The Katrina Syndrome: Big Oil's Interest in Tight Markets

by Judy Dugan and Tim Hamilton

The U.S. oil industry’s refining profits remain at record or near-record levels. Two consecutive years of soaring prices in the spring and summer of 2006 and 2007 have equaled the price effects of 2005’s Hurricane Katrina, without any natural disaster.

What is starkly apparent is that while rising prices of crude oil lead to gas price hikes, the price at the pump in the United States no longer follows downward changes in the price of crude oil.

Oil companies and their refineries have failed to raise gasoline inventories during the off-season. Longer than usual maintenance shutdowns, mechanical failures, fires and other incidents also spiked gasoline prices and compounded the effects of the lack of inventory. These events disconnected the price of gasoline from the price of crude oil.

The oil industry sets and controls the inventory of refined products in the United States without active government oversight. Absent collusion between individual refineries, antitrust and other laws protecting consumers do not typically apply to the inventory practices of the industry. The lack of a competitive market means that “market forces” do not operate to correct refineries’ profit-taking.

The Crude/Gasoline Divide

The price of crude oil set record highs in the summer of 2006. In July, the U.S. benchmark West Texas Intermediate (WTI) set a new record averaging $74.41 per barrel, or $1.77 per gallon, of crude oil. Likewise, the monthly average retail price of regular unleaded gasoline in the United States that month was a record-breaking $2.98.

The price of crude oil began to decline in fall 2006. By January 2007, the average monthly spot market price of WTI dropped almost $20.00 per barrel to $54.51, a 27 percent reduction. Per gallon, crude oil dropped 47 cents to $1.30. During the entire first quarter of 2007, crude oil prices were down $5.24 per barrel on average from the same quarter of the previous year.

As the price of crude oil declined at the end of summer in 2006, the monthly average price at the pump initially started down in a similar fashion. The average retail price of regular unleaded gasoline in the United States fell from $2.95 per gallon in August to $2.23 in November 2006, and remained relatively stable through February 2007, when it averaged $2.28 nationally.

If, as the oil industry often claims, pump prices generally track the price of crude oil, motorists would have expected the stable prices at the pump seen in the winter of 2006-2007 to continue into the spring with crude prices creeping up 7 percent from February ($1.41 per gallon of crude) to May ($1.51 per gallon). If gas prices followed the crude oil trend into the spring, drivers across the country might have seen pump prices increase from $2.28 per gallon in February to $2.44 per gallon in May. Instead, national pump prices skyrocketed to $3.15 in May, a staggering 87 cents per gallon, or 38 percent increase, during this period when crude prices rose only 7 percent.

Comparing May 2006 data with May 2007 further illustrates the fallacy that pump prices are primarily tied to crude oil prices. Crude prices, above $70 per barrel, or $1.69 per gallon, in May of 2006, fell by 18 cents per gallon by May 2007. On the other hand, the pump price of refined gasoline in the United States rose by 24 cents per gallon from May 2006 to May 2007. This 42 cent increase in the difference between crude oil and gasoline pump prices was primarily captured by the industry as record-high refinery margins — as high as $39 a barrel, according to the San Francisco Chronicle.

Discretionary Inventory

Since regulatory decontrol of the refining industry in the 1980s, the industry has basically set fuel production rates and inventory levels at its discretion.

Historically, the industry refined more gasoline and diesel during the winter than was sold at the pump, and the large storage tanks at truck loading terminals filled up. When consumption increased in the spring and summer, the predictable increase in demand was served without a price spike by using fuel inventory built up in the tanks during the winter. Inventory was also adequate to largely compensate for unexpected disruptions, mechanical or weather-related, at refineries.

The industry has in the last few years lowered gasoline inventory levels in the winter and early spring. Inventory levels are drawn down as the industry chooses to “run off the bottom of the tanks.”

The oil industry is fully aware that lower levels of inventory set the stage for gasoline price spikes in the event consumption increases or production somehow decreases, especially during peak demand periods.

In April 2007, gasoline inventories controlled by the industry were dramatically lower than in either of the two previous years. The drop from 2005 to 2007 was 9.6 percent. With the supply of gasoline provided by the industry dropping below the level needed to fulfill demand, prices spiked to another record high.

Maintenance Economics

The companies owning refineries have significant discretionary control over how much gasoline is refined each year.

In the long term, companies decide whether to build or upgrade production capacity.

In the short term, they decide how and when to conduct planned maintenance or “turnarounds” that limit production. Finally, during periods of normal operation, companies use their discretion to limit or increase the flow of crude into the refinery and the volume of gasoline and other refined products coming out to storage terminals. Pipeline breaks, fires and nature-related problems also occur, and their effect is related to the age and maintenance of refineries, both of which are under the companies’ control.

In recent years, the industry has blamed unplanned refinery outages that would have gone unnoticed in earlier years as the causes of gasoline price spikes. But these outages have such an impact only because of the companies’ decisions not to maintain supplies sufficient to compensate for refinery downtime.

A review of the refined gasoline inventory in the U.S. West in Spring 2007 provides a stark insight into the industry’s ability to utilize discretionary decisions in refinery operations to affect the availability of supply. >From 2005 to 2007, gasoline inventory fell 13.5 percent.

In Fall 2006, refinery utilization fell to 87.1 percent of capacity, down from 93.7 percent the previous year. In the first quarter of 2007 utilization fell to 81.8 percent of the region’s potential, down from 89.3 percent at the beginning of 2006.

These largely discretionary cutbacks rival those caused by Hurricane Katrina. In the fourth quarter of 2005, the Energy Information Agency reported the average monthly Gulf region refinery utilization was down to 79.3 percent. The industry’s 81.8 percent utilization rate in the West at the beginning of 2007 was thus nearly equivalent to the utilization rate in the wake of Hurricane Katrina, arguably the worst natural disaster in the history of the oil industry in the United States. As a result, gasoline prices spiked even higher than after Katrina.

The Diesel Counter-Example

Since gasoline and diesel are both motor fuels and refined from the same barrel of oil in the same refinery, tracking the price of each and the inventory levels for each fuel provides insight into the impact of inventory levels for each finished product.

The inventory levels of gasoline in the United States and especially the West were drawn down in early Spring 2007. Subsequently, pump prices spiked dramatically. At the same time, diesel inventories were substantially higher in 2007 in the West than the levels of the previous two years. The price of diesel, backed up by adequate inventory levels, did not spike nearly as high in the West as gasoline.

From January to May 2007, the average price of crude oil increased approximately 21 cents per gallon. During the same period, the average monthly price of diesel in California increased 16 cents per gallon and unleaded gasoline in California increased nearly 87 cents. While both came from the same barrel of oil, gasoline spiked 71 cents per gallon higher than diesel.

(In January 2006, diesel inventories were low as the industry retooled U.S. refineries to produce ultra-low sulphur diesel without building inventory beforehand. As a result, in 2006 diesel in many areas of the United States often sold at a much higher pump price than gasoline.)

The difference in cost between crude oil and a gallon of fuel, the best indicator of refinery profits, showed a nearly 43-cent spread between gasoline and diesel in April. If regular gasoline prices had stayed closer to diesel prices in the entire first six months of 2007, California motorists would have spent $1 billion less in those months — about $170 million per month in savings.

The Lessons of Katrina

Oil industry data shows that price spikes faced by motorists are not tied or even much related to the price of crude oil. Instead, oil refiners have learned a lesson from Hurricane Katrina, which temporarily hampered gasoline refining in its wake. Companies learned that by reducing the refined gasoline they produce, they can dramatically push up price. Which, as the data shows, is exactly what led up to the massive spring price hikes faced all around the United States in 2007.

Without new state or federal oversight of oil industry refining practices and the regulation of gasoline supplies, consumers can expect dramatic price spikes to be an annual event, with higher prices lingering through summer.

Judy Dugan is research director of the Santa Monica, California-based Foundation for Taxpayer and Consumer Rights and OilWatchdog.org. Tim Hamilton is an independent oil industry analyst in McCleary, Washington.