadequate capacity is a problem in these markets. The low elasticity of supply and demand should be considered in antitrust analysis.

Restrictive marketing practices, such as zonal pricing and franchise restrictions on supply acquisition, should be examined and discouraged. These practices restrict flows of product into markets at key moments.

Consideration of expanding markets with more uniform reformulation requirements should not involve a relaxation of clean air requirements. Any expansion of markets should ensure that total refinery capacity is not reduced.

Every time energy prices spike, policymakers scramble for quick fixes. Distracted by short-term approaches and focused on placing blame on foreign energy producers and environmental laws, policymakers have failed to address the fundamental causes of the problem. In the four years since the energy markets in the United States began to spin out of control we have done nothing to increase competition, ensure expansion of capacity, require economically and socially responsible management of crude and product stocks, or slow the growth of demand by promoting energy efficiency. We have wasted four years and consumers are paying the price with record highs at the pump.