Is Gas Rationing Superior to Raising Prices for Consumers?

With New Jersey about to end the odd-even gasoline rationing  imposed in the aftermath of Hurricane Sandy, we have an opportunity to consider whether this kind of response actually produces better outcomes than the price increases by which the market would normally balance supply and demand.  Most of the defenses of "price gouging" that I've seen, including Matthew Yglesias's recent posting in Slate, tend to focus mainly on its supply-side aspects. Yet such arguments, however well-reasoned, are unlikely to sway Americans from their innate sense of fairness, on which most anti-gouging regulations are premised.  That's inherent in the judgmental term itself.  However, having spent my share of time in gas lines during the energy crises of the 1970s, I believe that supporters of these rules are ignoring some even more pragmatic, consumer-based arguments for allowing prices to rise after a disaster.

In addition to the tragic loss of life and property inflicted by Sandy, the storm left the petroleum products infrastructure on which New Jersey depends paralyzed for days.  Refineries were shut down, distribution terminals full of gasoline were unable to deliver product, and gas stations without power had no way to sell the fuel stored in the tanks under their forecourts.  This combination represented a huge supply shock to the region, and it wasn't long before gas lines formed at those stations that had both product and electricity.  New Jersey has strict and specific anti-gouging rules and is already charging merchants with violations following Sandy.  Within a few days, in an effort to alleviate the queuing that resulted from the supply shortfall and the inability of retailers to raise prices, Governor Christie resorted to rationing by license plate number.

Although restricting prices might superficially appear more equitable--particularly for lower-income consumers--than allowing them to climb to the levels necessary to clear the market without long lines, it also imposes significant costs on all consumers.  For starters, anti-gouging rules effectively confine motorists to their vehicles precisely when they have many other urgent priorities, including attending to their families and homes. They also implicitly put a very low monetary value on consumers' time.  Waiting on line for four hours to obtain 10 gallons of gas at a pre-disaster price of $3.50/gal., instead of experiencing a much shorter wait to purchase fuel for $5.00/gal., is equivalent to being paid $3.75 per hour--around half the state's official minimum wage.  This situation also increases the chances that an individual will wait for hours only to see the station run out of fuel before his or her turn comes, because demand is unchanged or temporarily higher than before the crisis.  Adding odd/even rationing might reduce gas lines by limiting demand and breaking the psychology contributing to the lines, but it also compounds the harm to consumers, some of whom are left with no legal means of acquiring fuel when they need it most.

I don't expect politicians and regulators suddenly to embrace a purely market-based approach towards post-disaster pricing of necessities like fuel.  However, we ought to expect them to look at the real-world results of their policies and apply some common sense and creativity to improve how they function.  Anti-gouging rules clearly benefit some at the expense of others. How could we simultaneously preserve the benefits for the first group, while allowing those willing to pay a premium for emergency supplies to do so, in the process sending the appropriate price signal to reduce overall demand? One solution might be to allow gas stations with multiple pump islands to raise prices as long as they have at least one set of pumps offering the pre-disaster price.   Technology should provide even more innovative and effective options.

Given the magnitude of the supply disruption post-Sandy, there was no way to avoid a serious shortage of motor fuel in the affected region.  However, the appearance of long gas lines and the resort to a 1970's expedient of odd-even rationing shouldn't satisfy anyone concerning the effectiveness of the pre-existing emergency energy policies that were called into play following the storm.  I can't imagine New Jerseyans being content with the outcome they experienced.   

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The Oil Earnings Backlash

Another oil industry earnings season bolstered by high oil prices has sparked the customary controversies about price gouging and industry subsidies. Last Thursday I participated in ExxonMobil's press call following the release of that company's first quarter earnings. In addition to the responses to my questions about access to non-US energy resources and the progress of the company's algae venture with Synthetic Genomics, I was intrigued by the answer of Ken Cohen, VP of Public and Government Affairs, to a question concerning Exxon's crude oil sales to other refiners. It resonated with my own experience in commodities trading at Texaco in the 1980s and '90s. Not only do major companies like Exxon, Chevron, Shell and BP control only a small fraction of the world's petroleum reserves and production, but they are often large net buyers of crude oil for their refining operations. Understanding the relationship between industry profits, gas prices and the federal tax deductions and credits designed to promote domestic energy production requires a deeper look into the results.

It's discouraging how much confusion still exists in the media concerning oil prices and gasoline prices, as noted in an excellent posting on the topic by Robert Rapier. Members of the public who are convinced that oil companies are manipulating prices to gouge them can always find some poorly reported news story or garbled explanation to justify their belief. Yet while it's certainly true that oil companies benefit from the higher oil prices that result when global demand for petroleum products is strong and supply is constrained and/or subject to unusual risks--both factors are at work today--their interests are not quite as divorced from those of gasoline consumers as they appear, because they are, to a very large extent, also consumers themselves.

A quick look at ExxonMobil's 1Q11 earnings release shows their net global production of crude oil and natural gas liquids at 2.4 million barrels per day (MBD). Meanwhile the company's refineries processed nearly 5.2 MBD in support of global refined product sales of nearly 6.3 MBD. In other words, Exxon had to buy more crude oil from other suppliers than it produced itself in order to feed its refineries, and then still had to acquire more than a million barrels per day of additional refined products from other refiners to meet its marketing demand. Meanwhile, 81% of its nearly $10.7 billion of first quarter earnings was attributable to oil and gas production, and 85% of that was from production outside the US. By comparison, just 6% of that $10.7 billion came from the domestic refining and marketing activities affected by US gasoline prices.

That's a fairly typical pattern for the majors, which have generally been short of crude oil for their refining systems since the big wave of nationalizations and expropriations in the 1970s. My old company, Texaco, refined about twice as much oil as it produced and sold roughly half-again more products than it refined. That meant that my trading colleagues and I were in the market every day, buying crude oil and refined products from our competitors, in order to keep our refineries and marketing outlets supplied. When supplies were tight, the only way to secure what we needed was to bid more than the next company, and that reinforced the dynamic of rising prices until supplies expanded or demand slackened. I see that as of the first quarter, Texaco's successor Chevron Corp. (of which I am a shareholder) produced about as much oil globally as it refined, though not in the US, where it processed 80% more crude than it produced domestically. Global product sales exceeded refinery throughput by more than a million barrels per day. Royal Dutch Shell's results exhibit an even more pronounced case of net purchases of both crude oil and refined products.

So while higher oil prices are good for some parts of these companies' businesses--the exploration and production divisions that contribute the majority of profitability in most years--other business segments find higher prices a mixed blessing, at best. That's particularly true for the parts of these companies with which US consumers have the most contact.

As for the questions I posed to Mr. Cohen, I was somewhat surprised to hear that ExxonMobil isn't looking for the US government to provide it with any assistance in gaining access to resources around the world. Foreign governments routinely help their national and quasi-national oil companies to negotiate for access. ExxonMobil seems able to compete in this arena without help from the US government but is much more concerned about the latter's restrictions on access here at home, and its efforts to tax non-US income that has already been taxed by host governments overseas. And with regard to ExxonMobil's activities in algae, I was informed that R&D is progressing well in both California and in Baytown, TX, where a large pond has just been completed. Mr. Cohen stressed that it was still early days for algae.

The purpose of drawing my readers' attention to the distinction concerning oil companies' large net oil and product purchases isn't to solicit sympathy for an industry that's obviously having a very profitable run, but to remind you that the oil and gasoline price situation is a lot more complicated than suggested by the sound bites we often hear. The biggest companies make most of their profits producing oil and gas outside the US, while refining and marketing here remains a capital-intensive and relatively low-return sideline that many of them have been quietly exiting for years. Ending the industry's tax breaks outside of the comprehensive tax system reform I believe to be necessary probably wouldn't harm the big oil companies as much as it would accelerate their shift away from operations in the US that contribute less to company profits than they do to US energy security.

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Gas Lines and Bank Runs

What do the recent runs on banks such as IndyMac and Washington Mutual have in common with the gas lines that have appeared in the Southeast in the aftermath of hurricanes Gustav and Ike? The correct answer, in my view, is that both reflect consumer behavior that might be rational at the individual level, but is highly counterproductive in the aggregate. Moreover, rather than demonstrating the failure of unregulated markets to protect consumers, the gas shortage in Georgia and the Carolinas has been compounded by consumer-protection, or "price gouging" laws that prevent the market from reducing demand and encourage hoarding when supply is constrained.

Bank runs and gas lines both begin with a perception that there isn't enough of the desired commodity to go around: cash in the former case, fuel in the latter. In the Southeast, that perception is grounded in the reality that two weeks after Hurricane Ike made landfall in Texas, a number of Gulf Coast refineries were still operating at reduced rates. For the week ending September 19th, the average utilization rate for refineries in the region was approximately half that for the same period last year. Most of the petroleum product supply for Georgia and the Carolinas originates at Gulf Coast refineries and is transported along the Colonial and Plantation pipelines, which only this week resumed shipping at pre-hurricane flow rates. Since the transit time from Houston to Atlanta is around eight days, it could take another week for supplies to return to normal--and longer still for normal inventories to be re-established.

In the meantime, with a significant shortfall in deliveries along these pipelines, and US gasoline inventories that were already extremely low going into the storms, local prices should have risen dramatically, in order to balance supply and demand. Yet although an internet search revealed many stations in the Atlanta, GA and Charlotte, NC metro areas pricing above $4.00 per gallon for unleaded regular, the region only averaged 15 cents per gallon above the national average in this Monday's DOE price report. Although lower prices in surrounding states with access to other sources of supply may contribute to that low differential, regulations have also kept a lid on prices. Following the hurricanes, the Georgia and North Carolina state governments triggered their anti-gouging laws, subjecting retailers to strict penalties for increasing their margins over the cost charged by their suppliers.

There are two problems with this well-intended approach. First, it impedes the price signal to consumers that would otherwise alert them to sharply-reduced availability and promote conservation. We've learned a lot about the price elasticity of demand for gasoline in the last couple of years. It took an increase of approximately $1 per gallon to reduce average US demand by 5%, and the storm-related disruptions cut supplies to the Southeast by a much larger fraction than that. No one knows how high gas prices would have had to go to constrain demand without gas lines, transaction limits, or other non-price controls, but it is reasonable to conclude that the necessary level would be a lot higher than that allowed by law in these states. By imposing price limits, government makes an explicit choice in favor of gas lines, in order to keep the price of whatever gas is available within reach of lower-income consumers. That may be a popular decision, but it is hardly a market failure.

The other drawback of these "soft" price controls is that they encourage a feedback loop that fosters panic and amplifies scarcity. High prices discourage hoarding, while artificially-low prices amid vanishing availability egg consumers on to get theirs, before it's all gone. And as I've noted before, a shift in psychology concerning how low to let our gas gauges get before refueling can drain even a well-supplied service station network. If every American decided to buy a half-tank of gasoline on the same day, demand would spike to more than four times average. That is the last thing you want when product is already tight. Moreover, uncertainty about how price gouging laws will be interpreted leaves retailers perceiving an unpleasant choice between running out and being fined or imprisoned. That's a lot of extra grief for a business that usually only clears a few cents per gallon, after expenses.

Perhaps this situation offers some lessons about our present financial crisis, as well. The most pertinent one bolsters the idea of increasing FDIC insurance levels, to avoid the kind of depositor flight that contributed to my waking up on Monday with my primary bank in the hands of a new and possibly much less customer-focused owner. At the very least, the Southeast gas lines serve as a reminder of the unintended consequences associated with most regulations arising from our populist instincts, rather than sound economics. As we enter a new era that will almost certainly include much greater oversight and regulation of a smaller and more risk-averse financial sector, that bears keeping in mind.

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The Storm Spike - Updated

If you're wondering why the price of gasoline at your local stations has suddenly spiked, despite little movement in crude oil prices, and even if you don't live anywhere near Texas or the path of Hurricane Ike, here are a few factors to keep in mind:

1. Although the price of oil is a major component of the cost of a gallon of gasoline, the crude and refined product markets are separate and distinct, and if there aren't enough refineries to turn it into transportation fuel, the price of oil isn't very relevant to the price at the pump. In the short term, refineries without electricity matter more than damaged oil platforms.


2. US gasoline inventories were already extremely low, before Ike made landfall, both in absolute terms and in days of supply. That's the result of months of high oil prices and weak gasoline demand, which together have crushed refining margins and made producing gasoline a break-even proposition.


3. Prices are set by supply and demand. For the moment, with many Gulf Coast refineries shut down or running at reduced rates, we are a nation that uses 9 million barrels per day of gasoline but has less than 8 million barrels per day of supply, including the million barrels or so we routinely import. Extra supplies from Europe and elsewhere are at least 10 days away. When supply and demand are so mismatched and inventory so low, the only choices for rationing supply are higher prices or gas lines and run-outs, which we may yet see in some areas. In general, our gut instincts about "gouging"--fed by misinformed or cynical politicians--are deeply unhelpful in such circumstances. Panic buying is even worse, because it can create a shortage by itself.


4. Service station owners have also been squeezed between weak demand and high prices this year. When they saw spot wholesale gasoline prices spike over $4/gal. on Friday, they knew their next deliveries were likely to cost them a lot more. Stretched by months of weak retail margins, they are in no position to absorb that hit without raising prices in anticipation of it.

As of Monday morning, it appears that the Texas refineries have not sustained major damage. Most should be able to restart within a week or two. Imports will increase in the meantime, and refineries not affected by the storm can run at higher rates, to make up for lost production and rebuild inventories, allowing prices to come back down pretty quickly.

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The Storm Spike

If you're wondering why the price of gasoline at your local stations has suddenly spiked, despite little movement in crude oil prices, and even if you don't live anywhere near Texas and the path of Hurricane Ike, here are a few factors to keep in mind:

1. Although the price of oil is a major component of the cost of a gallon of gasoline, the crude and refined product markets are separate and distinct, and if there aren't enough refineries to turn it into transportation fuel, the price of oil isn't very relevant to the price at the pump.

2. US gasoline inventories were already extremely low, before Ike made landfall, both in absolute terms and in days of supply. That's the result of months of high oil prices and weak gasoline demand, which together have crushed refining margins and made producing gasoline a break-even proposition.

3. Prices are set by supply and demand. At the moment, with many of the Gulf Coast refineries shut down, we are a nation that uses 9 million barrels per day of gasoline but has less than 8 million barrels per day of supply, including the million barrels or so we import every day, with any extra supplies from Europe and elsewhere at least 10 days away. When supply and demand are so mismatched and inventory so low, the only choices for rationing supply are rapid and significant price increases, or gas lines and run-outs, which we may yet see in some areas. Our gut instincts about "gouging"--fed by misinformed or cynical politicians--are deeply unhelpful right now.

4. Service station owners have also been squeezed between weak demand and high prices. When they saw spot wholesale gasoline prices spike over $4/gal. yesterday, they knew their next delivery was going to cost them a lot more. Stretched by months of weak retail margins, they are in no position to absorb that hit without raising prices in anticipation of it.

If the Texas refineries haven't sustained major damage, most should be able to restart within a week or two. Imports will increase in the meantime, and refineries not damaged by the storm can run at higher rates, to make up for lost production and rebuild inventories, allowing prices to come back down pretty quickly. If the damage turns out to be significant, however, we're going to be paying a lot more for gasoline and diesel fuel for a while, no matter what happens to crude oil prices.

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