Proof of Price Fixing at the Pump?

Last month, perhaps I was the bearer of bad news when I wrote Gas Prices Won't Go Down. A number of readers wrote in to point out that, "all of the gas stations in my town are selling at the same price -- that is proof of price fixing."

The local view
To test the theory, I decided to take a walk. My neighborhood is a perfect location for such a survey, since there are seven fuel outlets within a little over a mile, sporting brands like Chevron (NYSE:CVX), ConocoPhillips (NYSE:COP) -- the "76" brand, Royal Dutch Shell (NYSE:RDS-A), and Petroleos de Venezuela -- the "Citgo" brand. Here are the results, starting at the interstate and walking into a residential/commercial area:

I know what you're thinking: "I'm glad I don't live in his neighborhood."

Beyond that, the results show that it pays to compare prices. Driving one block from the interstate yields a discount of $0.08 per gallon for the same brand (No. 1 Chevron and No. 3 Chevron). Furthermore, shopping around provides a $0.10 per-gallon difference between the highest and lowest price (No. 5 Shell and No. 3 Chevron).

Of course, my mini-survey does nothing to disprove price fixing any more than reader comments that, "all the stations have the same price" proves price fixing. Let's take a look at the national picture instead.

The national view
The National Association of Convenience Stores (NACS) helps put the retail gasoline industry into perspective. Take a few moments to read "Who Sells Gasoline in the United States." Here are the relevant statistics from this document and other data on the NACS site:

• There are 168,987 fuel outlets total,
• 110,895 of which are convenience stores.
• 70% are owned by small businesses with 10 or fewer stores.
• 55% of convenience stores are one-store operations.
• 13% of stores are owned by companies with 500+ store operations.
• 2.6% of convenience stores are owned and operated by one of the major integrated oil companies.

So, if there are approximately 169,000 sites selling gasoline, owned by tens of thousands of small businesses, why does this price fixing myth persist? First, gasoline prices are more visible than almost anything else we buy. If you drive down the street, and everyone is charging $2.89/gallon, it looks like the retailers are in cahoots. However, back in 1998, when the same four outlets were all charging $0.89/gallon, were you complaining about the same conspiracy? Obviously, if stores are located within sight of each other, a store with a higher price needs to lower its price and match the price of its competitor, or motorists will simply cross the street.

Second, it seems as though power has been concentrated into the hands of a very small number of companies -- I call this the "They're putting Standard Oil back together" theory. From the street, this might appear plausible, as the top eight brands hang their banners on over 50% of fuel outlets. Going back to the statistics above, we see that only 2.6% of the outlets are owned by major oil companies, leaving most of the remainder in the hands of small businesses and independent oil companies like Valero Energy (NYSE:VLO).

What causes the high prices?
Looking at current prices, consumers can easily believe that the retail outlets must be raking in profits. Unfortunately, these small business owners are not profiting from high prices -- the prices are high because wholesale gasoline prices are high.

In his May 11, 2006 testimony (link opens PDF file) to the House Committee on Energy and Commerce, Paul Reid, president of Reid Petroleum, representing NACS and The Society of Independent Gasoline Marketers of America (SIGMA), outlined the major factors leading to the current high prices. According to Mr. Reid, the usual suspects are to blame.

First, the fact that crude oil sells at above $70/barrel accounts for more than 50% of the current gasoline price. Beyond that, boutique fuel regulations have limited flexibility of supply. Low-sulfur fuel regulations result in lower gasoline yields from the refining process. Plus, European refiners do not produce low-sulfur fuels, blocking a potential source of imports.

Perhaps more troubling are state and federal mandates to use ethanol, combined with federal tariffs on imported ethanol. Because of this mandated demand for ethanol, wholesale ethanol prices have doubled in the past year. Ethanol currently sells for $0.50/gallon more than wholesale gasoline. Ethanol tariffs prevent imported ethanol from entering the market, which could meet our demand and reduce price volatility. Furthermore, in areas where reformulated gasoline is required, MTBE is being replaced by ethanol to create cleaner-burning fuels. Removal of MTBE further reduces fuel supplies by roughly 2%.

Conclusions
First, it should be obvious that the local gas station is not where prices are being set. Convenience store operators make a small profit on fuel sales, typically around $0.12 per gallon -- resulting in a 4% gross margin at current prices. These companies stay in business through merchandise sales inside the store, where gross margins are closer to 30%.

The bad news is that nothing will happen overnight to drop the prices at the pump. No one holds a valve that can flood the crude oil market and send prices plummeting. Refinery expansions take several years and billions of dollars. The Environmental Protection Agency (EPA) is not going to abandon clean-air regulations that Americans have long supported. Ethanol supplies also require long lead times and massive capital expenditures.

The good news for consumers is that most of these factors are being addressed. Oil companies have announced expansion projects that will increase refining capacity by a total of 1.3 million barrels per day by 2011. The EPA seems to recognize the logistics problems presented by boutique fuel standards, and discussion is under way to identify a balance between fuel supply and local air pollution. Crude oil supplies remain the wild card, with many tumultuous oil-producing regions (e.g., Iraq, Nigeria) creating an uncertain supply environment in the face of rising global demand.

For more petro-political Foolishness:

• Don't Invest Like the President
• Congress Is a Joke
• Gas Prices Won't Go Down

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Fool contributor Robert Aronen owns no shares of any company mentioned. Feel free to share your comments with him. The Motley Fool has a disclosure policy.