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Monday, October 1, 2007

Putting a Bureaucrat in Your Tank: Gasoline Markets and Regulation

Government Regulation of Gasoline Has Created a Fragmented Market and Vulnerability to Price Spikes

If you run a barrel of crude oil through a still, the technique used by the earliest refineries and still a stage in modern refining, it separates into various fractions, including kerosene, gasoline, diesel, fuel oils, waxes, and asphalt. Without further processing, about 10 percent will be “straight run” gasoline. In the 1870s this 10 percent was a waste product from kerosene refineries, frequently dumped in streams because the explosive liquid had no known uses. John D. Rockefeller’s Standard Oil Co. unsuccessfully experimented with gasoline stoves, trying to create a market for gasoline. By 1910, however, the nation faced a gasoline shortage as demand from the growing number of automobiles outstripped refinery production. Market forces transformed gasoline from a useless byproduct into a valued commodity.

Responding to the increased demand, private entrepreneurs funded the development of cracking technology. This method of transforming one set of hydrocarbons into another increased the proportion of the most-valuable products. On average 100 barrels of crude yielded 75.2 barrels of kerosene and 10.3 barrels of gasoline in 1880. By 1940 those same 100 barrels of crude produced an average of 5.5 barrels of kerosene and more than 40 barrels of gasoline. An equally dramatic example of technological progress occurred in the early 1930s and 1940s. The development of higher-performance engines prompted growing demand for higher octane gasoline, kicking off what came to be known as the “octane race” among refiners in the 1930s. Then World War II created demands for large quantities of high-performance 100-octane aviation fuel. Millions of gallons a year of this fuel, which had only been produced in tiny quantities as a reference chemical at a cost of $25 per gallon in the 1930s, became available at a cost of just over 25 cents per gallon in the early 1940s.

As a result, gasoline has been the subject of multiple regulatory efforts since the early twentieth century. (What? You thought they might produce public acclaim for an industry that had turned a waste stream into a valuable commodity and then upgraded the quality and reduced the price of its products to fuel the war effort?) These regulations have severely distorted the market for gasoline, increasing costs for consumers and diverting investment into political maneuvering. The government meddling produced a transportation-fuel network that is dangerously fragmented and at risk from natural disasters, accidents, terrorist attacks, and just plain old stupidity. Even worse, each time the fragile nature of the gasoline market is exposed, the reaction in Washington and state capitals is to layer on yet more bureaucracy and regulations, worsening the problem.

Aside from comparatively lightly regulated periods in the 1920s, 1950s, and 1980s, American governments have rarely left the oil business alone. Politicians use four different, and often mutually contradictory, rationales for their interventions.

  • Antitrust. Since the Standard Oil litigation in the early twentieth century, politicians regularly invoke antitrust issues in support of claims that oil companies are conspiring against the public. When prices go up, you can be sure that politicians will call for antitrust investigations, windfall-profits taxes, and other measures to keep “greedy oil companies” from profiting “too much.”
  • Destructive competition. When prices go down, however, domestic oil producers suffer reduced revenue, and less-efficient refiners and retailers lose market share. This spurs calls for investigations into measures to stop “destructive competition.” The governors of Texas and Oklahoma declared martial law in the oil fields during the Great Depression as part of their efforts to stop unregulated “excessive” pumping. Creating an oil “industry code” to reduce competition was a key element in the New Deal. Later regulatory programs have been filled with exemptions and special treatment for “small” players in the energy business in an attempt to protect inefficient firms from the ravages of competition.
  • National security. From the time oil proved its worth as a naval fuel in World War I, the military has worried about adequate oil supplies. Domestically, national security concerns led to the creation of petroleum reserves after World War I (which later played a role in the Teapot Dome scandal) and these reserves have served as a fig leaf for import quotas and other restrictions on several occasions. You can count on the federal government to trot out national security as a justification almost every time it unveils a new subsidy or some other barrier to trade.
  • Environmental protection. Governments at all levels take a keen interest in fuel formulation, inclusion of renewable fuels, and the location and operation of refineries, terminals, and filling stations. Since the appearance of the modern environmental statutes in the early 1970s, federal, state, and local governments have increasingly involved themselves in gasoline markets on environmental grounds. The actual regulations and laws enacted in pursuit of these goals often do not advance the stated purpose, which frequently serves as convenient window-dressing for interest groups looking for favors. (The definitive source on energy markets through the 1980s remains Robert Bradley’s monumental 1996 study, Oil, Gas, and Government.) To see how these interventions have disrupted gasoline markets, let us consider three of the largest regulatory programs: the Mandatory Oil Import Program (MOIP), the 1970s era of price and allocation controls, and the current mishmash of “boutique” fuel requirements.


After World War II the refinery capacity built up to serve the military’s needs quickly refocused on producing gasoline for the booming domestic market. Freed from wartime scarcity and price controls, people bought cars and drove them, sending gasoline sales soaring. Many of the major oil companies invested heavily in developing new sources of crude oil in the Persian Gulf, Latin America, and elsewhere. These investments included construction of tanker fleets and oil terminals and acquisition of oil rights around the world. Production costs in the newly opened fields overseas were low enough that it was soon cheaper to import crude oil and refine it in U.S. refineries than it was to use domestic oil. As oil imports rose during the 1950s domestic producers and refiners who had not invested in access to the cheap foreign oil worried (correctly) that they were losing market share to foreign oil producers and the refiners who had made those investments.

Rather than playing catch-up in the marketplace, however, the disgruntled domestic oil producers and smaller and inland refiners headed to Washington, where they began a relentless lobbying campaign for restrictions on oil imports, citing the detrimental effects of competition from abroad and national-security concerns. At first the Eisenhower administration resisted the idea of quotas, then it experimented with “voluntary” quotas, but the administration ultimately gave in to the political pressure and created the Mandatory Oil Import Program. The program was in effect from 1959 to April 1973.

MOIP was simple in theory. Each refiner received a permit to import crude oil. The total number of barrels authorized was set below the amount that would have been imported in a free market. Refineries’ allocations of the permits started with a proportional share of this smaller total based on their prior level of imports, but these amounts were then adjusted in attempts to achieve various policy goals and reward particular interest groups. Crucially, every refinery got some permits, even if it had not imported any oil previously, and smaller refineries received a disproportionately large share of the permits. The permits were made tradable, making it possible for refiners that received permits, but did not need imported oil, to trade or sell them.

This system had five important effects. First, domestic oil producers got their reward as domestic crude prices were higher than they would have been in the absence of the quota system.

Second, because domestic prices were artificially above the world market price, the right to import the cheaper foreign crude granted by the permits became quite valuable.

Third, the major oil companies that had invested in tankers and terminals learned their lesson and shifted their investment dollars to lawyers and lobbyists who could find profits in the pages of the Federal Register. Within a few years they had learned to play the game well enough that they no longer opposed the MOIP.

Fourth, anyone who could slap together something that could pass as a refinery now had an incentive to do so, leading to a rapid expansion in the least expensive and least sophisticated refinery sector as new entrants built “teakettles” to get quotas. As a result U.S. refineries tended to lack the capacity to handle high-sulfur crudes, which have become an increasingly large proportion of the crude supply.

Finally, because independent ownership of refineries maximized quota allocations, consolidation in the industry was discouraged, leading to lower operating efficiency. (A group of refineries can often be operated more efficiently than an individual plant, because joint management allows operators to use equipment at one plant to prevent a bottleneck from developing at another.)

All that is bad enough, but the MOIP also proved to be a classic example of the unintended consequences of regulation. When the MOIP was enacted it allowed imports only under the permit system. Almost immediately, however, the Canadian government objected that limiting oil imports from Canadian oil fields through pipelines to refiners in the northern Great Plains was counterproductive. Not only would the limits hurt Canada, since the oil had no other export route, but the Canadians argued that it made no sense on national-security grounds to reduce imports from a loyal ally across a secure land pipeline. This argument proved persuasive and regulations exempted land imports.

When the exemption was granted, however, no one remembered to retract the permits that had been issued to the “Northern Tier” refiners. These refiners had no access to any other source of crude—there being no crude oil pipeline connection between Minnesota and the Dakotas and no port where tankers could unload Persian Gulf or Latin American oil. As a result, these refiners now found themselves with both access to the Canadian oil and valuable import permits that they physically could not use. So they sold and traded the permits to other refiners and pocketed the proceeds. On discovering the mistake, the federal government attempted to take back the permits. The “Northern Tier” refiners fought back with the aid of valuable allies like Minnesota Sen. Hubert Humphrey and succeeded in retaining what became known as the “double dip” for years.

That was just the first level of unintended consequences, however. Mexico soon came knocking on the State Department’s door, complaining of the special treatment Canadian oil was getting. True, Mexican oil was not imported via a land route, but wasn’t the Caribbean virtually as safe? And wasn’t Mexico vulnerable to communist subversion? Didn’t national security dictate that some accommodation be found for a key ally and neighbor?

To mollify Mexico, the State Department lawyers found what was termed a “crevice” in the MOIP regulations on overland imports launching the “Mexican Merry-Go-Round.” Tankers of Mexican crude sailed to Brownsville, Texas. The crude was unloaded into tank trucks, but remained outside the United States in the eyes of the law by being placed in customs bond, which prevented its transfer to Americans. The tank trucks were then driven across the border into Mexico, released from the customs bond, driven around a traffic circle, and then driven back into the United States, importing their cargo “by land.” The trucks returned to the port, and the oil was loaded into tankers headed to the east-coast refineries. Since the oil had entered the United States via a land route, it was eligible for exemption from the MOIP quotas. This strategy boosted Mexican exports to the United States from 7,000 barrels to 40,000 barrels per day.

The next complaint came from Venezuela, which pointed out that it too was an important Latin American ally and that there was a limited market for its heavy, sour crudes outside of U.S. refiners. An exemption for “resid,” or “residual fuel oil,” a minimally refined product, followed and industrial users in the northeastern United States began using Venezuelan resid largely because it was exempt from the quotas. The result was that the ratio of domestic resid production to resid imports fell from 1.42 before the MOIP to 0.46 during it, demonstrating a clear substitution of the foreign product for the domestic one. The exemption basis for the success of Venezuelan resid became clear when the end of the MOIP triggered a massive conversion to natural gas and distillate fuels by U.S. resid users.

Perhaps most ironically, it was the oil-rich countries’ concern over the impact of the MOIP on their ability to export to the United States that proved to be a key factor in spurring the formation of the organization now known as OPEC, surely one of the most counterproductive impacts of a policy in history.

Price and Allocation Controls

The proliferation of exemptions and special provisions by 1970 made the MOIP more of a sieve than an effective regulatory barrier, and the Nixon administration considered abolishing it. But Nixon was worried about energy prices as a factor in inflation, and the price controls imposed in August 1971 froze domestically produced and refined oil product prices. The price freeze had no impact on world prices, of course, and as these continued to rise, refiners dependent on crude imports were required to sell their products at a loss. The federal government continually modified the price controls, attempting to address the growing problems that this massive interference in the operation of the free market produced. Politics dictated the adjustments, however, with Nixon refusing to allow increases in politically sensitive commodities like home heating oil and gasoline. By 1973, when the Arab oil producers declared an embargo on shipments to the United States in retaliation for U.S. support for Israel in the Yom Kippur War, there had already been calls for a government allocation scheme to control crude supplies and distribution of refined products. A series of proposals created in response to these special-interest demands were cobbled together into a “response” to the oil embargo and passed as the Emergency Petroleum Allocation Act (EPAA) in 1973.

Not surprisingly the EPAA made the embargo’s impact worse. Mistaken assumptions that consumption patterns would not change and bad weather predictions, together with politically driven decisions about the appropriate product mix, left some regions awash in gasoline while shortages caused long lines elsewhere. But because the government dictated distribution patterns, the federal government ensured that areas with surplus gasoline could not send them to areas experiencing shortages and so exacerbated the initial misallocation problems.

Each misstep led to further expansions of controls—the Nixon administration even instituted a price freeze dubbed “Phase III1/2” to give the bureaucracy time to catch up on the flood of problems caused by Phases I to III.The crowning misstep in the program was Phase IV’s introduction of a distinction between new and old domestic oil supplies. Old supplies were price-controlled to prevent “windfall” profits; new ones were allowed higher prices to provide an incentive to expand supply. Of course, the distinction also meant that there was considerable money to be made if an oil well could be reclassified from “old” to “new,” and an industry sprang up doing exactly that.

The 1976 presidential campaign put pressure on both the new Ford administration and the Democratically controlled Congress to demonstrate that it had done something about energy issues. Desperate for a showpiece for voters, the administration and Congress produced the incoherent Energy Policy and Conservation Act (EPCA) of 1975, which managed to include both measures that would lead to price increases and others that would push prices down. Economic opinion of the EPCA was that it was “infinitely worse” than the prior programs because it left out the market-based quota-trading provisions of the MOIP and instead allowed transfers of quotas only at government-set prices.

The regulations issued under the EPCA granted entitlements to fuel to anyone with a refinery; energy analyst Daniel Yergin concluded in his massive history The Prize that “the result was the bringing out of mothballs any piece of ‘refining junk’ that could be found—leading to the return of hopelessly inefficient ‘tea kettle’ refineries of the kind that had not been seen since the flood of oil in the East Texas field in the early 1930s.” It also tilted allocations toward small refiners, ensuring that large refineries ran at less than maximum efficiency and so increased costs and rewarded the least efficient players in the market. Economists Kenneth Arrow and Joseph Kalt calculated in 1979 that the EPCA was worth $17 billion to special interests in 1979. The Carter administration began the move toward decontrol of oil prices, but these efforts were impeded by concerted special-interest pressures.

It took the election of Ronald Reagan to speed up the phase-out of energy price and allocation controls. The Reagan administration brought in a period of relatively relaxed regulation of energy markets, and the results confirmed what economists had predicted. The small, inefficient refineries set up to obtain quotas quickly closed (23 in 1981 alone), while refining technology improved as the more efficient refineries expanded capacity.

Boutique Fuels

When drivers fill up their tanks they rarely notice anything different about their gasoline whether they are in Denver or Detroit. But gasoline has evolved from the “straight run” distilled from crude by early refiners to a highly complex fuel whose characteristics vary widely from location to location. For example, fuels sold at higher altitudes (Denver) are less volatile than those sold in lower altitudes (Detroit). Many of these variations are the result of refiners adapting gasoline to optimize performance under different altitude and weather conditions. Gasoline retailers have also spent millions on advertising campaigns aimed at convincing drivers that there is a difference in the mixture of additives that should lead the buyer to prefer a “tiger in the tank” (Exxon) to “the detergent gasoline” (Mobil). (Of course, Exxon and Mobil then merged into ExxonMobil, presumably giving drivers a cleaner tiger in their tanks.)

Beginning with the mandate to remove octane-enhancing lead additives from gasoline in the 1970s, however, the federal, state, and local governments have exerted increasing control over the formulation of gasoline—in the name of improving environmental quality and increasing (you guessed it) national security by substituting locally produced ethanol for a portion of the gasoline. As the number of formulation requirements increased they came to be known as “boutique fuel requirements” because they made it impossible to sell gasoline formulated for Tucson in Phoenix.

There is no question that some measures can make gasolines burn cleaner. Removing lead octane enhancers from gasoline, for example, produced major environmental quality improvements, although the replacements for lead brought their own environmental problems. What is questionable is whether the particular mandates imposed by various regulators actually accomplish that goal and what the cost of splitting the gasoline market into an assortment of boutique markets is. And many of these mandates (particularly the use in the 1990s of MTBE and the current mania for ethanol) have little or no benefit and actually can be harmful to the environment.

Three things should make us worry about boutique-fuel mandates. First, by fragmenting markets, they are raising the cost of gasoline in the same ways as the 1970s allocation programs. The best statistical evidence suggests that they have increased prices in many instances, although EPA denies this. Second, limiting the sources for fuel for many regions to a small number of refineries set up to produce particular blends leaves those markets’ supplies vulnerable to refinery closures from accidents, natural disasters, and routine maintenance. Finally, boutique requirements reduce the availability of gasoline imports from foreign refineries. For example, European refineries produce more gasoline than is needed to satisfy European demand for gasoline (which is lower because of the much higher proportion of diesel-powered passenger cars in Europe). Because those refineries are primarily concerned with producing diesel for their home markets, however, the gasoline they make is not compatible with some U.S. fuel requirements. Since there are other buyers for this gasoline (like China), the refineries have little reason to make the large investments necessary to produce a U.S.-boutique fuel. But because U.S. refineries lack sufficient capacity to meet U.S. demand, any shift away from exports of European gasoline to the U.S. market will cause shortages and price hikes here.

Energy markets have demonstrated the power of private enterprise each time they have been permitted to function freely. A waste product, gasoline, became a valuable commodity, and production yields soared. Better engines required higher octane, and the quality of gasoline increased dramatically. But as this brief account describes, the American gasoline market has moved away from a national market and toward a series of fragmented regional markets. Further, domestic refining capacity is well below what a free market in gasoline would have produced in the absence of the pervasive government interference of the 1960s and 1970s. The combination leaves the market fragmented and vulnerable to price spikes caused by everything from hurricanes to refinery fires. If we want to fix gasoline markets, the first step is to take the bureaucrats out of the process.

  • Andrew P. Morriss is the D. Paul Jones, Jr. & Charlene A. Jones Chairholder in Law and Professor of Business at the University of Alabama. He is coeditor (with Roger E. Meiners and Pierre Desrochers) of Silent Spring at 50: The False Crises of Rachel Carson, forthcoming from the Cato Institute.