Jeremy Bulow: What Causes Gasoline Price Spikes?

Production factors and local regulations — not political conspiracies — cause price fluctuations at the pump.

August 01, 2002

| by Lisa Eunson

Ah, sweet summer time: Long, balmy evenings, kids playing in the pool, and spikes in the price of gas. Although such price jumps may have a modest impact on an overall household budget, they get our attention because we buy gas on average twice a week, and buy more gas in the summer for vacation travel. Crude oil, refining, and shipping costs affect the price of gas. Pump rates also vary by short-term factors such as refinery and pipeline outages, and state and local regulations on shipping and zoning.

“Gasoline prices are sharply etched into consumers’ minds, more so than possibly any other consumer product,” according to Stanford Graduate School of Business economist Jeremy Bulow. When gas prices spiked in the Midwest in the spring of 2000, with the presidential election in full swing and political fingers pointing at either the potential for market collusion or the lack of market incentives as the culprits, Congress demanded an investigation by the Federal Trade Commission. The FTC report, a compromise between the lawyers and economists on the commission, did not tell the whole story. “The economists felt it was an inaccurate portrayal of what had happened, and so it prompted us to put out a paper,” says Bulow, who was Chief Economist on the FTC during the Clinton administration.

Bulow, the Richard A. Stepp Professor of Economics at the Graduate School of Business, with Jeffrey H. Fischer, Jay S. Creswell, Jr., and Christopher T. Taylor, economist colleagues from the FTC, concluded that the oil companies responded as quickly as was logistically possible to correct this price spike. This Midwest event was caused by a combination of complex factors, many of which will inevitably cause future rate hikes. “Refiners are producing at a very high percentage of capacity these days. When there is a supply disruption, we will have a price spike,” Bulow says. There is no excess fuel production from which to draw. Complicating the supply side are the “boutique fuel” regulations concerning fuel additives, which vary by region. The gasoline in Chicago is different from the gasoline in Detroit, and even from the gasoline in the suburbs of Chicago. It takes two weeks to refine a specific formulation of gasoline, and several more weeks to ship it to a specific market. If the entire country were using the same kind of gasoline, it would speed the availability of fuel to any area facing a shortage and keep prices more level.

In a recent interview, Bulow pointed out that last year the American Petroleum Institute and the American Lung Association made a joint proposal to change the reformulated gas rules in the United States. “They made the point that with the changes in gasoline technology, we could produce an environmentally superior gasoline without any additives like ethanol. The ethanol lobby managed to quickly defeat this proposal.” Ethanol is made from corn; but Bulow does not think the price of corn is much affected by the production of ethanol. “The people who have ethanol processing facilities, like Archer Daniels Midland, are the primary beneficiaries of these rules; Congress has recently exacerbated this by passing rules to triple the amount of ethanol in gasoline,” Bulow said.

Another factor in gasoline pricing is local and regional regulations. For example, in California, which has its own specific gas formulation, when there is a refinery outage, gasoline can be shipped in from another U.S. location only in something called a “Jones Act Vessel,” a boat built in, crewed by, and flying under the flag of the United States. This means it costs as much to ship fuel from Louisiana to California as from Norway to California. The price of gas in the San Francisco area is significantly higher than in Los Angeles because of the price of real estate and limits on certain local permits. Bulow says, “In LA, gas stations are attached to profitable convenience stores, so gasoline can become a loss leader. In San Francisco, you can only get a permit for having a service station, so in order to sell gasoline you also need to have a mechanic on duty during all business hours and some service facilities.”

Bulow notes that the consequence of such regulations almost always will be higher gasoline prices. “It’s a reasonable choice to make, but we have to understand we are making that choice. The thing that aggravates me more is this business about the boutique fuels. If it is environmentally better to adopt something like the API/ALA proposal, the fact that the political process is preventing that bothers me.”

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