Monday, May 01, 2006

Gas Prices and Petroleum Distribution in North America

Everyone is talking about gas prices these days, so I thought I'd explain what I know about the petroleum industry since I work in the petroleum industry. (Before you start sending me hate mail, my company sells accounting software to oil jobbers and I train those jobbers. Don't blame me for the price of gas! I'm as far removed from the executives at Exxon as a Dell tech support person is from Bill Gates.)

Crude Oil and the World Market

Petroleum companies in the U.S. have announced record profits. They claim that this is not from gouging customers but from petroleum sales on the open oil market. I tend to believe them. There is a profit to be made on fuel sales, to be sure, but it is nowhere near as large as people believe.

Crude oil is sold on the open market. Corporations and nations purchase crude oil on the market. The oil is refined into fuels, lubricants, and other petroleum products. This is an open market, based on supply and demand. If the nations of the world use a lot of fuel and there is a limit to how much oil is available, the oil producers can ask more money for it. Oil prices are also dependent on what's happening in the world geopolitically. If a war is in the offing, more fuel will be needed. If things are relatively stable and the supply of oil is not likely to be disrupted, there is less reason for companies and nations to stockpile. Also, if the world economy is about to take an economic downturn, less fuel will be used, so the price will drop.

We think of the Middle East as the big oil producers. There are about 68 countries that produce crude oil, but only 10 of those are in the Persian Gulf. Persian Gulf oil is of a high grade and they produce more per nation than anywhere else in the world (so far) but the production of crude from all other sources is greater. The Organization of Petroleum Exporting Countries (OPEC) is heavily influenced by Persian Gulf states (though it also includes Algeria, Indonesia and Venezuela). We hear a lot of rhetoric about OPEC controlling the price of crude, but actually they have little say right now. OPEC likes to have the minimum and maximum costs in a certain range, to dissuade conservation efforts and to make certain competitive oils (like oil extracted from Canada's tar sands) economically unviable. They don't have as much influence right now as they used to, because OPEC nations let their excess capacity slip in the '90s when prices were low, and are now trying to play catch-up. Yeah, they are making money hand over fist, but they fear gasoline prices will accelerate the use of alternative energy sources.

So, when Exxon said it made most of its profit based on the price of crude oil and market demands, they are probably stating the truth.

These corporations have to purchase oil for refining. The exploration and extraction business isn't just going to give the oil to the same company's refineries for free when they could sell it to other companies for refining at $70+ a barrel. Even though they are raking in huge profits from selling oil to refineries, they aren't cutting their own refineries any slack, nor are they passing on their oil sale profits to the consumer via lower fuel prices.

For an interesting article on international oil pricing, see this Wikipedia article.

Refining Oil

Crude oil is converted into fuels in refineries through a distillation method. They heat crude oil until it boils into a vapor, and then they push it into the bottom of a "fractioning column". This is a tall column with cool plates. Oil is a hydrocarbon, meaning its molecules are made of chains of hydrogen and carbon molecules. As the petroleum vapor rises, the longer chains are heavier and cool on the lower plates. The lighter "petroleum distillates" (like gasoline) cool on the upper plates. It's possible to take a heavier distillate, like diesel oil, and run it through the process additional times to get gasoline out of it. This is why we sometimes see gasoline prices drop after a particularly warm winter. Refineries will process home heating oil into gasoline (which is easier to sell), thus creating a spike in supply.

Fuel Terminals

Once the petroleum products are refined, they are put in large containers. In North America fuels like gasoline, diesel, and kerosene are taken from these containers and shipped off to terminals. (These are not to be confused with the big terminals at refineries where crude oil is offloaded from supertankers.) Fuel terminals receive their fuel usually through a pipeline but sometimes through other methods. On the Mississippi River, for instance, huge barges deliver fuel to terminals.

The terminal is where the fuel is picked up by tanker trucks. The terminals are often owned by the oil companies, but there are also independent dealers. I believe that there are terminals that are independently owned and operated, though they are affiliated with a particular brand. Several different companies might have terminals in the same place because it makes sense to share the pipeline infrastructure. Some terminals even sell different brands of fuel.

The fuel pumped into the terminal can be from any of the refineries, at least in North America. The refineries put it into the pipeline, and the terminals pump it out without much care as to who refined the fuel. Exxon gasoline may be from oil extracted by Shell and refined by Citgo. The fuel from the refineries are all of about equal quality. What makes an Exxon gasoline "Exxon" are the additives. Each company adds stuff to their gasoline in order to make it more efficient, or make your engine cleaner, or help with fuel lines freezing in the winter. These additives are added at the terminal. Until that point, there is no difference between Exxon, Shell, Petro-Canada, Chevron, etc. gasoline. When you buy branded gasoline you are actually buying generic gasoline mixed with branded additives.

The Oil Jobber

Our company sells software to oil jobbers. Most of our clients deliver fuel to gas stations and other companies (such as construction companies, airlines, and, oh, chicken farms... well, how do you think they kept those places warm? electricity? please!). Some oil jobbers deal only in lubricants, thus they only sell lubricating oils and greases. Most deal in fuel to some degree. Some jobbers will deliver the fuel themselves, while others will simply handle the administration of moving fuel from a terminal to a station, using a freight company to haul the liquid.

Oil jobbers exist because there are economies of scale in purchasing full transport loads of fuel. Most gas stations simply couldn't afford to keep a driver on staff and a truck in good repair (not to mention all the regulatory paperwork needed to haul volatile liquids, and the necessary insurance), so they hire another company to get them the fuel. Insurance liability alone is driving some jobbers to hire outside trucking companies to deliver the fuel for them.

The Gas Station

The gas station is where you get your fuel, ah, d'uh! What you may not know is who owns the gas station and who owns the gas in the station. Some gas stations are owned by oil companies, but most are franchise stores. In the past, oil jobbers owned a lot of gas stations. This is falling by the wayside; a lot of oil jobbers are getting out of the service station market. There isn't much profit to be made on gasoline, so stations have to be managed by someone who knows how to use gasoline to drive in-store sales. This is a lot of work for most jobbers. Many have concluded that it is best to sell off their stations in favour of concentrating on the distribution end of things.

Branded gas stations (Chevron, Petro-Canada, Exxon, Esso Canada, etc.) sell branded gasoline, the stuff with the additives. (They also sell branded diesel, though gasoline is where the big branding effort comes in. Trucking companies are even more price sensitive than consumers.) Discount stations sell unbranded gasoline (without the additives). Whether or not the branded gas is better than the unbranded gas is open to conjecture. Some people swear that there is a difference. Some people swear that there is no difference. Some folks swear they can detect a difference between individual brands, but I personally haven't seen it.

Now I have heard that there is a big difference between cut-rate stores and branded stores with regard to filtering water. Gasoline and diesel are less dense than water, so they float on water. Since fuel is pumped from the bottom of a tank, any water that seeps into a tank will be on the bottom. The pumping equipment has filters to catch the muck at the bottom of the tank and to catch any water in the liquid. I've heard anecdotal evidence that Wal-Mart and several of the discount chains do a worse job of filtering the water than branded stores. I've heard it enough that I suspect it might be true. The only really bad fuel problem I heard about was when a truck driver accidentally filled a gasoline tank with diesel, and that was at a branded station.

The gasoline in the service station may belong to the gas station, but in many cases it does not. It may be owned by the oil jobber, who sells it through the gas station on a consignment basis. In this case they will give the gas station a commission on the sale.

Gasoline Price Volatility

Gas prices are usually the same among all branded stations in a given area. This is because gasoline has virtually no product differentiation. You could argue that the branded stuff is a higher quality due to additives and better filtering. Even so, there's often less three cents per gallon difference between branded and unbranded fuel. The biggest reason for people to go to a specific brand is because of easy credit via a gas station credit card. Other than that, the deciding choice is usually location and a preference for the attached convenience store.

Gas stations have to pretty much sell gas for the same price as their competitors. If they go lower, they run the risk of a gas war where no one wins (except the consumer). It's a fundamental problem with gasoline that you simply won't buy it for even a fraction of a cent higher at one station than another if the two stations are equally convenient. That's why gas in a single area tends to be the same price.

Many people think that's collusion, that the gas companies are conspiring to keep the price fixed among themselves. That's not true. The gas station has to sell it for the same price as the guy across the road (assuming they are both branded or both unbranded), because otherwise people will buy from the cheaper price and ignore the expensive price. That should mean that gas stations are making the lowest possible profit they can. Well, they do, in a given area. I've seen the prices between what a gas station buys the fuel for and what they sell it for. In some cases gas stations are making US$0.01 a gallon. Some cases they will make as much as $0.04 or $0.06 a gallon. Those higher amounts are usually commissions for selling gas on commission for an oil jobber, and often at the higher ranges the jobber is making less profit. This is because the jobber sets the street price of their fuel, which often has to conform with everyone else's street price.

At a cent a gallon profit, buying $30 of gas at $3 per gallon means you've just given the gas station 10 cents. That's not all profit, either. The overhead of an attendant, electricity, building maintenance, lawn care, etc. all comes out of that 10 cents. Don't yell at the gas station attendant for the price of gasoline. The station is often losing money on you unless you walk into the store and buy a candy bar or something.

Oil jobbers make a profit selling gasoline. It's not a windfall by any means. Several of our clients are doing quite well, but they are doing "quite well" in the same way as any small company, be they a printing company, a bakery, a plumbing company, or any number of small businesses. This is a capitalist country. Making a profit is a good thing. Oil jobbers are usually comfortable, but they are not getting rich from the profits. There are big jobbers, but the smaller ones are running at about 5 to 25 employees. They aren't the reason prices are so high.

Jobbers can eke out a profit by making their job as efficient as possible. This involves finding the cheapest fuel to purchase. Fuel is not sold at the same rate at each terminal. In fact, there can be some vast differences in prices at the terminals ("vast" in this case meaning three to five cents a gallon). The jobber has to balance the cost of the product and the shipping cost from one terminal to another. This is one reason gas can be different prices in the same general area. One city may be more accessible from one terminal versus another. One terminal may run out of fuel that day (it happens, and it was a major problem in Louisiana during Katrina's and Rita's aftermaths; one local company was buying gas from North Carolina!), forcing the jobber to buy it at a more distant location. Even if the more distant terminal sells gas for the same price as a closer terminal, the cost of the gas will be higher due to the cost of running the truck to haul the gasoline.

Unbranded stores will drive the price down, particularly if it's a huge store like Wal-Mart. Wal-Mart uses gasoline as a "loss leader". In other words, they don't care if the gas station loses money, as they know statistically that having a gas station increases in store sales by X amount. They cheat because they will flagrantly flaunt certain restrictions. For instance, most Wal-Mart stations are owned by Murphy Oil, a refining company. They run the stations because it gets around a number of regulations, employee and tax issues that would be pretty severe if the station was officially part of Wal-Mart. In Louisiana there is a law about gas stations needing restrooms (I'm not sure what happens if they don't comply). The Murphy Oil stations at Wal-Mart don't have restrooms. The attendants point to the "Wal-Mart" sign on the station and then point to the Wal-Mart store, saying, "The restrooms are in there." So on one hand Wal-Mart says the gas station is separate from the store, and on the other hand the gas station will say it is not separate from the store.

At any rate, since Wal-Mart is seen as selling higher quality gasoline than Spirit, Patriot or Kangaroo (a belief that is frequently wrong), stations near Wal-Mart have to sell their prices for less than they'd really like to. This pushes prices in those areas down a little bit.

Sometimes branded gasoline is cheaper than unbranded. After Katrina it became hard to get fuel. For that reason, the oil companies and their terminals made sure that they could sell as much branded fuel as possible. Since the supply of branded fuel was greater than unbranded (because the terminals sold branded fuel as a priority), the unbranded stations had to fight for what was available, driving up their prices.

The fuel terminals charge prices based on a number of factors, including the price they are charged for the fuel from the refineries, their own overhead, and the amount of profit they want to make. Prices can vary quite wildly from one terminal to another. The prices are not uniform over the range of products, either. One terminal may be cheaper for gasoline while another terminal is cheaper for diesel. Not all terminals carry the same products. Most carry at least two grades of gasoline (regular and super/premium) and at least one grade of diesel (low sulfur clear). Most that sell diesel will also carry dyed diesel, the diesel that is only legal for off road use (there are tax rebates for farmers and construction companies, allowing them to use diesel with red dye in it). Not all terminals sell the cheaper, dirtier high sulfur dyed diesel, and not all terminals sell kerosene.

Price Summary

You'll see that the oil companies have managed to effectively insulate themselves from any charges of collusion. Crude is traded on the open market. I don't know how much fuel terminals pay the refineries, but the terminals themselves do not have identical rates, suggesting that the terminals are competing in a free market. Oil jobbers hide what they charge their customers because competition is pretty fierce. Prices are the same among gas stations in a particular area, but that's because there's no price differentiation and they are probably as cheap as they can go given how much they are charged.

Gas stations make very little money on fuel, even to the point of losing money on it.

Oil jobbers are making a profit, but it's not an unreasonable profit. They can make a fair bit of extra profit when prices are voluntary and trending upward (they know the prices a couple of hours before they go into effect, so they can buy cheap and sell the gas the next day at that day's prices). They have problems when the price goes down. None of the jobbers I've seen are particularly rich or anything, so that's not where the money goes. Some jobbers are having trouble keeping a float because the stations they sell to are collapsing; this is particularly true in rural areas.

I don't know how much fuel terminals make as profit, but it doesn't seem like people are getting rich there, either. Gasoline and diesel fuel are all the same once it gets into the pipeline, so there's probably little price differentiation for the actual product. There could be differences in price for the additives, but I suspect there isn't much of a difference. The amount of money stations make varies little by brand.

We're pretty much at the mercy of whatever price the refineries put on gasoline. As long as they peg that to the price of crude oil (more or less), they can't be accused of price gouging.

What You Can Do About It

This isn't the answer people want to hear. They want to know what they can do about it. I've heard of one-day boycotts on buying gas. That won't work. Even if people could organize, it would only hurt the local gas station owner. Put them out of business and you'll have less competition, not more, and less incentive for companies to drop prices.

E-mails have suggested boycotting Exxon-Mobil, as the largest publicly traded oil and gas company in the world. There's a town in Texas doing just that. Sorry, it won't work. As I outlined above, Exxon puts its gas into the mix with everyone else. They will still make obscene billions of dollars profit from crude sales and from the gasoline that goes into the pipeline, even if not a drop flows through their own stations. Sure, they'll lose money from the lack of sales of their branded gasoline (basically, from the sale of the additives) and from no one using their credit cards. Their gas will still sell through other stations, and since there would be less competition there is less incentive to lower the prices. Oh, and it assumes that people would be willing to act in concert based on an e-mail.

There is nothing the average person can do to lower the price of gas. All you can do is use less of it. It's not even guaranteed that reducing fuel usage will drop the price, as lowered demand for gasoline in the U.S. could be offset by higher demand elsewhere. At least you would pay less for fuel.

Get used to higher gas prices. Write letters to your local politician telling them that more money has to go to alternative fuel source research. If you are an American, tell them that the increased fuel efficiency standards for SUVs through 2010 is paltry and that more stringent requirements are necessary. When you are in the market for a car, tell the car salesman that you want to see models that get 30 miles per gallon in the city minimum, and walk away if he can't do that. Don't drive so much. Car pool. Cycle or walk. You know the drill.

Oh, and hunker down as best you can. High gas prices will increase inflation. Since we poor sods in the trenches are actually worse off today than three years ago we will spend less on other things as we buy gas to get to work. That will push forward the next recession, which will be exacerbated by a president who cut taxes to the rich in a time of war. I'm sure similar stupidity has happened, or will happen, elsewhere. Make politicians accountable.

Finally, write your version of the above paragraph to your local politician. Tell them that this is the reason you're not voting for them. The only way politicians will help you is if you threaten their chance of re-election.

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