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Testimony:

Before the Committee on Government Reform, Subcommittee on Energy and 
Resources:

United States Government Accountability Office:

GAO:

For Release on Delivery Expected at 1:00 p.m. EDT:

Monday, May 9, 2005:

Energy Markets:

Understanding Current Gasoline Prices and Potential Future Trends:

Statement of Jim Wells, Director, Natural Resources and Environment:

GAO-05-675T:

GAO Highlights:

Highlights of GAO-05-675T, a report to House Committee on Government 
Reform, Subcommittee on Energy and Resources: 

Why GAO Did This Study:

Gasoline prices have increased dramatically in recent weeks and 
currently, California has the highest gasoline prices in the nation. 
Consequently, consumers are expected to spend significantly more on 
gasoline this year than last. Specifically, EIA recently projected 
that, because of higher expected gasoline prices, the average American 
household will spend about $350 more on gasoline in 2005 than they did 
in 2004. Understandably, the public and the press have focused on these 
higher gasoline prices and some have questioned why this is happening. 
Moreover, people are concerned about the future, with some analysts 
projecting prices of crude oil—the primary raw material from which 
gasoline is produced—to remain at current high levels or even increase. 
Other analysts expect prices to fall as new oil supplies are developed 
and as consumers adjust to the current high prices and adopt more 
energy-efficient practices. 

This testimony, as requested, address factors that help explain today’s 
high gasoline prices in the nation as a whole and specifically in 
California. In addition, potential trends that may impact future prices 
of crude oil and gasoline are addressed. 

What GAO Found:

Crude oil prices and gasoline prices are linked, because gasoline is 
derived from the refining of crude oil. As a result, crude oil prices 
and gasoline prices generally follow a similar, albeit not identical, 
pattern over time. For example, from January 2004 to the present, the 
price of West Texas Intermediate crude oil rose by almost $20 per 
barrel, an increase of almost 60 percent, while over the same period, 
average gasoline prices rose nationally from $1.49 to $2.20 per gallon, 
an increase of 48 percent. Explanations for this large increase in 
crude oil and gasoline prices include rapid growth of world demand for 
crude oil and petroleum products, instability in the Persian Gulf 
region, and actions by the Organization of Petroleum Exporting 
Countries (OPEC) to restrict the production of crude oil and thereby 
increase its price on the world market. In addition to the cost of 
crude oil, gasoline prices are influenced by a variety of other 
factors, including refining capacity constraints, low inventories, 
unexpected refinery or pipeline outages, environmental and other 
regulations, and mergers and market power in the oil industry. 

Gasoline prices in California, and in other West Coast states, have 
consistently been among the highest in the nation and recent experience 
is no different. For the last week in April, the price of regular grade 
gasoline in California was $2.57 per gallon, about 37 cents above the 
national average. Explanations for California’s higher than average 
gasoline prices include (1) California’s unique gasoline blend, which 
is cleaner burning and more expensive to produce than any of the other 
commonly used gasoline blends; (2) a tight balance between supply and 
demand in the West Coast, and the long distance to any viable sources 
of replacement gasoline in the event of local supply disruptions; and 
(3) California’s higher level of gasoline taxes—California currently 
taxes a gallon of gasoline at 30 cents per gallon more than the state 
with the lowest taxes, Alaska. Some sources have also attributed high 
gasoline prices, in part, to the fact that California’s refining sector 
is more concentrated in the hands of fewer companies than in other 
refining areas, such as the Gulf Coast. 

Future gasoline prices will, in large part, be determined by the supply 
and demand for crude oil and its price on the world market. World crude 
oil demand is projected to rise, so new sources will have to be 
developed or prices will rise. Technological innovations that reduce 
the cost of finding or extracting crude oil could reduce prices, other 
things remaining constant. Greater conservation, or improvements in 
energy efficient technologies could also mitigate rising demand and 
reduce upward pressure on prices. In addition, alternative fuel sources 
may become more economical, thereby supplanting some of the demand for 
crude oil and gasoline in the future. 

America faces daunting challenges in meeting future energy demands, and 
policy makers must choose wisely to ensure that the country can meet 
these demands, while balancing environmental and quality of life 
concerns. 

www.gao.gov/cgi-bin/getrpt?GAO-05-675T. 

To view the full product, including the scope and methodology, click on 
the link above. For more information, contact Jim Wells at (202) 512-
3841 or wellsj@gao.gov. 

[End of section]

Mr. Chairman and Members of the Subcommittee:

I am pleased to participate in the Subcommittee's hearing to discuss 
today's gasoline prices and the factors behind future trends in those 
prices. Soaring retail gasoline prices have garnered much media 
attention and generated much public anxiety, particularly in a state as 
dependent on gasoline as California. According to data published by the 
American Automobile Association, since a year ago, average national 
gasoline prices have increased 23 percent to $2.20, with average prices 
in California currently at $2.57 per gallon. In the Los Angeles area, 
prices have increased 19 percent to $2.60 in the same period. According 
to the Department of Energy's Energy Information Administration (EIA), 
which compiles and analyzes energy statistics, higher expected gasoline 
prices in 2005 will increase the average American household's spending 
on gasoline by about $350 over 2004 expenditures. Nationally, each 
additional ten cents per gallon of gasoline adds about $14 billion to 
America's annual gasoline bill. Still, when adjusted for inflation, 
gasoline prices are not at an all time high--the highest inflation 
adjusted prices occurred in 1981 and were equivalent to a price of 
about $3.00 today. In addition, U.S. consumers pay less for a gallon of 
gasoline than consumers in many other industrialized nations, in large 
part because the United States imposes much lower taxes on gasoline 
than these other countries. 

The availability of relatively inexpensive gasoline has helped foster 
economic growth and permitted a quality of life not widely available 
across the globe. Large price increases, especially if sustained over a 
long period, pose long term challenges to consumers. In this regard, 
some recent analyses suggest that gasoline prices may stay at today's 
relatively high level or even increase significantly in the future. For 
example, some analysts have projected that the price of crude oil--the 
primary raw material in the production of gasoline--while changing from 
day-to-day, may remain in the vicinity of current levels for some time. 
One analysts has even projected that oil may reach $105 per barrel in 
coming years--almost double the current price. In contrast, others 
suggest that crude oil prices--and therefore, gasoline prices--will 
fall as oil companies invest in more crude oil producing capacity and 
as consumers respond to higher prices by adopting more energy-efficient 
practices. Regardless of what happens in the future, the impact of 
gasoline prices is felt in virtually every sector of the U.S. economy 
and when prices increase sharply, as they have in recent months, 
consumers feel it immediately and are reminded every time they fill up 
their tanks or read in the newspapers about high oil company profits. 

It is therefore essential to understand the market for gasoline. In 
this context, you asked us to discuss (1) how gasoline prices are 
determined nationally, (2) what factors cause California's prices to be 
consistently among the nation's highest, and (3) some of the important 
factors that will determine gasoline prices in the long run. You also 
requested that we provide some graphical depiction of gasoline prices 
and other relevant data and we include these in appendix 1 of this 
document. 

To respond to your questions, we relied heavily on previous work on 
gasoline prices and other aspects of the petroleum products industry 
and collected updated data from a number of sources that we deemed 
reliable. This work was performed in accordance with generally accepted 
government auditing standards. 

In summary, our work has shown:

* Crude oil prices and gasoline prices are inherently linked, because 
crude oil is the primary raw material from which gasoline and other 
petroleum products are produced--when crude oil prices fluctuate, 
gasoline prices generally follow a similar pattern. In recent months, 
crude oil prices have risen significantly--from January 2004 to the 
present, the price of West Texas Intermediate crude oil, a benchmark 
for international oil prices, has risen by almost $20 per barrel, an 
increase of almost 60 percent. Over the same period, average gasoline 
prices rose nationally from $1.49 to $2.20 per gallon, an increase of 
48 percent. Explanations for this large increase in crude oil and 
gasoline prices include rapid growth of world demand for crude oil and 
petroleum products, particularly in China and the rest of Asia, 
instability in the Persian Gulf region (the source of a large 
proportion of the world's oil reserves), and actions by the 
Organization of Petroleum Exporting Countries (OPEC) to restrict the 
production of crude oil and thereby increase its price on the world 
market. Figure one illustrates the relationship between crude oil and 
gasoline prices over the past three decades. The figure shows that 
major upward and downward movements of crude oil prices are generally 
mirrored by movements in the same direction by gasoline prices. 

Figure 1: Gasoline and Crude Oil Prices--1974-2004 (Not adjusted for 
inflation):

[See PDF for image]

[End of figure]

* While crude oil is a fundamental determinant of gasoline prices, a 
number of other factors also play a role in determining how gasoline 
prices vary across different locations and over time. For example, 
refinery capacity in the United States has, in recent years, not 
expanded at the same pace as demand for gasoline and other petroleum 
products--during the same period we have imported larger and larger 
volumes of gasoline from Europe, Canada, and other countries. It is 
important to note that imports are not, in and of themselves a problem-
-frequently imported goods are available at lower prices than 
domestically produced goods. However, the American Petroleum Institute 
has recently reported that U.S. refinery capacity utilization has 
increased to 92 percent. As a result, domestic refineries have little 
room to expand production in the event of a temporary supply shortfall. 
Further, the fact that imported gasoline comes from farther away than 
domestically produced gasoline means that when supply disruptions occur 
in the United States, it might take longer to get replacement gasoline 
than if we had excess refining capacity in the United States, and this 
could cause gasoline prices to rise and stay high until these new 
supplies can reach the market. In addition, refinery accidents and 
other localized supply disruptions have at times caused price spikes 
especially at the state or regional level. Recently, a tragic fire at a 
BP refinery in Houston killed 15 people and temporarily shut down about 
3 percent of the nation's refining capacity--while this event has not 
been definitively linked to increased prices, such events in the past 
have, at times, had major effects on prices. 

* The volume of inventories of gasoline, maintained by refiners or 
marketers of gasoline, can also have an impact on prices. As with 
trends in a number of other industries, the petroleum products industry 
has seen a general downward trend in the level of gasoline inventories 
in the United States. Lower levels of inventories may cause prices to 
be more volatile because when a supply disruption occurs, there are 
fewer stocks of readily available gasoline to draw from, which puts 
upward pressure on prices. Regulatory factors also play a role. For 
example, in order to meet national air quality standards under the 
Clean Air Act and amendments, many states have adopted the use of 
special gasoline blends--so-called "Boutique Fuels." Many experts have 
concluded that the proliferation of these special gasoline blends has 
caused gasoline prices to rise and/or become more volatile, especially 
in regions such as California that use unique blends of gasoline, 
because the fuels have increased the complexity and costs associated 
with supplying gasoline to all the different markets. Finally, the 
structure of the gasoline market can play a role in determining prices. 
For example, we recently reported that some mergers of oil companies 
during the 1990s led to reduced competition among gasoline suppliers 
and may have been responsible for an increase in gasoline prices by as 
much as 2 cents per gallon. 

* Gasoline prices in California, and in other West Coast states, have 
consistently been among the highest in the nation and recent experience 
is no different. For example, for the last week in April, when the 
national average price for regular grade gasoline was $2.20, the 
California price was $2.57. Explanations for why California's prices 
have been higher than the national average include (1) California's 
unique gasoline blend, which is cleaner burning and more expensive to 
produce than any of the other commonly used gasoline blends; (2) a 
tight balance between supply and demand in the West Coast, and the long 
distance to any viable sources of replacement gasoline in the event of 
local supply disruptions; and (3) California's higher level of gasoline 
taxes--California currently taxes a gallon of gasoline at 30 cents per 
gallon more than the state with the lowest taxes, Alaska. 

* Future gasoline prices will reflect world supply and demand balance. 
If demand for oil and petroleum products continues to rise as it has in 
past years--EIA projects that U.S. demand for crude oil will rise about 
38 percent by the year 2025--then oil supply will have to expand 
significantly to keep up. Currently, world surplus crude oil production 
capacity--the amount by which oil production can be increased in the 
short run without installing more drilling equipment or developing new 
oil fields--is very small. Moreover, many of the world's known and 
easily accessible crude oil deposits have already been developed and 
many of these are experiencing declining volumes as the fields become 
depleted. As a result, new production facilities will have to be built, 
and perhaps new oil deposits will need to be developed, to meet rising 
demand for gasoline and other petroleum products. In so doing, entities 
may encounter higher costs of extracting and processing oil. For 
example, there are large stores of crude oil in tar sands and oil 
shale, or potentially beneath deep water in the ocean, but these 
sources are more costly to extract and process than many of the sources 
of oil that we have already tapped. To the extent that extraction and 
processing costs rise, the price of crude oil and the petroleum 
products made from it will have to rise to make supplying it 
economically viable. If, on the other hand, technological innovations 
improve our ability to extract and process oil, this will increase the 
available future supply and ease pressure on petroleum product prices. 

* Although demand for crude oil is projected to increase, it could fall 
below current expectations if consumers choose more energy efficient 
products or otherwise conserve more energy. Such a reduction in demand 
could lead to lower-than-expected future prices. For example, in 
response to high gasoline prices in the United States, in the 1980s 
many consumers chose to switch to smaller or more fuel-efficient 
vehicles, which reduced demand for gasoline. Environmental issues could 
also have an impact on world crude oil and petroleum product prices. 
For example, international efforts to reduce greenhouse emissions could 
cause reductions in demand for crude oil and petroleum products as more 
fuel-efficient processes are adopted or as cleaner sources of energy 
are developed. Additional factors that will likely influence future oil 
and gasoline prices include geopolitical issues, such as the stability 
of the Middle East; the valuation of the U.S. dollar in world currency 
markets; and the pace of development of alternative energy supplies, 
such as hydrogen fuel cell technology. 

Background:

In 2004, the United States consumed about 20.5 million barrels per day 
of crude oil accounting for roughly 25 percent of world oil production. 
A great deal of the crude oil consumed in this country goes into 
production of gasoline and, as a nation, we use about 45 percent of all 
gasoline produced in the world.[Footnote 1] California alone presently 
consumes almost 44 million gallons of gasoline per day. To put this in 
perspective, in 1997 (the last year for which we found available data 
for international comparisons), only the rest of the United States and 
Japan consumed more gasoline than California. 

Products made from crude oil--petroleum products, including gasoline--
have been instrumental in the development of our modern lifestyle. In 
particular, gasoline, diesel, and jet fuel have provided the nation 
with affordable fuel for automobiles, trucks, airplanes and other forms 
of public and goods transportation. Together, these fuels account for 
over 98 percent of the U.S. transportation sector's fuel consumption. 
In addition, petroleum products are used as raw materials in 
manufacturing and industry; for heating homes and businesses; and, in 
small amounts, for generating electric power. Gasoline use alone 
constitutes about 44 percent of our consumption of petroleum products 
in the United States, so when gasoline prices rise, as they have in 
recent months, the effects are felt throughout the country, increasing 
the costs of producing and delivering basic retail goods and making it 
more expensive to commute to work. It is often the case that prices of 
other petroleum products also increase at the same time and for the 
same reasons that gasoline prices rise. For example, today's high 
gasoline prices are mirrored by high jet fuel prices, which have put 
pressure on airline companies, some of which are currently in the midst 
of financial difficulties. 

Gasoline prices vary a great deal over time. For example, in the 10-
year period April 1995 through April 2005, the national average price 
for a gallon of regular grade gasoline has been as low as $0.89 and as 
high as $2.25 without adjusting for inflation. In addition, gasoline 
prices vary by location and, in recent years, California has 
consistently had among the highest prices in the nation. 

The future path of gasoline prices is difficult to predict, but it is 
clear that the use of petroleum products worldwide is going to increase 
for the near term and maybe beyond. Some analysts have predicted much 
higher crude oil prices--and as a result, higher prices of petroleum 
products--while others expect prices to moderate as producers respond 
to high prices by producing more crude oil and consumers respond by 
conserving more, and investing in more energy-efficient cars and other 
products. In either case, the price of gasoline will continue to be an 
important part of the household budgets of Americans for the 
foreseeable future and therefore, it is important to understand how 
prices are determined so that consumers can make wise choices. 

Gasoline Prices Are Determined by the Price of Crude Oil and a Number 
of Other Factors:

Crude oil prices feed directly into the price of gasoline, because 
crude oil is the primary raw material from which gasoline is produced. 
For example, according to our analysis of EIA data, crude oil accounted 
for about 48 percent of the price of a gallon of gasoline on average in 
2004 in the United States.[Footnote 2] When crude oil prices rise, as 
they have in recent months, refiners find their cost of producing 
gasoline also rises, and in general, these higher costs are passed on 
to consumers in the form of higher gasoline prices at the pump. Figure 
2 illustrates the importance of crude oil in the price of gasoline. The 
figure also shows that taxes, refining, and distribution and marketing 
also play important roles.[Footnote 3]

Figure 2: Elements in the Price of a Gallon of Gasoline (Average for 
2004):

[See PDF for image]

[End of figure]

Because of the prominent role of crude oil as a raw material of 
gasoline production, in order to understand what determines gasoline 
prices it is necessary to examine how crude oil prices are set. 
Overall, the price of crude oil is determined by the balance between 
world demand and supply. A major cause of rising crude oil prices in 
recent months has been rapid growth in world demand, without a similar 
growth in available supplies. In particular, the economy of China has 
grown rapidly in recent years, leading to increases in their demand for 
crude oil. In contrast, oil production capacity has grown more slowly, 
leading to a reduction in the surplus capacity--the amount of crude oil 
that is left in the ground, but could be extracted on short notice in 
the event of a supply shortfall. EIA has stated that the world's 
surplus crude oil production capacity has fallen to about one million 
barrels per day, or just over one percent of the world's current daily 
consumption, making the balance between world demand and supply of 
crude oil very tight. This tight balance between world crude oil demand 
and supply means that any significant supply disruptions will likely 
cause prices to rise. For example, a workers' strike in Nigeria's oil 
sector in October 2004 forced world crude oil prices to record highs 
(Nigeria is the world's seventh largest oil producer, supplying an 
average 2.5 million barrels per day in 2004). 

Another important factor affecting crude oil prices is the behavior of 
the Organization of Petroleum Exporting Countries (OPEC)--members of 
which include Algeria, Indonesia, Iran, Iraq, Kuwait, Libya, Nigeria, 
Qatar, Saudi Arabia, United Arab Emirates, and Venezuela. OPEC members 
produce almost 40 percent of the world's crude oil and control almost 
70 percent of the world's proven oil reserves. In the recent past and 
on numerous other occasions, OPEC members have collectively agreed to 
restrict production of crude oil in order to increase world prices for 
that commodity. 

In addition to the cost of crude oil, gasoline prices are influenced by 
a variety of other factors, including refining capacity constraints, 
low inventories, unexpected refinery or pipeline outages, environmental 
and other regulations, and mergers and market power in the oil 
industry. 

First, domestic refining capacity, has not kept pace with growing 
demand for gasoline. As demand has grown faster than domestic refining 
capacity, the United States has imported larger and larger volumes of 
gasoline and other petroleum products from refiners in Europe, Canada, 
and other countries. EIA officials told us that, in general, this 
increase in imports has reflected the availability of gasoline from 
foreign sources at lower cost than building and operating additional 
refining capacity in the United States would entail. However, the 
American Petroleum Institute (API) has recently reported that capacity 
utilization has been high in the U.S. refinery sector. Capacity has 
typically averaged over 90 percent, and has recently increased to 92 
percent--much higher than the rate in many other industries, which API 
reports are more typically operating at around 80 percent of capacity. 
As a result, domestic refineries have little room to expand production 
in the event of a temporary supply shortfall. Further, the fact that 
imported gasoline comes from farther away than domestically produced 
gasoline means that when supply disruptions occur in the United States, 
it might take longer to get replacement gasoline than if we had excess 
refining capacity in the United States, and this could cause gasoline 
prices to rise and stay high until these new supplies can reach the 
market. 

Gasoline prices may also be affected by unexpected refinery outages or 
accidents that significantly disrupt the delivery of gasoline supply. 
For example, in a recent report, we found that unexpected refinery 
outages had been a factor in a number of prices spikes in California in 
the 1990s. More recently, the tragic explosion and subsequent fire at a 
BP refinery in Houston, that killed 15 people, temporarily shut down 
about 3 percent of the nation's refining capacity. While we have not 
analyzed the potential impact on gasoline prices of this specific 
event, similar events in the past have caused temporary increases in 
prices until alternative sources of supply can be brought to market. 
Pipeline disruptions can have a similar effect, as was seen when 
Arizona's Kinder Morgan pipeline broke in July 2003 and average 
gasoline prices jumped 56 cents in a month in Arizona. In addition, 
tanker spills, and other similar events can all have an impact on 
gasoline prices at various points in time because they cause 
interruption in the supply of crude oil or petroleum products, such as 
gasoline. 

The level of gasoline inventories can also play an important role in 
determining gasoline prices over time because inventories represent the 
most accessible and available source of supply in the event of a 
production shortfall or increase in demand. Similar to trends in other 
industries, the level of inventories of gasoline has been falling for a 
number of years. In part, this reflects a trend in business to more 
closely balance production with demand in order to reduce the cost of 
holding large inventories. However, reduced inventories may contribute 
to increased price volatility, because when unexpected supply 
disruptions or increases in demand occur, there are lower stocks of 
readily available gasoline to draw from. This puts upward pressure on 
gasoline prices until new supplies can be refined and delivered 
domestically, or imported from abroad. 

Regulatory steps to reduce air pollution have also influenced gasoline 
markets and consequently have influenced gasoline prices. For example, 
since the 1990 amendments to the Clean Air Act, the use of various 
blends of cleaner-burning gasoline--so-called "boutique fuels--has 
grown. A number of reports by government agencies, academics, and 
private entities have concluded that the proliferation of these special 
gasoline blends has put stress on the gasoline supply infrastructure 
and may have led to increased price volatility because areas that use 
special blends cannot as easily find suitable replacement gasoline in 
the event of a local supply disruption. However, these special gasoline 
blends provide environmental and health benefits because they reduce 
emissions of a number of pollutants. GAO is currently working on a 
report on special gasoline blends that will look at these issues and 
discuss the effects of these special blends on emissions and on the 
supply system. 

Finally, we recently reported that industry mergers increased market 
concentration and in some cases caused higher wholesale gasoline prices 
in the United States from the mid-1990s through 2000.[Footnote 4] 
Overall, the report found that the mergers led to price increases 
averaging about 2 cents per gallon on average. For conventional 
gasoline, the predominant type used in the country, the change in the 
wholesale price, due to specific mergers, ranged from a decrease of 
about 1 cent per gallon--due to efficiency gains associated with the 
merger--to an increase of about 5 cents per gallon--attributed to 
increased market power after the merger. For special blends of 
gasoline, wholesale prices increased by from between 1 and 7 cents per 
gallon, depending on location. 

California's Unique Gasoline and Isolation from Other Markets 
Contribute to its Higher Gasoline Prices:

California, and the West Coast states more generally, have consistently 
had among the highest gasoline prices in the nation. For example, 
California's gasoline prices averaged about 21 cents more per gallon 
than national gasoline prices over the last ten years. In addition, 
California has at times had more volatile gasoline prices than the rest 
of the country. For example, in an earlier report on California 
gasoline prices, we noted that, while gasoline prices did not spike 
more frequently than in the rest of the United States, California's 
gasoline price spikes were generally higher.[Footnote 5]

Many of the factors influencing gasoline prices nationwide have had an 
even more dramatic effect on California prices. For example, 
California's high gasoline prices have been attributed, in part, to its 
cleaner burning gasoline. In response to air quality problems and in 
order to meet air quality standards resulting from the Clean Air Act 
and amendments, California adopted a unique blend of gasoline in 1996 
that increased refining costs and likely caused prices of gasoline in 
the state to rise. California's blend of gasoline is unique in the 
United States and, according to EPA models, is the cleanest burning of 
all the widely used special gasoline blends in the country. This 
gasoline blend is also very difficult to make, and those refineries 
that chose to make it had to install expensive new equipment and 
refining processes in order to meet the specifications of the gasoline. 
Some studies have suggested that the current blend of California 
gasoline costs between 5 and 15 cents more per gallon to make than 
conventional gasoline. It is likely that these costs are passed on, at 
least in part, to consumers. 

In addition, in recent years, California has developed a tight balance 
between supply and demand, which has at times led to sharper or longer 
price spikes when supply disruptions have occurred. Expansion of the 
gasoline supply infrastructure has not kept pace with growing demand, 
and as a result, the California refinery system has run at near 
capacity. For example, according to EIA testimony before the Congress, 
demand for gasoline in California has grown at roughly two to four 
times production capacity growth. California Energy Commission staff 
told us that the tight supply and demand balance has led to large price 
movements in response to even small supply disruptions, caused by 
refinery outages and other events. 

Moreover, supply disruptions may have a larger impact on California 
than on other states. First of all, only a few refineries outside of 
the state can produce California's special blend of gasoline. In 
addition, there are no major pipelines connecting the state with other 
major refining areas. Therefore, if supply is disrupted in California, 
gasoline must be brought in from the few refineries outside the state 
that make California's blend of gasoline--often from as far away as the 
Gulf Coast or beyond. And because of the lack of pipeline access to the 
state, tankers and other means must be used, and the process is slow. 
For example, we recently reported that gasoline shipped into California 
by tanker from such places as the Gulf Coast, the U.S. Virgin Islands, 
Europe, and Asia, can take between 11 and 40 days and added 3 to 12 
cents per gallon to the retail price. 

Another factor contributing to the prices Californians pay at the 
gasoline pump is that residents of California pay comparatively higher 
gasoline taxes than residents in many other states. For example, at 
about 57 cents per gallon on average, California's total gasoline tax 
rate is among the highest, behind only New York and Hawaii, and is 30 
percent higher than the national average of 44 cents per gallon, 
according to a November 2004 survey by the American Petroleum 
Institute. 

In our recent report on oil industry mergers discussed earlier in this 
testimony, we found that the highest price impact of mergers--over 7 
cents per gallon of gasoline--was in California. In addition, the 
California Attorney General recently reported that California's 
gasoline industry is more concentrated than that of the rest of the 
United States, with California's six largest refiners controlling more 
than 90 percent of refining capacity. The California Attorney General 
noted further, that these six refiners in California control a majority 
of the terminal facilities and 85 percent of the retail locations in 
the state. To the extent that these factors lead to greater market 
power on the part of refiners or gasoline marketers, prices may be 
higher as a result. However, we have not analyzed this directly. 

Future Oil and Gasoline Prices Will Reflect Supply/Demand Balance, but 
Technological Change and Conservation Will Also Play a Role:

Looking into the future, daunting challenges lie ahead in finding, 
developing, and providing sufficient quantities of oil to meet 
projected global demand. For example, according to EIA, world oil 
demand is expected to grow to nearly 103 million barrels per day in 
2025 under low growth assumptions, and may reach as high as 142 million 
barrels per day in 2025--increases of between 25 and 71 percent, from 
the 2004 consumption level of 83 million barrels per day. For the 
United States alone, EIA estimates that oil consumption will increase 
by between 1.2 and 1.9 percent annually through 2025 depending on 
assumptions about economic growth and other factors. Looking further 
ahead, the rapid pace of economic growth in China and India, two of the 
world's most populous and fastest growing countries, may lead to a 
similarly rapid increase in their demand for crude oil and petroleum 
products. While these countries currently consume only a small fraction 
of world crude oil, the pace of their demand growth could have far 
reaching implications if recent trends continue. For example, 
consumption of oil by China and India is currently far below that of 
the United States, but is projected to grow at a more rapid rate. EIA's 
medium-growth projections estimate that oil consumption for China and 
India will each grow by about 4 percent annually through 2025, while 
consumption in the U.S. is projected to grow at an annual rate of 1.5 
percent over the same period. 

To meet the rising demand for gasoline and other petroleum products, 
new oil deposits will likely be developed and new production facilities 
built. Currently, many of the world's known and easily accessible crude 
oil deposits have already been developed, and many of these are 
experiencing declining volumes as fields become depleted. For example, 
the existing oil fields in California and Alaska have long since 
reached their peak production, necessitating an increasing volume of 
imported crude oil to West Coast refineries.[Footnote 6] Developing new 
oil deposits may be more costly than in the past, which could put 
upward pressure on crude oil prices and the prices of petroleum 
products derived from it. For example, some large potential new 
sources, such as oil shales, tar sands, and deep-water oil wells, 
require different and more costly extraction methods than are typically 
needed to extract oil from existing fields.[Footnote 7] In addition, 
the remaining oil in the ground may be heavier and more difficult to 
refine, necessitating investment in additional refinery processes to 
make gasoline and other petroleum products out of this oil. If 
developing, extracting, and refining new sources of crude oil are more 
costly than extracting and refining oil from existing fields, crude oil 
and petroleum product prices will rise to make these activities 
economically feasible. 

On the other hand, technological advances in oil exploration, 
extraction, and refining could mitigate future price increases. In the 
past, advances in seismic technology significantly improved the ability 
of oil exploration companies to map oil deposits, which enabled them to 
ultimately extract the oil more efficiently, thereby getting more out 
of a given oil field. In addition, improvements in technology have 
enabled oil companies to drill in multiple directions from a single 
platform, and also to pin-point specific oil deposits more accurately, 
which has led to increases in the supply of crude oil. Further, 
refining advances over the years have also enabled U.S. refiners to 
increase the yield of gasoline from a given barrel of oil--while the 
total volume of petroleum products has remained relatively constant, 
refiners have been able to get more of the more valuable components, 
such as gasoline, out of each barrel, thereby increasing the supply of 
these components. Further technological improvements that lower costs 
or increase supply of crude oil or refined products would likely lead 
to lower prices for these commodities. 

Similarly, innovations that reduce the costs of alternative sources of 
energy could also reduce the demand for crude oil and petroleum 
products, and thereby ease price pressures. For example, hydrogen is 
the simplest element and most plentiful gas in the universe and its use 
in fuel cells produces almost no pollution. In addition, hydrogen fuel 
cell cars are expected to be roughly three times more fuel-efficient 
than cars powered by typical internal combustion engines. Currently, 
enormous technical problems stand in the way of converting America's 
fleet of automobiles from gasoline to hydrogen, including how to 
produce, store, and distribute the flammable gas safely and 
efficiently, and how to build hydrogen cars that people can afford and 
will want to buy. However, there are federal and state initiatives 
under way as well as many private efforts to solve these technical 
problems, and if they can be solved in an economical way in the future, 
the implications for gasoline use could be profound. 

Greater conservation or improved fuel efficiency could also reduce 
future demand for crude oil and petroleum products, thereby leading to 
lower prices. The amount of oil and petroleum products we will consume 
in the future is, ultimately, a matter of choice. Reducing our 
consumption of gasoline by driving smaller, more fuel-efficient cars--
as occurred in the 1980s in response to high gasoline prices--would 
reduce future demand for gasoline and put downward pressure on prices. 
For example, the National Academies of Science recently reported that 
if fuel-efficiency standards for cars and light trucks had been raised 
by an additional 15 percent in 2000, consumption of gasoline in the 
year 2015 would be 10 billion gallons lower than it is expected to be 
under current standards. The Congress established fuel economy 
standards for passenger cars and light trucks in 1975 with the passage 
of the Energy Policy and Conservation Act. While these standards have 
led to increased fuel efficiency for cars and light trucks, in recent 
years, the switch to light trucks has eroded gains in the overall fuel 
efficiency of the passenger fleet. Future reductions in demand for 
gasoline could be achieved if either by fuel efficiency standards for 
cars and light trucks are increased, or consumers switch to driving 
smaller or more fuel-efficient cars. 

The effect of future environmental regulations and international 
initiatives on oil and petroleum products prices is uncertain. On one 
hand, regulations that increase the cost or otherwise limit the 
building of refining and storage capacity may put pressure on prices in 
some localities. For example, the California Energy Commission told us 
the lack of storage capacity for imported crude oil and petroleum 
products may be a severe problem in the future, potentially leading to 
supply disruptions and price volatility. Alternatively, international 
efforts to reduce the generation of green house gas emissions could 
cause reductions in the demand for crude oil and petroleum products 
through the development and use of more fuel-efficient processes and as 
cleaner, lower-emissions fuels are developed and used. 

Moreover, geopolitical factors will likely continue to have an impact 
on crude oil and petroleum product prices in the future. Because crude 
oil is a global commodity, the price we pay for it can be affected by 
any events that affect world demand or supply. For example, Venezuela-
-which produces around 2.6 million barrels of crude oil per day, and 
which supplies about 12 percent of total U.S. imports for oil--is 
currently experiencing considerable social, economic, and political 
difficulties that have, in the past, impacted oil production. In April 
2002, the oil flow from Venezuela was stemmed during 3 consecutive days 
of general strikes, affecting oil production, refining, and exports. 
Finally, instability in the Middle East, and particularly the Persian 
Gulf, has in the past, caused major disruptions in oil supplies, such 
as occurred toward the end of the first Gulf War, when Kuwaiti oil 
wells were destroyed by Iraq. 

Finally, the value of the U.S. dollar on open currency markets could 
also affect crude oil prices in the future. For example, because crude 
oil is typically denominated in U.S. dollars, the payments that oil-
producing countries receive for their oil are also denominated in U.S. 
dollars. As a result, a weak U.S. dollar decreases the value of the oil 
sold at a given price. Some analysts have recently reported in the 
popular press that this devaluation can influence long-term prices in 
two ways. First, oil-producing countries may wish to increase prices 
for their crude oil in order to maintain their purchasing power in the 
face of a weakening dollar. Secondly, because the dollars that these 
countries have accumulated, and that they use, in part, to finance 
additional oil exploration and extraction, are worth less, the costs 
these countries pay to purchase technology and equipment from other 
countries whose currencies have gained relative to the dollar will 
increase. These higher costs may deter further expansion of oil 
production, leading to even higher oil prices.[Footnote 8]

Conclusions:

In closing, clearly none of the options for meeting the nation's energy 
needs are without tradeoffs. Current U.S. energy supplies remain highly 
dependent on fossil energy sources that are costly, imported, 
potentially harmful to the environment, or some combination of these 
three, while many renewable energy options are currently more costly 
than traditional options. Striking a balance between efforts to boost 
supplies from alternative energy sources and policies and technologies 
focused on improved efficiency of petroleum burning vehicles or on 
overall energy conservation present challenges as well as 
opportunities. How we choose to meet the challenges and seize the 
opportunities will help determine our quality of life and economic 
prosperity in the future. 

What is true for the nation as a whole is even more dramatically so in 
California. California is one of the most populous and steadily growing 
states in the nation, and its need for gasoline, as well as other 
energy sources, will grow. However, California's unique problems with 
respect to developing the right amount and type of infrastructure 
necessary to ensure a sufficient supply of gasoline, other petroleum 
products, or alternative fuels must be resolved or viable alternatives 
developed if California is to continue to enjoy the prosperity and high 
quality of life it is known for. 

We are currently studying the gasoline prices in particular, and the 
petroleum industry more generally, including a primer on gasoline 
prices, a forthcoming report on special gasoline blends, an analysis of 
the viability of the Strategic Petroleum Reserve, an evaluation of 
world oil reserves, and an assessment of U.S. contingency plans should 
oil imports from a major oil producing country, such as Venezuela, be 
disrupted. With this body of work, we will continue to provide Congress 
and the American people the information needed to make informed 
decisions on energy that will have far-reaching effects on our economy 
and our way of life. 

Mr. Chairman, this completes my prepared statement. I would be happy to 
respond to any questions you or the other Members of the Subcommittee 
may have at this time. 

GAO Contacts and Staff Acknowledgments:

For further information about this testimony, please contact me at 
(202) 512-3841 (or at wellsj@gao.gov ). Godwin Agbara, Nancy Crothers, 
Randy Jones, Mary Denigan-Macauley, Samantha Gross, Mark Metcalfe, 
Michelle Munn, Melissa Arzaga Roye, and Frank Rusco made key 
contributions to this testimony. 

[End of section]

Appendix I: Selected Charts and Figures:

Figure 3: U.S. Retail Price of Gasoline (Not adjusted for inflation):

[See PDF for image]

[End of figure]

Figure 4: U.S. Gasoline Consumption (1970-2004):

[See PDF for image]

[End of figure]

Figure 5: Refining Capacity and Number of Refineries (1970-2004):

[See PDF for image]

[End of figure]

[End of section]

FOOTNOTES

[1] The large percentage of total world gasoline production that is 
consumed by the United States partly reflects the fact that diesel is a 
commonly used fuel for cars in Europe, while U.S. cars primarily run on 
gasoline. If all motor vehicle fuels were accounted for, the United 
States' share of these fuels would be smaller than its share of 
gasoline. However, we do not have the data to present this more 
comprehensive measure. 

[2] EIA also lists taxes; refining costs and profits; and distribution 
and retail marketing costs and profits as other components of gasoline 
prices. 

[3] The latter two categories, refining, and distribution and 
marketing, includes costs associated with these activities as well as 
profits. The figure is a snapshot of how much each component 
contributes to the price of a gallon of gasoline, and the relative 
proportions attributable to each component vary over time as crude oil 
prices and other factors change. 

[4] Energy Markets: Effects of Mergers and Market Concentration in the 
U.S. Petroleum Industry (GAO-04-96, May 2004). 

[5] GAO, Motor Fuels: California Gasoline Price Behavior, GAO/RCED-00-
121 (Washington, D.C.: April 28, 2000). 

[6] Even if new oil fields are developed in the Arctic National 
Wildlife Refuge, by the time these fields reach their expected peak 
production of 876,000 barrels per day, according to EIA projections, 
U.S. demand at this time would have increased by far more than this 
amount. 

[7] We are currently working on a report on global oil reserves that 
will address the constraints on global supply due to tapped oil 
reserves and the difficulty in extraction. 

[8] Higher oil prices, because they increase the U.S. trade deficit, 
may also contribute to the further devaluation of the dollar. Hence, 
analysts have called this process a vicious cycle in which a weak 
dollar drives up oil prices, which then feeds back into the trade 
deficit and cause the dollar to weaken further.