President Clinton has all but accused the oil industry of price fixing. The Federal Trade Commission is investigating gasoline refiners and retailers. Various members of Congress, as usual, are calling for hearings. And frustrated consumers are simply looking for some relief at the pump. There hasn't been this much agitation over gasoline prices since the OPEC oil embargo caused prices to double, to more than $20 a barrel, in late 1973 and early 1974.
So who's to blame? Democrats and consumer groups suspect the oil companies. Republicans and the industry are pointing fingers at the Environmental Protection Agency and recently implemented regulations on cleaner fuel. And of course, everybody is blaming OPEC.
Surprisingly, all these various accusations are correct--to a certain extent. Oil refiners failed to accumulate sufficient stocks of gasoline to meet the summer's peak demand. New clean-fuel regs definitely added to the per-gallon cost. And OPEC--with the help of other producers--has constrained the supply of crude, although as worldwide demand has increased since the beginning of the year, OPEC's grip has loosened. It was a fatal confluence of events, none of which by itself would have produced a national average price of $1.68 per gallon--a record before it is adjusted for inflation.
But one last element in the runup may be the least acknowledged: market psychology and expectations. Analysts say the markets for crude oil and gasoline are no different than those for equities. Prices are set by a combustible blend of speculation, greed, and fear. While supply and demand rules in the long run, the near-term price of unleaded gas has been set as much by bets of thousands of large and small market players. Says Shell Oil Co. Chairman and CEO Steven Miller: "The perception of future oil supply and demand has a lot to do with the current price."
Indeed, a failed bet made by refiners last winter that prices for crude oil and gasoline would be lower this spring has prompted much of the current market hysteria. Last December and January, as the price of crude hovered in the mid- to high 20s, refiners--already struggling to supplement insufficient heating-oil stocks--failed to build gasoline inventories to the levels necessary to meet the heightened demand of the summer's peak driving season. They thought that higher interest rates would take their toll on the U.S. economy and consumption. Then, as the biggest per capita consumer of oil lost its appetite, the price of crude would fall and they could stock their refineries for less.
Crude-oil futures prices seemed to support this scenario. But speculators also watched gasoline inventories, and they, too, made a bet--that the rush to stock up would drive crude prices higher. Prices never went below $25, which left refiners scurrying to find affordable supply. "Refiners weren't anticipating $30 oil this late in the game," says Howard Rennell, president of Windham Group, a New York-based oil broker. "When they came back into the market, they bid the price up further."
Despite the current nationwide panic, the price spike may dissolve as demand falls over the summer and refiners finish supplementing inventories. What is less likely to fade is the market's increasing volatility. The oil industry has adopted the same just-in-time approach as auto makers and retailers. Companies keep smaller stocks of crude oil and refined products. They no longer pay costly leases on fields they aren't ready to explore. And they don't drill production wells in fields when they don't need oil. So when demand leaps, they don't have much extra capacity.
The surprise this spring was the strength of the demand given the Federal Reserve Board's vigorous efforts to slow the economy. The Energy Dept. estimates that world demand will rise 1.8% this year and 2.5% in 2001, vs. 1.4% in 1999. "What all the calculations did not do was foresee the rebound in oil demand," says Daniel H. Yergin, chairman of Cambridge Energy Research Associates. "Few saw how buoyant the U.S. economy would be. And few expected a strong rebound in Asia so soon."
Meantime, refiners have hardly been scrambling to add capacity--for good reason. Until recently, gasoline prices had been totally uninspiring--particularly for a refining industry that returned less than 4% on capital in the decade of the 1990s, according to the American Petroleum Institute, an industry trade organization. That is less than half the average of the energy industry as a whole and well below the returns of the average Standard & Poor's 500-stock index company. On top of the lousy prices, refiners also had to invest as much as $90 billion to meet the new environmental requirements. The result: Gasoline production has increased only from 6.4 million barrels per day in 1984 to 8.5 million today. And now, even though gasoline demand has grown significantly, stocks of crude oil and gasoline are kept at around 500,000 barrels--down from the typical 800,000 barrels refiners would hold in the early 1980s.
The flash point for the U.S. crisis has been the Upper Midwest, where prices have topped $2.10 a gallon for regular unleaded in cities such as Detroit and Milwaukee, and more than $2.30 in Chicago. The region suffered two major pipeline outages since March and a refinery shutdown that further cut already constrained gasoline supplies--exactly the unexpected disruptions that just-in-time inventories cannot accommodate.
SHIRKERS. At the same time that refiners faced insufficient stocks, they also were wrestling with a new phase of reformulated gasolines, which took effect in about one-third of the nation beginning on June 1. But having known about these changes for years, why weren't they better prepared? "The industry helped us write [the regs]. They should have had enough time," says EPA Assistant Administrator Robert Perciasepe.
Refiners say implementing all of the new formulas proved more complex than expected. Here, some of the blame lies with the states. The mandate to make cleaner-burning reformulated gasoline originally came from Washington, but individual states have tinkered with the formulations to suit their own particular air-quality problems and political interests. Atlanta and Birmingham, Ala., for instance, have different gasoline standards than Jacksonville and Tampa, Fla. El Paso is required to sell a different formula than East Texas. Citgo Petroleum Corp., a major U.S. refiner, says it must provide nine different forms of gasoline in just the eastern half of the country to satisfy the various permutations.
The reformulated gasoline already costs more to produce. But refinery officials say it is no coincidence that the Midwest suffered the highest prices in an effort to try to meet the EPA standards. Many of those states, in a nod to their farm constituencies, encourage the use of corn-based ethanol as an additive. In many other areas of the country, refiners use a natural gas-based additive called MTBE. Ethanol creates problems, refiners say, because it is difficult to store and causes gasoline to evaporate more quickly. In addition, because of the difficulty of making this gasoline, refineries produce less of it than conventional blends, leading to supply shortages.
Environmental regulators and industry officials had anticipated that the new fuels would cost more: 5 cents to 8 cents per gallon was the original estimate. But that didn't include the market's reaction to a supply shortage. Indeed, in the Midwest, reformulated currently sells for an average of 16 cents more than conventional gasoline.
Further complicating matters was a suit won recently by Unocal Corp. supporting the company's claims that it held the patent on certain types of reformulated gasoline and was owed royalties from other refiners. As a result, refiners did everything they could to avoid using Unocal formulas, leading to additional costs and further shortages.
The trouble in the Midwest should have come as no surprise to gasoline consumers in California. After the state mandated its own special reformulated gasoline blend in March, 1996, the price of gasoline took off, jumping 30%, to $1.60 a gallon. Consumers were outraged. There were at least four separate state and federal investigations of California's gas prices, but no charges of improprieties were ever filed against the state's refiners. Capacity in the state is so tight that whenever there is a refinery outage, gasoline marketers must find out-of-state refiners who can meet California requirements.
PROFITS GALORE. But for the industry--though certainly not the consumer--there's a silver lining to all this. Thanks to higher oil prices and refining margins, analysts expect the average large oil company to double its earnings this year. In the second quarter, U.S. refining profits per barrel doubled from the levels of a year ago, to an average of $6.50 per barrel, one of the highest quarterly averages in a decade.
Of course, at these prices, oil companies and refineries are beginning to figure out ways to create more supply. Already, there is evidence that exploration and production spending is picking up. According to Lehman Brothers' mid-year E&P spending survey, as of May, companies are planning an 18.2% increase in worldwide E&P expenditures in 2000, vs. a 10.2% rise budgeted in December, 1999, when E&P budgets were originally put together. That 18.2% represents some $86.7 billion in spending, vs. $73.4 billion in 1999. And as of June 16, the U.S. rig count, at 871 actively drilling, had increased to its highest level since mid-May, 1998. That may be good news for the consumer. But in the meantime, better buy a compact to keep that sport-utility vehicle company.