Statement
J.
S. Carter
Regional
Director, United States
ExxonMobil
Fuels Marketing Company
before the
Senate Permanent Subcommittee on Investigations
April 30, 2002
Mr.
Chairman, ExxonMobil appreciates the opportunity to appear before the Senate
Permanent Subcommittee on Investigations today to discuss the causes of price
volatility in the gasoline marketplace and our recommendations to help reduce
future fluctuations. . ExxonMobil has previously
provided a considerable number of documents for the Subcommittee's review and
has worked closely and cooperatively
with the Subcommittee
staff over the past nine
monthsa to provide information to enhance understanding of the gasoline marketplace.
ExxonMobil
markets fuel products in 47 states and the District of Columbia. Our goal is to provide reliable supplies of
products to our customers at competitive prices while respecting the
environment and protecting the safety of the communities we serve. We understand the public's sensitivity to
price swings and the impact of fluctuating prices on consumers' budgets. The gasoline market is the only market where
consumers can see prices daily while driving to and from work. In addition to the corner gasoline station,
these prices increasingly appear just outside the entrances to huge retailers
who use low gas prices to attract customers into their parking lots. Gasoline prices are reported daily through
surveys conducted by independent companies, and are frequently broadcast on the
evening news. Oil markets reflect the
latest unrest in the world even before the ink in the morning's headlines is
dry. As a result, our customers readily
know when prices are rising or falling.
As
the Subcommittee is aware, the FTC conducted a detailed investigation into the
causes of price increases in Midwest markets in the spring and summer of 2000,
and concluded that a combination of the EPA fuel quality requirements and
unforeseen market circumstances was responsible for the price spike. The investigation found no evidence of
collusion or anti-competitive behavior in the oil industry. To the contrary, Commissioner Swindle stated
that the industry acted quickly in response to the price spike, which was
intense but relatively short-lived because of the effective workings of the
market.
My
testimony will address the Subcommittee's questions regarding retail pricing,
marketing and distribution infrastructure, and industry consolidation. In addition, it will present recommendations
to help mitigate the price volatility in the retail market. Mr. Chairman, I hope my testimony today will
leave you with the following messages:
§
Gasoline price
volatility is a reflection of a highly competitive market operating with high
transparency and a tight supply / demand balance;
§
The gasoline market is
very efficient at setting prices that reflect supply and demand; and
§
The free market should
be allowed to set prices to the benefit of consumers.
Pricing
Practices
The
Subcommittee asked a number of questions about how ExxonMobil sets prices. Over 90 percent of our branded retail
outlets are operated by dealers or distributors. These independent business operators establish the retail prices
they charge to their customers. Regarding pricing to dealers, to whom we
deliver product, our practices include competitive zone pricing. This practice has been used by ExxonMobil
throughout the United States for more than 30 years. Zone pricing allows us to take into account localized competitive
conditions in setting the wholesale prices we charge to our dealers. Through careful analysis of local market
conditions, we establish "price
zones," which group together a number of dealers who face similar
competition. All dealers within a zone
are charged the same price, one that is appropriate to local competitive
conditions.
Zone
pricing provides the most reliable method of assessing and responding to local
competition faced by dealers operating in a competitive environment, with high
transparency and a tight balance between supply and demand. Because zone pricing reflects supply and
demand conditions at the local level, it is a reflection, rather than a cause,
of price volatility.*
Pricing
to distributors, who pick up product at our terminals, is commonly called
"rack pricing". In
establishing rack prices, ExxonMobil examines spot market prices and published
prices of key competitors, and determines a proper competitive rack pricing
relationship between ExxonMobil and these key competitors. As prices in the spot market fluctuate with
supply and demand conditions, ExxonMobil adjusts rack prices accordingly,
within the context of the previously defined competitive relationship to other
suppliers in the market. All
distributors purchasing the same product at a given ExxonMobil terminal pay the
same rack price.
Market is
Increasingly Competitive
The
refining and marketing business in the United States operates in an intensely
and increasingly competitive environment.
Retail gasoline marketing has evolved over the past 30 to 40 years, from
its historic focus on the petroleum products and services such as automotive
repair, to the current emphasis on customer service, convenience, and driver
needs.
One
factor contributing to this evolution is improved gasoline quality. The Clean Air Act Amendments of 1990 and
subsequent federal and state actions have increased minimum gasoline quality
standards. For example, all gasoline
today must contain a detergent additive. Although our branded gasoline still
possesses unique properties, consumers have concluded that most gasoline,
regardless of brand, is adequate to meet their needs assuming the correct
octane level is used. One result is
that a market once served in large part by the so-called "major"
brands today includes these significant new
entrants, such such as convenience store chains,
supermarkets, and discount retailers.
For instance, over 200 different retail "brands" are available in the greater Boston
market. There are over of 300 in the greater Houston
market. Thus, today more than ever, the
consumer has many choices.
The
historic financial returns generated by the domestic refining and marketing
industry reflect the intense competition.
Domestic refining and marketing companies combined generated an average
return on capital of just under five percent per year from 1981 through
1998. By contrast, during the same
period, the average return
on equity of the companies in the S&P 500 Index was approximately 13
percent.[1] These relatively low industry returns
tend to motivate companies to seek out economies of scale to increase
efficiency.
More
recent entrants to the gasoline market, especially "hypermarkets",
large grocery, discount, or membership club retailers, can typically establish
a significant market presence in a relatively short time. They tend to use very competitive gasoline pricing to build traffic
on their site. The increased traffic,
in turn, generates incremental store
sales with margins at much higher than those on gasolinelevels. These sales synergies are fueling a high
growth rate for the hypermarkets. Some
experts say hypermarket share of the retail gasoline market could rise from 4%
today, to almost 16% over the next three to five years,2
which is higher than ExxonMobil's
current market share. The traditional
"major" suppliers combined today hold approximately 45% of the retail
gasoline market.3
As
with any business, petroleum refining and marketing must earn a reasonable
return on the capital invested in the business in order to remain viable. The trend among traditional gasoline
retailers has been to close smaller retail outlets, and enhance revenue from
remaining stores by adding convenience stores and car washes.
Increased
competition has clearly benefited the consumer in two ways. First, gasoline marketing margins have generally declined over time. Second, although it may not be readily
evident, gasoline prices have also declined.
Over the past 80 years, inflation-adjusted retail gasoline prices have
exhibited a general downward trend, with some interim fluctuation due to
changes in crude oil prices and other short-term factors. Measured in 1999 dollars, prices have
declined from around $2.50 in 1920 to just above $1.50 in 2000, even while
taxes have increased. Today, taxes make
up about 30 percent of the retail price.4
In
refining, the trend has been toward larger, more efficient refineries. As refinery investment costs become more
difficult to recover, smaller refineries become uneconomic. Highly efficient refineries can expand
production incrementally, while less-efficient spare capacity becomes
unaffordable.
Reasons
for Price Volatility
The
causes for
of price
volatility can be best explained by looking at three factors which impact the
petroleum retailing market - market transparency, crude oil prices, and the
proliferation of fuel specifications in the U.S.
Market
Transparency
Although
futures markets have always been responsive to news events, in recent years
some trends have increased market transparency. News is available more quickly with the advent of 24-hour cable
news and Internet communications, and trading volume in the futures market has
increased. When new information
appears, market participants immediately assess its impact and take actions
based on their interpretations of the likely outcomes. Participants in the NYMEX and other futures
markets include not only some oil companies, but also a large number of traders and investors. Rather than purchasing or selling physical
barrels of oil, market participants trade contracts for these barrels. The value of the contracts represents the
value of the oil at a specified time in the future. But most market participants (over 99 percent) never actually receive or deliver the oil.5 Instead, they buy the contracts, then sell
again before expiration, or vice versa.
Essentially, they are trading financial instruments in an open market.
ExxonMobil
uses oil-related derivatives on a limited basis in conjunction with physical
barrel transactions. We do not trade
derivatives or engage in speculative trading in the futures markets.
Most
crude oil and gasoline transactions are linked to published spot market prices,
or to commodity futures prices determined in markets such as the NYMEX. Given that these prices reflect the
available information about supply and demand, the resulting retail gasoline
prices are also reflective of market conditions. Importantly for consumers, this transparency supports an
efficient free market that helps to balance supply and demand and provide the
lowest possible price at any point in time.
Cost of
Crude Oil
At
current price levels, the cost of crude oil comprises approximately 40 percent
of the retail price of gasoline. Every
one dollar change in the price of a 42-gallon barrel of crude oil results in a
two to three cent per gallon increase in the cost to produce a gallon of
gasoline. During the past three years,
crude oil prices have ranged from a low of around $10 per barrel to a high of
over $30 per barrel. Exclusive of other
related factors, this $20 range in crude prices would account for gasoline
price variation of between 40 and 60 cents per gallon.
Increases
in crude prices since late January have been a major factor in the recent rise
in gasoline prices. During this period,
crude prices have increased by over $7 per barrel, accounting for 15 to 20
cents of the overall 30 cent per gallon increase in average retail gasoline
prices.
Proliferation
of Fuel Specifications
Fuel
specifications developed in recent years to address air quality requirements,
especially in the summer months, have placed significant demands on the
petroleum industry. Because of efforts
by states to comply with the Clean Air Act Amendments of 1990, gasoline specifications have
become more numerous and complex since 1995.
As a result, the number of unique grades has increased from six in 1980,
to over 25 today. Some specifications
apply to fairly small geographic regions, such as a metropolitan area comprising
a few counties. These more localized
"boutique" fuels and the differences between summer and winter
product blends present challenges for both the refining and distribution
systems.
Summer
grades are generally more difficult and expensive to refine than winter grades
because they require additional processing to meet more stringent environmental
standards. Summer grades generally must
have lower volatility, or less tendency to evaporate during warmer months. For the sake of clarity, the term "volatility"
here refers to the volatility of gasoline itself, not volatility of
prices. Reducing gasoline volatility
requires removing some of the lightest, most volatile components that make up
finished gasoline. To meet other
aspects of the specifications, some of the heaviest components must also be
removed. Removal of these components
effectively reduces the total volume of summer gasoline production capacity of
a typical refinery versus its winter capacity.
Thus,
in summer, supply is tighter when demand is typically highest. Under normal conditions, adequate refining
capacity exists, complemented by some imported gasoline, to meet peak
demand. But the entire system is closely arefully
balanced, and this balance is more sensitive to changes in summer
than in winter. A refinery or pipeline
disruption can quickly upset the balance in one or more regions of the country,
leading to price increases, which attract incremental supply. In winter, demand is lower and producibility
is higher, so a similar disruption has less overall impact, and a smaller price increase is
required tomake attract additional supply.
One
of the most difficult grades to refine is Phase 2 Reformulated Gasoline (RFG 2)
with ethanol, which has been used to supply the Chicago and Milwaukee areas
since the spring of 2000. Because
adding ethanol raises gasoline volatility, even more of the light components
must be removed from this grade than from others to allow the finished blend to
meet specifications. Initial
difficulties in refining RFG 2 with ethanol contributed to the supply
shortfalls and resultant price spikes in the Midwest in 2000. This was noted in the final FTC report on
its investigation into Midwest gasoline prices.6
The
FTC also noted as a factor the disputed Unocal patent on the most efficient
production method of for the unique gasoline blendstock needed for
ethanol reformulationintended . This fuel is known as Reformulated Blendstock for Oxygenate Blending
(RBOB). Because refiners were forced to
either pay Unocal high royalties or use a less efficient method of producing
RBOB, manufacturing costs went up and production went down. The FTC noted that two Midwest refiners
reported reduced RBOB
production capability as a result of the Unocal patents. In testimony to Congress, another refiner reported a significant
drop in RBOB production. Furthermore, at least one previous gasoline supplier to the Midwest
reportedly avoided that market in 2000 due to Unocal patent concerns.
Since 2000, ExxonMobil has taken specific steps to
increase our capacity to produce summer grades of fuel at a number of our
refineries, and we ship gasoline components from our Baton Rouge, Louisiana
refinery for finished blending at our Joliet, Illinois refinery, which serves
the challenging Midwest market. In
addition, the EPA's 2001 relaxation of the volatility specifications for RFG 2
with ethanol has increased our production capacity for this grade.
To
produce the many required grades of cleaner-burning gasoline and meet other
environmental requirements, the domestic refining and marketing industry
invested over $20 billion during the
1990's. The cost and complexity of
these upgrades undoubtedly contributed to the closure of over 50 smaller and
less efficient refineries. Even so,
overall refining capacity has continued to increase, by a total of about one
million barrels per day, as larger refineries with greater economies of scale
have expanded capacity. The net result
is that imports of finished products were essentially unchanged during the
1990's, even as demand continued to grow.7
This
prior expansion of refining capacity is being challenged, and further expansion
is being impeded, by retroactive and erroneous reinterpretation of New Source
Review (NSR) guidelines and regulations.
This retroactive reinterpretation has increased the number of projects
requiring time-consuming and costly review, creating a backlog and bottleneck,
thereby delaying even minor changes, including routine maintenance and
modifications intended to improve refining capacity, energy efficiency, and
environmental performance. NSR reforms
are needed to address the difficult and uncertain environment the current
interpretation creates for refiners.
The
effects on the domestic refining industry of various regulatory driven product
specification changes including reducing sulfur in gasoline and diesel fuel,
and removing MTBE from the gasoline pool, were assessed as part of the 2000
report by the National Petroleum Council (NPC) entitled "U.S. Petroleum Refining: Assuring the Adequacy and Availability
of Cleaner Fuels." In this
report, NPC concluded that these changes will be very expensive to refiners,
and difficult if not impossible to complete in the proposed time frame. In addition, they theywill lead to
less supply flexibility, and there is present an increased likelihood of localized
supply disruptions and the associated increase in price volatility.8
Boutique gasoline specifications also present
distribution challenges. Gasoline is
distributed by a complex system of pipelines, ships, barges, storage terminals,
and delivery trucks. In large part, the
system was designed and constructed many years ago, to handle a small number of
different products, not the complex array of fuels with differing specifications that exists
today. This added complexity has
limited the flexibility of the system and, in many cases, reduced the number of
alternate supply points available in the event of a disruption. Even so, the system works efficiently under
normal circumstances.
The
key role of the distribution system becomes evident upon examining the
configuration of industry refining capacity.
The Texas and Louisiana Gulf Coast region is home to approximately 44
percent of US refining capacity. But
demand in this region is only 16 percent of the US total. The rest of the demand is elsewhere,
requiring product distribution from this region to others, primarily by
pipeline shipment. The Northeast
contains about 12 percent of refining capacity, but comprises 37 percent of US
demand. Similarly, the Midwest has 24
percent of the refining capacity, but 30 percent of demand.9 As a result, the major consumption centers in
the Northeast and Midwest rely heavily on product distribution by pipeline to
meet the balance of their needs not provided by local refining capacity.
At
the local distribution level, numerous supply terminals are typically located
within reasonable distances of each other, especially near major metropolitan
centers. If one terminal experiences a
product shortage, other terminals in the area can often supply sufficient
product to meet the immediate need. For
example, a terminal may be temporarily unable to supply gasoline for any of a
number of reasons. If regulations
result in nearby terminals supplying gasoline of a different specification,
those terminals may be unable to assist in covering the shortfall. If this occurs, obtaining additional
supplies will be more costly, difficult, and time consuming.
The
problem is best illustrated by example.
The metropolitan Detroit, Michigan area requires a specific grade in the
summer, known as "7.8 RVP conventional" gasoline, which is more
stringent than that required in neighboring areas. When the Wolverine Pipeline experienced a disruption in early
2000, the ability to ship product to the Detroit area was significantly reduced
during the repair period. Since only a
few local terminals supplied this grade, the nearest major alternate source of
7.8 RVP gasoline was Pittsburgh, Pennsylvania.
Many tank trucks were dispatched to nearby terminals, and some to
Pittsburgh, to pick up gasoline. But
this did not fill the gap in supply to Detroit, for two reasons. First, at some terminals near Detroit,
trucks typically waited in line for five or six hours to get gasoline,
significantly reducing total delivery capacity of the fleet. Second, insufficient excess trucking
capacity was available to haul enough product from Pittsburgh due to the long
distance involved.
Due
to these factors, our cost of truck transportation to Detroit stations nearly
tripled, from a normal level of about 1.7 cents per gallon to approximately 4.5
cents per gallon. The Detroit situation
also had an impact on the Pittsburgh market.
In the Detroit area, prices rose because demand exceeded available
supply. The incremental demand from
Detroit created a potential supply shortfall in Pittsburgh, raising prices there
as well. As this example illustrates,
the lack of substitutable grades created by localize boutique specifications
can contribute to local or regional price volatility and significantly reduced
distribution capacity.
ExxonMobil
has taken a number of steps to address distribution issues. As mentioned in the FTC report on the
Midwest prices, market participants tend to respond quickly to any disruption
and take appropriate actions to restore balance between supply and demand.
To
help mitigate the effects of boutique fuels in the long term, ExxonMobil
proposes that the number of unique gasoline specifications be reduced,
increasing the flexibility of both refining and distribution and facilitating
interchangeability of supplies across geographies. The EPA Staff White Paper, issued in October, 200110, examined the boutique
fuels issue and reached similar conclusions about the impact of the current
specifications. The paper also proposed
several options for reducing the number of unique specifications while
maintaining or improving emissions performance of each area currently covered
by Federal, State, or local fuel programs.
Factors
Not Contributing to Price Volatility
The
number of recent petroleum industry mergers has become the focus of much
discussion. However, examination
reveals Midwest and West Coast refining and marketing profiles have not changed
significantly as a result of industry consolidation.
With
respect to refining, as of January 1, 1997, before most of the industry
consolidation occurred, the West Coast (from Washington to California) included
22 gasoline-producing refineries, owned by 14 companies. Five years later, those same 22 refineries
were owned by 12 companies. Applying the measure used
by both the Federal
tTrade Commission (FTC) and the Department of
Justice in their merger review process , West Coast gasoline refining reflects
the same "moderate" degree of concentration now as before these
mergers occurred.
A similar
picture emerges in the Midwest. As of January 1, 1997, the
Midwest included 27 gasoline-producing refineries, owned by 19 companies. After five years, there were 25 refineries owned by 18 companies. Using
the same measure,
refining in the Midwest was classified as "not concentrated" in
1997 and retains that classification
today.11
Regarding consolidation in gasoline marketing, the entry of the
hypermarkets and other new
competitors indicates increasing competition.
Forecasts predict further increases in market share for these new
participants at the expense of the so-called major brands. Thus, significant competition will continue
in these markets.
Recommendations
ExxonMobil
believes a number of steps can be taken to minimize the effects of market
disruptions and increase industry capacity.
We recommend the following:
§
Reduce the number of
boutique fuels, which will increase flexibility of refining and distribution,
thereby mitigating some price volatility effects without adversely impacting
the environment. The API five-fuel
proposal, put forth last summer, is a good starting point.
§
Coordinate the timing of
future specification changes , including those regarding
ultra low-sulfur diesel fuel, and removal
of MTBE from the gasoline pool. In
particular, appropriate sequencing of these changes with the current requirement to reduce sulfur in gasoline,
will minimize
overlap and facilitate the necessary investments.
§
Appropriately interpret
and enforce the New Source Review rules, which will enhance the industry's
ability to invest in the necessary upgrades to operate efficiently and achieve
incremental capacity increases while achieving the program's original
environmental objectives.
Mr. Chairman, thank you for the opportunity to comment. I would be happy to address any questions the Subcommittee may wish to ask.
* The FTC thoroughly investigated zone pricing
in its multi-year Western States Investigation and found no evidence that zone
pricing was inappropriate or illegal in any way.
1 U.S. Petroleum Refining:
Assuring the Adequacy and Affordability
of Cleaner Fuels; National Petroleum Council; June, 2000.
2 U.S.
Hypermart Petroleum Market Study; Energy Analysts International, Inc.
("EAI"); May, 2001.
3 Share of Market Database; Lundberg Survey;
December 2001.
4 Gasoline and the American People; Cambridge
Energy Research Associates (CERA); 2001
5 NYMEX Delivery Statistics; New York
Mercantile Exchange; April, 2002
6 Final Report: Midwest Gasoline Price
Investigation; Federal Trade Commission; April 29, 2001
7 NPC Study; June; 2000
8 Ibid.
9 2000 Petroleum Supply Annual; Energy
Information Agency (EIA)
10 Staff White Paper: Study of Unique Gasoline
Fuel Blends, Effects on Fuel Supply and Distribution, and Potential
Improvements; US Environmental Protection Agency (EPA); October, 2001
11 Oil & Gas Journal