RECORD PRICES, RECORD OIL COMPANY PROFITS THE FAILURE OF ANTITRUST ENFORCEMENT TO PROTECT AMERICAN ENERGY CONSUMERS

DR. MARK COOPER

SEPTEMBER 2004

Contents EXECUTIVE SUMMARY ................................................................................ 1 RECORD PRICES, RECORD PROFITS AND A HUGE BURDEN ON HOUSEHOLD BUDGETS ............................................................ 1 DOMESTIC SOURCES OF INCREASING PETROLEUM PRICES .................................... 4 THE MERGER WAVE IN THE PETROLEUM INDUSTRY ............................................ 5 CONSOLIDATION AND STRATEGIC BEHAVIOR ......................................................... 8 THE FAILURE OF THE FTC TO PROTECT CONSUMERS ......................................... 9

I. INTRODUCTION ........................................................................................ 11 THE IMPACT OF RISING ENERGY PRICES ............................................................ 11 THE DEBATE OVER DOMESTIC CAUSES OF ENERGY PRICE INCREASES ............... 11 PURPOSE AND OUTLINE OF THE PAPER ............................................................... 14

II. DOMESTIC ENERGY PRICE SHOCKS ................................................................ 16 RISING PRICES, INCREASING HOUSEHOLD ENERGY COSTS ................................. 16 PROFITING FROM PRICE INCREASES IN CONCENTRATED MARKETS .................... 19 THE CAUSES OF PETROLEUM PRICE INCREASES ................................................. 21 METHODOLOGY ................................................................................................. 21 DOMESTIC PRICE RATCHETS ............................................................................. 22 THE ROLE OF CRUDE ........................................................................................ 24 CONCLUSION ..................................................................................................... 28 III. ANALYZING MARKETS AND EVALUATING MERGERS .............. 29 MERGER ANALYSIS ............................................................................................ 30 METHODOLOGY ................................................................................................. 30 MODERATE CONCENTRATION IN THE PETROLEUM INDUSTRY CREATES MARKET POWER ................................................................................ 34

IV. THE MERGER WAVE IN THE PETROLEUM INDUSTRY .............. 38 WEAK MARKET FUNDAMENTALS PUT ENERGY CONSUMERS AT RISK ................ 38 DEMAND IS INELASTIC ....................................................................................... 39 SUPPLY IS INELASTIC ......................................................................................... 43 CONSOLIDATION ................................................................................................ 45 STRATEGIC DECISIONS ....................................................................................... 50 GASOLINE SUPPLY .............................................................................................. 51 NATURAL GAS SUPPLY ....................................................................................... 56

V. THE IMPACT OF MERGERS ON MARKET CONCENTRATION AND PRODUCT PRICES .......................................................................... 61 THE IMPACT OF LAX MERGER POLICY ON MARKET CONCENTRATION .............. 61 THE IMPACT OF MERGERS AND MARKET CONCENTRATION ON PRICE ................. 68

VI. PUBLIC POLICY ..................................................................................... 73 POLICY ORIENTATION MATTERS ........................................................................ 73 THE WRONG EXPLANATIONS LEAD TO THE WRONG POLICY .............................. 74 POLICY THAT REFLECTS THE DOMESTIC REALITY .............................................. 79

ENDNOTES ...................................................................................................... 82

RECORD PRICES, RECORD OIL COMPANY PROFITS: THE FAILURE OF ANTITRUST ENFORCEMENT TO PROTECT AMERICAN ENERGY CONSUMERS EXECUTIVE SUMMARY After nearly two decades of the Federal Trade Commission (FTC) pursuing a policy of allowing massive consolidation in the oil and gas industry, the last five years has seen the prices that consumers pay for gasoline, natural gas, heating oil and propane soar. Consequently, industry profits since the beginning of the new millennium are well above historical levels. Now the Government Accountability Office (GAO), the government’s nonpartisan accountant, has taken a look at the FTC’s merger review process. The GAO found that mergers had resulted in price increases. The GAO finding echo concerns we have expressed since the start of the price ratchet and supports our conclusion that the FTC was essentially asleep at the switch. The consolidation that the Commission approved had real world consequences for consumers’ pocketbooks. In addition to reviewing the recent analyses of the FTC and the GAO, this report provides new estimates of the impact of rising prices for petroleum products on consumer expenditures, as well as oil company profits. The need for more vigorous antitrust enforcement at the FTC and broader policies to protect America’s energy consumers is clear. RECORD PRICES, RECORD PROFITS AND A HUGE BURDEN ON HOUSEHOLD BUDGETS During the second quarter of 2004, gasoline prices, natural gas wellhead prices and oil company profits all set records, while consumer spending and the economy slowed. No less an astute observer of the American economy than Federal Reserve Chairman Allen Greenspan was quoted in the Wall Street Journal making the connection between rising energy prices and slowing economic activity. He added an important point, however, that is frequently glossed over in the press; domestic factors – ‘unusually wide gasoline retailer’s margins’ – have played a part in the price problem (see Exhibit ES-1). 1

E x h ib it E S -1 : D o m e s tic R e f in in g a n d M a r k e tin g S p r e a d o n G a s o lin e ( P u m p P r ic e M in u s C r u d e a n d T a x e s )

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Two-thirds of Americans heat with a petroleum product (natural gas, heating oil, or propane) and most own automobiles. They have been hammered by petroleum product price increases in the past four years (see Exhibit ES-2). In the year ending in the second quarter of 2004 (which includes the summer 2003 driving season and the 2003-2004 winter heating season), their annual household expenditures for petroleum products were about $1200 higher than they were in 1999-2000 (the 1999 summer driving season and the 1999-2000 winter heating season). Department of Energy (DOE) price projections for 2004-2005 suggest that they will be hit with another $200 increase in the year ahead. A DOE analysis also shows that the record profits were led by record increases in domestic refining and marketing profits, topped off with increases of 130 percent in the first half of this year. Cumulatively, in the period from 2000 to 2004, oil companies will enjoy an increase in after-tax profits of about $100 billion, compared to 1995-1999. Only a small part 2

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(one-quarter) of the huge increase in cash flow enjoyed by the oil companies has been devoted to increased expenditures for exploration and development. In spite of the sharp increase in prices, the rate of production from existing reserves has declined. Reacting to the GAO finding that the merger wave of the past eight years substantially increased concentration across a wide range of markets and geographic areas and contributed to the price run up, the FTC, which has primary responsibility for consumer protection in the gasoline industry, the FTC steadfastly defended oil industry mergers and sought to place the blame for price increases overwhelmingly on foreign crude oil prices. The FTC attacked the GAO study and contradicted the DOE analyses.

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This paper examines the domestic sources of price increases. It shows that the GAO analysis is correct and the FTC’s oversight over oil industry mergers has failed to protect consumers. DOMESTIC SOURCES OF INCREASING PETROLEUM PRICES The total increase in gasoline prices at the pump and natural gas wellhead prices in the between January 2000 and June 2004, compared to average prices in January 1995 to December 1999, is about $422 billion. At the prices projected by the Department of Energy for the rest of this year, the total increase for the first four years of the new millennium will be close to half a trillion dollars by the end of this year. We divide these recent price increases into three components – domestic price shifts, domestic price following, and crude oil. For gasoline, we analyze the increase in the domestic spread, relative to the historical trend. The domestic spread is the pump price of gasoline minus crude oil costs and taxes. It is the share of the pump price accounted for by domestic refining and marketing. For natural gas, we focus on the wellhead price, observing that in the late 1990s the wellhead price of natural gas averaged about two-thirds of the price of crude. Since 2000, it has averaged about nine-tenths. This shift in price, relative to crude, is analyzed as a domestic price shift. Domestic price following occurs when domestic resource costs follow the world price up. Although it may seem natural for domestic producers to increase their prices whenever world prices rise, there are many places in the world where that does not happen, either because local market conditions (especially for natural gas) or government policy (for oil) will not allow it. In any event, when domestic prices follow world prices up, the profits go into the coffers of domestic, not foreign, companies. Of course, international crude oil price increases contribute to rising energy costs in the U.S., because the U.S. imports significant amounts of petroleum products. Starting in 2000, but escalating much more rapidly after the 2000 election, both the domestic spread for gasoline and the wellhead price of natural gas shifted upward. Although they declined to their historic levels at the bottom of the 2002 recession the respite was short lived. They have mounted steadily to the record set this past spring. Throughout the second half of the 1990s, the domestic spread on gasoline averaged just under 40 cents per gallon (Exhibit ES-1, above). That began to change in mid-2000 and after the 2002 recession, the domestic spread began a steady rise. It has been above historic levels almost continually ever since, with an average spread of just over 50 cents per gallon from January 2000 to June 2004. That increased out-of-pocket costs to consumers by over $75 billion.

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A similar pattern can be found in natural gas (Exhibit ES-2, above). The total increase in the wellhead price of natural gas in the 2000-2004 period, above the historic relationship to crude, is over $100 billion. Crude oil prices increased as well, from an average of $17.40 per barrel in 1995-1999 to $26.75 per barrel in 2000-2004 (see Exhibit ES-3). Domestic prices followed crude. Price following for gasoline accounted for over $50 billion to the consumer bill. Domestic price following added over $100 billion to the wellhead price. Thus of the total of increase in gasoline and natural gas prices paid in the 2000-2004 period compared to 1995-1999, about $180 billion or 42 percent was caused by the domestic price shift. About $160 billion was caused by domestic price following, or about 36 percent. In other words, over three-quarters of the recent petroleum price increases have gone to domestic companies. THE MERGER WAVE IN THE PETROLEUM INDUSTRY The shift in domestic pricing behavior that played a significant role in the recent price increases took place in the context of a massive merger wave in the industry. The DOE E x h ib it E S -3 : C r u d e O il P r ic e s (U .S . R e f in e r A c q u i s it io n C o s ts ) 40

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identified a total of 34 major oil and gas companies that merged into 13 during this period, and an additional 15 refining companies that had shrunk to seven. Twenty-one of the 31 companies listed in the oil and gas sector by Business Week in 1995 engaged in mergers with other companies between 1997 and 2002. In 2003, 15 of the 21 businesses listed by the magazine had engaged in mergers during the previous five years. Exhibit ES-4 shows the GAO’s summary of the mergers. This figure tracks the numbers in Business Week closely. Exhibit ES-4: GAO Selected Major Petroleum Industry Mergers

Source: General Accountability Office, Energy Markets: Effects of Mergers and Market Concentration in the U.S. Petroleum Industry (Washington, May 2004), Figure 8.

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As a result of this merger wave, between 80 and 90 percent of regional refining markets, state gasoline wholesale markets and city-retail gasoline markets are concentrated (see Exhibit ES-5). The GAO’s review of the mergers found that all five of the regional refining markets had seen increased concentration between 1994 and 2003 and four of the five were concentrated in 2003. In 1994, 47 percent of state wholesale gasoline markets were unconcentrated, 43 percent moderately concentrated and 10 percent concentrated. By 2002, only 8 percent of markets were unconcentrated, 75 percent were moderately concentrated and 18 percent were highly concentrated. Of the 13 major urban gasoline markets identified by the FTC, 12 suffered an increase in concentration and all were concentrated in 2002. Even on a

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national level, data shows that mergers allowed 13 companies that accounted for 57 percent of domestic refining capacity in 1996 to shrink to just six. CONSOLIDATION AND STRATEGIC BEHAVIOR The massive consolidation in the oil and gas sector has happened under the watch of the FTC, which had to review and approve each of these mergers. These levels of concentration are a source of concern because of the conditions of supply and demand in energy markets. Energy is a necessity of daily life. Consumers cannot radically alter their energy needs in the short-term. With a low elasticity of demand, energy markets are vulnerable to abuse, leaving consumers at the mercy of price increases. The supply situation is no better, as short-term it is also extremely inelastic and cannot be quickly increased due to production, transportation and storage difficulties. Even slight disruptions in the supply-demand balance cause prices to quickly increase. The market exhibits “rockets and feathers” behavior – prices rise like rockets and float down like feathers. But when energy markets become as concentrated as they are in America, the prices do not float back down to where they began. The problem is not a conspiracy, but the rational action of large companies with market power. With increasing concentration, long-term strategic decisions by the industry to tighten production capacity interacted with short-term (mis)management of stocks to create a tight supply situation that provides ample opportunities to push prices up quickly. Individual companies can let supplies become tight in their area and keep stocks low, since there are few competitors who might counter this strategy. They push prices up when demand increases because they have no fear that competitors will not raise prices to steal customers. In the 1990s alone, approximately 50 refineries were closed. Since 1995, over 20 refineries have been shut down. Operating stocks to meet demand and cushion price swings have declined to very low levels. They generally are in the range of a couple of days, compared to four or five days in the early 1990s and over a week in the 1980s. The move of the majors into natural gas production in the 1990s changed the nature of that sector. The consolidation in the industry came hand-in-hand with the shift to acquisition of resources through merger (rather than exploration) and a shift of drilling away from exploration. Decisions about which wells to produce and which wells to cap, how much to inject into storage, how to use pipeline capacity and ultimately, how to report prices are business decisions that affect the price paid at the wellhead. The trading markets that drive wellhead natural gas prices are quite new and lack price transparency. Enron played a large roll in these markets and when it collapsed, so too did much private trading. The evidence is mounting that manipulation and abusive practices have been part of these markets since 2000.

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The long-term trend to much lower stocks relative to demand is clear in natural gas as well. Compared to the decade of 1985-1994, stocks were about 25 percent lower in the 19951999 period. During the price spikes of the new millennium, stocks were 40 to 50 percent lower than the 1985-1994 period and 25 percent lower than the 1995-1999 period. The GAO looked both within the local markets affected by individual mergers and in the industry at large. It found that mergers and consolidation in the industry were associated with price increases of two to seven cents per gallon. The GAO report, however, may underestimate the impact of the merger wave in the oil industry on prices. Consider: The study looks only at the effect on wholesale gasoline prices, but changes in retail markets may also contribute to higher prices. Its data stops in 2000, when gasoline prices were just beginning to take off. Additional mergers took place and the price increases attributable to domestic refining and marketing sectors grew substantially thereafter. The GAO does not consider how strategic gaming in an increasingly consolidated industry raised the general price level, as the tight oligopoly of oil giants learned how to exploit its market power with experience. The study shows that increased refinery utilization rates and decreased inventories of product add a great deal to price on a seasonal basis. GAO does not attribute any part of the price increases associated with high capacity utilization and lower inventories to the merger wave, even though company documents show that the trend of tightening markets across time was an intended consequence of the merger wave. The study shows that “supply” disruptions also have a large impact on price, but does not consider slow reactions to disruptions as a consequence of the merger wave. When the more recent data are taken into account and these other factors are considered, the price effects of concentration would be much larger. These strategic behaviors brought on by the merger wave account for a substantial part of the increase in the domestic spread. THE FAILURE OF THE FTC TO PROTECT CONSUMERS The FTC did nothing to mitigate market power in many of the mergers involving moderately concentrated markets. Moreover, given the concentrated nature of the industry, the enforcement actions that the FTC has taken might not effectively address the market power problem. Divesting to other large players, who are not in a particular market, might not alleviate problems, since patterns of behavior – or misbehavior, in this case – easily emerge among all of the players. Divesting to a smaller player within the market can have the effect of increasing the general level of concentration in the market, albeit less than merely allowing the merger to pass without divestiture. Because market forces are weak, this may result in an increase in market power and rising prices. Ironically, the FTC recognizes that in the early 1980s it was the policy at the agency to apply a more rigorous standard. Had the agency not abandoned that approach, the industry would be far less concentrated today and prices would be lower. 9

The GAO’s empirical analysis provides a very substantial basis for concluding that there is a market structure problem in the domestic gasoline industry. The FTC’s analysis is a mixture of theories about why competition will not be harmed and projections by oil companies about how their efficiency will be improved, devoid of any analysis of what actually happened. Economic reality has proven to be quite different from the FTC theory. Entry barriers are greater, market forces much more feeble, and the willingness and ability of industry players to respond to price increases weaker than the FTC hoped. Reality thoroughly contradicts the theory of lax antitrust enforcement under which the industry was allowed to concentrate. It is time for the FTC to change the way it looks at mergers in the oil industry and provide genuine consumer protection. If it finds that antitrust is not enough because of the market fundamentals in the industry, it should propose policies that protect the public where antitrust cannot. In fact, the lengths to which the FTC has gone recently to deflect criticism of the industry raises broader issues. Pointing fingers at foreign oil producers and ignoring domestic market structure issues orients policy in the wrong direction. •

Blaming high gasoline prices on high crude oil prices ignores the fact that over the past few years the domestic refining and marketing sectors have imposed substantial price increases on consumers at the pump.

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Blaming natural gas price increases on crude oil prices ignores that fact that natural gas wellhead prices have increased much faster than the price of oil.

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Blaming tight refinery markets on Clean Air Act requirements to reformulate gasoline ignores the fact that in the mid-1990s the industry adopted a business strategy of mergers and acquisitions to increase profits by tightening refinery markets and reducing competition at the pump.

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Blaming high natural gas prices on a newly discovered scarcity ignores the fact that the merger wave led by the major petroleum companies has changed the way the resource base is developed.

This misdirection of attention lends support to proposals to increase subsidies for oil companies that are likely to have little effect. Since hundreds of billions of dollars of increased profits and cash flow have not elicited the appropriate responses from oil companies, tens of billions of new subsidies are not likely to do so either.

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I. INTRODUCTION THE IMPACT OF RISING ENERGY PRICES The second quarter economic numbers have laid to rest any lingering doubts about the impact of rising energy prices.1 In the very same week that the oil industry reported record profits,2 the Commerce Department reported an unexpectedly weak economic showing. 3 Numerous analysts drew a direct link between energy price increases and reductions in consumer spending on other items as causing the slowdown. As an article in The New York Times put it: “The economy’s recent slowdown seems to stem largely from higher energy costs and the gradual disappearance of government stimulus as tax savings have been spent and the effect of lower interest rates has lost its punch.”4 No less an astute observer of the American economy than Federal Reserve Chairman Allen Greenspan made the connection, but he added an important point that is frequently glossed over in the press – domestic factors have played a large part in the energy price runup. On August 2, 2004, The Wall Street Journal characterized observations by Greenspan as follows. Mr. Greenspan blamed most of the second-quarter slowdown on high oil prices. While crude prices have continued to rise, that might be absorbed through a narrowing of unusually wide gasoline retailers’ margins, rather than being passed through to consumers.5 Just as the impact of rising gasoline prices was sinking in, more bad news came from the Energy Information Administration’s 2004-2005 heating season price and cost projections.6 The EIA projected an increase in winter fuel costs of $100 to $200 per household compared to 2003-2004. Compared to 2001-2002, the increase was projected to be between $400 and $500. THE DEBATE OVER DOMESTIC CAUSES OF ENERGY PRICE INCREASES While any uncertainty over whether rising energy prices have had an effect on the economy appear to have been resolved, the debate over the causes of the price increases continued. In May, the Government Accountability Office (GAO),7 the government’s nonpartisan accountant, published a report concluding that mergers have contributed to price increases. GAO’s econometric analyses show that oil industry mergers and increased market concentration generally led to higher wholesale gasoline prices…. Six of the eight specific mergers GAO modeled – which mostly involved large, fully vertically integrated companies – generally resulted in increases in wholesale prices for branded and/or unbranded gasoline of about 2 cents per gallon, on average… Increased market concentration, which captures the 11

cumulative effect of mergers as well as other market structure factors, also generally led to higher prices for conventional gasoline, which is sold nationwide, and for boutique fuels – that has been reformulated for certain areas on the East Coast regions and in California to lower pollution. The price increases were particularly large in California, where they averaged about 7 cents per gallon.8 GAO’s conclusion was based on data that ran only through 2000, which was well before the massive increases of recent years. Interestingly, there are indications that the Clinton Administration began to recognize the problem that could arise from allowing industry structure to become too concentrated and began to criticize the industry and take steps against it. A March 2001 Federal Trade Commission (FTC) report, authored by Chairman Robert Pitofsky in response to the mid-2000 gasoline price spike, noted that by withholding supply, industry was able to drive prices up, and thereby increase profits.9 The FTC identified the complex factors in the spike and issued a warning: The spike appears to have been caused by a mixture of structural and operating decisions made previously (high capacity utilization, low inventory levels, the choice of ethanol as an oxygenate), unexpected occurrences (pipeline breaks, production difficulties), errors by refiners in forecasting industry supply (misestimating supply, slow reactions), and decisions by firms to maximize their profits (curtailing production, keeping available supply off the market). The damage was ultimately limited by the ability of the industry to respond to the price spike within three or four weeks with increased supply of products. However, if the problem was short-term, so too was the resolution, and similar price spikes are capable of replication. Unless gasoline demand abates or refining capacity grows, price spikes are likely to occur in the future in the Midwest and other areas of the country.10 Aside from Chairman Pitofsky’s analysis of the 2000 gasoline price spike in the upper Midwest, the FTC has generally been uncritical of conditions in the industry. In fact, under Chairman Timothy Muris, President Bush’s appointee, the FTC headed in a very different direction. In an unprecedented reaction to the GAO report, the FTC, which is responsible for antitrust oversight over gasoline markets, attacked the GAO findings. Muris issued a personal letter criticizing the GAO study.11 What made the attack notable is that the FTC had been given the opportunity to comment on the GAO report before its publication and the GAO had responded to each and every criticism.12 Muris’ individual action caught the attention of Commissioner Mozelle Thompson, 13 who challenged some of Muris’ statements, thereby revealing a deep division at the agency at a time when gasoline prices are at record levels. The FTC’s efforts to deflect blame from domestic market structure led it to contradict other agencies as well. In April, at a hearing on rising gasoline and natural gas prices, the FTC General Counsel testified that 85 percent of the increase in gasoline prices was caused by increases in crude oil prices.14 Less than a month earlier, the Energy Information 12

Administration (EIA) noted in its regular update that “about half of the increase reflects higher crude oil prices, with the remainder reflecting the impact of low inventories, robust demand, and uncertain availability of imports.”15 Less than a week after the FTC statement, however, a spokesman for the EIA observed that 60 percent of recent price increases were caused by the domestic refining sector.16 A couple of weeks later, the EIA spokesperson moderated his message, now claiming that “OPEC production cuts ranked higher as a cause for increased gas prices than tightness in the United States refining market.”17 There is no doubt that the 85 percent figure the FTC had used is too high, but in midAugust, on his last day at the FTC, Chairman Muris released an FTC staff study which again attacked the GAO report and repeated the claim that crude oil accounts for 85 percent of the price change in gasoline.18 The report went to great lengths to explain the theory under which the FTC reviews mergers and recounted its activities in dealing with oil company mergers, but it presented no analysis of the price impact of mergers. Commissioner Thompson disputed some of the findings.19 Commissioner Pamela James Harbour abstained, asserting that the FTC should have completed its gasoline price analysis before releasing the staff report.20 The statement by the three Republicans on the FTC insisted that it has been harder on the oil industry than other industries,21 but again Commissioner Thompson demurred, pointing out that the actions against oil companies may reflect the fact that oil product markets are different from other industries. A column in The Washington Post on the day FTC Chairman Muris left office summarized the agency’s attitude toward mergers in general and the oil industry in particular: Muris, however, was reluctant to block mergers even in concentrated industries unless someone could show empirical evidence of past or future anticompetitive behavior – an unreasonably high standard for a law that requires a degree of speculation… Muris also seems to have a blind spot when it comes to the oil industry, which claims to have realized vast savings from recent mergers and asset sales but has yet to show how even a penny of that has made its way to the pockets of consumers. Muris’ defense of high gasoline prices is that they simply reflect the fluctuating world price for oil – an explanation that conveniently ignores that the “market” price is manipulated by the price-fixing OPEC cartel, which counts on the major oil companies as partners, customers, and collaborators.22 As if to draw even greater attention to the fact that the FTC’s view seems out of step with reality, on the very same day that the FTC released its report, the EIA released a financial analysis of all major domestic energy companies, which found that “a 31-percent increase in oil and gas production net income was augmented by a 131 percent increase in refining/ marketing net income.”23 Or, as the Energy Daily put it under the headline “Refiners Feast as Gasoline Prices Soar:”

13

While the high gasoline prices generally have been blamed on rising crude oil prices, the EIA survey noted that refiners were raking in huge additional profits through higher margins – far outweighing their increased crude costs.24 PURPOSE AND OUTLINE OF THE PAPER With energy prices and the economy in the spotlight of policy debate, it is critically important for the public and policymakers to have a clear view of the causes of high gasoline and natural gas prices. Broadly speaking, if policymakers do not have a proper grasp of the causes of the problem, they are less likely to propose solutions that will be effective. More narrowly focused on the specific issue of antitrust enforcement, if the FTC’s view of industry market concentration problem is too narrow, its predictions about which mergers threaten to have anticompetitive effects and its actions opposing or modifying mergers may not have been correct. The ameliorative measures it uses may not be effective in reducing the threat of excessive concentration. Commissioner Thompson’s dissents point to the problem in the FTC analysis we have been stressing for several years. The FTC has applied a lax antitrust standard across the board and it refuses to recognize the market fundamentals in the petroleum industry. Even though it may have been a little harder on the oil industry, it has not been hard enough. Market forces – the elasticity of demand (the ability of consumers to cut back) and the elasticity of supply (the ability of producers to increase output) are so weak in petroleum product markets that market power can be exercised at much lower levels of concentration. Over the past three years we have analyzed this problem in a series of reports covering both gasoline and natural gas.25 The GAO report provides detailed econometric affirmation of what we have been saying all along – increasing concentration in the industry has led to increases in prices. This report updates our previous analyses in several ways and shows why the GAO got it right and the FTC got it wrong. It brings the most recent data on prices and profits into the picture. Although the primary focus is on gasoline prices, we briefly review natural gas prices, because they have contributed substantially to the increasing energy cost burden on American consumers and the record profits of the oil companies (which also dominate the domestic natural gas market). The analysis begins by demonstrating that the stakes are huge. Chapter II describes the recent price and profit increases. It then identifies three causes of those increases – domestic market structure changes, domestic price following, and crude oil price increases. Chapters III refines the framework for analyzing market structure adopted earlier to highlight the key points of difference between the FTC and the GAO analyses. Chapter IV describes the recent industry merger wave.

14

Chapter V presents quantitative measures of the impact of the merger wave on market concentration and prices. It uses the quantitative data on refining and gasoline markets published in the FTC and GAO reports to describe market concentration. Our earlier analyses had uncovered some of this data, but the government agency reports provide a much more complete set. The chapter shows why the FTC’s defense of its track record is incorrect and its attack on the GAO study way off base. It also suggests several ways in which the GAO actually underestimated the impact of the merger wave on prices. Chapter VI reiterates our policy recommendations. There is clearly a need for more vigorous antitrust enforcements, but the problem has become so severe that other policies are needed to reduce pressures on gasoline markets.

15

II. DOMESTIC ENERGY PRICE SHOCKS RISING PRICES, INCREASING HOUSEHOLD ENERGY COSTS Analysis of markets focuses on prices as the prime indicator of market performance. With the increasing recognition that energy prices are placing a drag on the economy, the total household bill also becomes relevant. Exhibit II-1 shows the pump price of gasoline (net of taxes) and the wellhead price of natural gas expressed in dollars per million British Thermal Units (BTU), the standard measure for energy prices. Converting to a common measure of price helps to show the similarity of price changes. By excluding taxes from gasoline and focusing on the wellhead price of natural gas, we identify the primary sources of revenue for the domestic petroleum industry. The pattern of prices is similar for both gasoline and wellhead natural gas. E x h ib it I I -1 G a s o lin e P u m p P r ic e N e t o f T a x e s a n d N a tu r a l G a s W e llh e a d P r ic e

14

12

10

$/MMBTU

8

6

4

2

N A TU R A L G A S W E LLH E A D

G A S O L IN E P U M P P R IC E

S o u r c e : S e e t e x t fo r m e t h o d o lo g y . U .S . D e p a r tm e n t o f E n e r g y , E n e r g y I n f o r m a tio n A d m in is t r a t io n , M o n th ly E n e r g y R e v ie w , W e e k ly P e tr o le u m S ta tu s R e p o r t, N a tu r a l G a s (W a s h in g to n , v a r io u s iss u e s a n d d a ta b a s e ).

16

M Y

S JA -0 4

M Y

S JA -0 3

M Y

S

-0 2

JA

M Y

S

-0 1

JA

M Y

S JA -0 0

M Y

S JA -9 9

M Y

S JA -9 8

M Y

S JA -9 7

M Y

S JA -9 6

-9 5 JA

M Y

0

Prices were stable in the second half of the 1990s and then began to rise in the middle of 2000. There was a sharp peak at the beginning of 2001. Prices began to decline in mid2001. At the depth of the recession in early 2002, they were back to the levels that had typified the 1990s. The respite did not last. Prices began to rise in the spring of 2002 and have been well above historic levels since then. Part of the increase in energy prices is paid by businesses. They may seek to recover these cost increases from consumers in the prices of goods and services they sell. However, a substantial part of the energy price increases are paid directly by consumers for their household energy costs – gasoline and heating oil; natural gas, for heating, cooking and hot water; and electricity, which is increasingly produced with natural gas. Exhibit II-2 shows two different data sources for household expenditures – the Bureau of Labor Statistics Consumer Expenditure Survey and the Department of Energy’s Residential Energy Consumption Survey. They provide similar estimates. E x h ib it I I -2 : H o u s e h o ld E n e r g y E x p e n d itu r e s

2000

1800

1600

Dollars Per Year

1400

1200

1000

800

600

400

200

0 1997

1998

G a s o lin e N a tu r a l G a s R E C S A ll H H

1999

2000

2001

F u e l O il a n d O th e r T o ta l H H P e tro le u m - B a s e d

2002

2003

N a tu r a l G a s B L S A ll H H

S o u r c e s : B u r e a u o f L a b o r S t a tis tic s , C o n s u m e r E x p e n d itu r e s ( W a s h in g to n , v a r io u s y e a r s ); E n e r g y I n f o r m a tio n A d m in is tr a tio n , R e s id e n tia l E n e r g y C o n s u m p tio n S u r v e y s (W a s h in g t o n , 1 9 9 7 , 2 0 0 1 ).

17

Household expenditures were stable in the late 1990s. Taken together, in 1999, expenditures for gasoline, heating oil and natural gas accounted for about $1400 per year of total household expenditures as reported by the Bureau of Labor Statistics Consumer Expenditure Survey.26 This is the average for all households, which includes households that do not own cars and “all electric residences” that use none of these fuels, as well as some that use gas for cooking, but not heating. On average, cost increases over the period between 1999 and 2003 associated with the price shock for gasoline added almost $400 per household per year (including all factors). Thus, gasoline price shocks have increased average household energy bills by over 35 percent. The comparison between 1999 and 2003 for all petroleum is even more dramatic, an increase of about $500. As noted above, the EIA’s winter heating cost forecast presents a gloomy picture for consumers for the 2004-2005 winter. Exhibit II-3 shows the annual bill for a household that heats with a petroleum-based fuel – natural gas, heating oil, or propane. About two-thirds of the households in the nation fall into this category.27 Energy prices are projected to be between 8 percent and 15 percent higher this winter than last. Household heating bills are E x h ib it I I -3 : E x p e n d itu r e s F o r H o u s e h o ld s th a t H e a t w ith a P e tr o le u m P r o d u c t

$ 3 ,0 0 0

$ 2 ,5 0 0

ANNUAL COST

$ 2 ,0 0 0

$ 1 ,5 0 0

$ 1 ,0 0 0

$500

$0 1 9 9 8 -2 0 0 0

2 0 0 4 -2 0 0 5 p H E A T IN G

S o u r c e s : G a s o lin e fr o m B u r e a u o f L a b o r S ta tis tic s , v a r io u s y e a r s ); h e a tin g fr o m E n e r g y I n fo r m a tio n A (W a s h in g to n , A u g u s t 1 3 , 2 0 0 4 ); h e a tin g is w e ig h te d p r o p a n e fr o m E n e r g y I n fo r m a tio n A d m in is tr a tio n , S u r v e y s ( W a s h in g t o n , 2 0 0 1 ) ..

18

G A S O L IN E

C o n s u m e r E x p e n d itu r e s (W a s h in g to n , d m in is t r a t io n , S h o r t T e r m O u tlo o k a v e r a g e o f n a tu r a l g a s , h e a tin g o il a n d R e s id e n tia l E n e r g y C o n s u m p tio n

projected to be about $100 to $200 higher. Compared to the late 1990s, the household energy bill for petroleum products will be about $900 higher, if these predictions come to pass. PROFITING FROM PRICE INCREASES IN CONCENTRATED MARKETS If price increases are not caused by cost increases, they result in profit increases. Thus, after price, the second important indicator to which economic analysts look for signs of the exercise of market power and market failure is excessive profits. Tracking profits from publicly available sources is difficult because some of the companies do not break out domestic operations, while mergers make long-term trends difficult to see and the allocation of one-time charges to specific lines of business are frequently not identified.28 Very recent data gathered by the Department of Energy are not available, but general filings from the Securities and Exchange Commission are. The bottom line for the domestic downstream industry, literally and figuratively, was a sharp run-up in oil company profits from refining and marketing (see Exhibit II-4). Net operating income (income before special items and taxes) tripled from 1997-1999 to 2001. E x h ib it I I-4 : R e fin in g /M a r k e tin g N e t O p e r a tin g I n c o m e

20000

18000

16000

MILLIONS OF $

14000

12000

10000

8000

6000

4000

2000

0 1995

1996

1997

1998

1999

2000

2001

2002

2003

YEAR

S ou rce: E n ergy P ro d u cers: 19 9 9 P ro d u cers: 20 0 1 P ro d u cers: 20 0 2 r e p o r ts.

I n fo r m a tio n (W a s h in g to n (W a s h in g to n (W a s h in g to n

A d m in is tr a tio n , P e r fo r m a n c e P r o file s o f , J a n u a r y 2 0 0 1 ) ; P e r fo r m a n c e P r o file s o f , J a n u a r y 2 0 0 3 ) ; P e r fo r m a n c e P r o file s o f , F e b r u a r y 2 0 0 4 ); 2 0 0 3 , e stim a te d b a se d

19

M a jo r E n e rg y M a jo r E n e rg y M a jo r E n e rg y on com p an y an n u al

While profits were down in 2002 due to very low prices early in the year as a result of the severe economic downturn and travel slowdown following September 11, they were still just above the levels of the late 1990s. They have skyrocketed since. Fortune reported return on equity of 25 percent for the petroleum industry in 2000,29 while Business Week reported 22 percent (see Exhibit II-5).30 This was almost twice the historic average for the industry and about 50 percent more than other large corporations achieved.31 These extremely high profits were not sustainable in the face of the weak economy of early 2002; prices declined and profits fell. By the end of 2002, profits had increased dramatically. The sharp price increases in 2003 produced another year of record high profits.32 These profits are continuing. Although 2003 was a record year for both downstream operations and total industry profits, the first half of 2004 saw large increases in profits, especially in downstream operations. The EIA’s analysis shows that net income from domestic refining/marketing for 24 major petroleum companies almost tripled in the first half E x h ib it I I -5 : R e tu r n o n E q u ity : O il a n d G a s C o m p a n ie s

30

RETURN ON EQUITY

25

20

15

10

5

B u s in e s s W e e k 9 0 0

S o u r c e : B u s in e s s W e e k 9 0 0 , a n n u a l r e s u lts .

20

O il a n d G a s

20 04 (1 H )

20 03

20 02

20 01

20 00

19 99

19 98

19 97

19 96

19 95

0

of 2004 compared to 2003. It rose from 23 percent of total profits for these companies to 38 percent. The Business Week reporting of annual after-tax profits of companies in the oil and gas industry in the first four years of the new millennium compared to the last five years of the 1990s shows a huge increase in profits. After-tax profits increased by over $50 billion, the equivalent of about $75 billion in pre-tax dollars. Exhibit II-5 is based only on the companies included in the Business Week survey, which account for fewer than half of all domestic natural gas and crude oil production and about 80 percent of all refinery capacity. Thus, on an industry-wide basis, the increase in after-tax profits in the 2000-2003 period could be as high as $80 billion. Before taxes, the figure could be as much as $110 billion. The dramatic increase in profits in the first half of this year will push the total increase in after-tax profits for the petroleum sector close to $100 billion and the pre-tax take to almost $150 billion. THE CAUSES OF PETROLEUM PRICE INCREASES While these price movements reflect both domestic and international factors – above all, the price of crude – the fact that refining/marketing profits have increased so dramatically suggests that crude alone was not the cause of rising prices and profits. This section breaks down the recent price increases into three components: domestic market shifts, domestic price following, and crude oil driven changes. METHODOLOGY Given the current debate and the fact that both resource costs and domestic pricing practices are driving the price increases, care must be exercised in estimating the various components of recent price increases. The share of the price increases attributed to foreign resource prices and domestic factors depends on how far back we look and how we calculate the baseline. Moreover, because the U.S. is a major producer of petroleum products, as well as a consumer, it is important to separate out domestic price following behavior from the impact of market structure changes. What factors should be analyzed? When international prices go up, Americans pay more to foreign producers of energy resources. To the extent that the price of domestic raw materials follows the international price up, consumers also pay more to domestic producers of energy resources. When the domestic price of crude follows the foreign price of crude (“price following”), the increase ends up in the pockets of domestic resource owners. In one sense, the complaints of the large industrial consumers of natural gas who are losing business to foreign firms or shifting their operations to overseas locations that have not suffered natural gas price increases remind us that all prices do not follow international prices, penny-forpenny.33 Domestic market conditions affect how prices follow. When domestic prices rise more than the foreign price or change their relationship to the final price because of changes in domestic pricing behaviors, that is a “domestic price shift.” For gasoline, we focus on what is known as the domestic spread. The domestic spread 21

is defined by the EIA as the price at the gasoline pump minus crude oil costs and taxes.34 This represents the share in the pump price that domestic refining and marketing operations take. (Refining and marketing are also known as downstream operations.) By calculating the domestic spread, we isolate the impact of changes in the domestic market from changes in the cost of crude, which is an input to the production of gasoline, heating oil and some other petroleum products. For natural gas, we focus on the wellhead price. Natural gas is overwhelmingly (90 percent) a domestic resource. Crude oil is not an input to the production of natural gas, but it does influence the price somewhat, since there are some uses, particularly industrial, in which crude oil and natural gas are substitutes.35 In order to isolate the effect of crude, we observe that between January 1995 and December 1999, natural gas averaged about 67 percent of the cost of crude. We use this as the historic average. How should baseline prices be calculated? In order to estimate the magnitude of a shift in pricing behavior, we must have some estimate of what prices would have been absent the shift. The Industrial Energy Consumers of America (IECA) provided an estimate of natural gas price increases of $111 billion.36 This is based on a simple comparison of prices before and after a specific date (in their case, June 2000). While such an estimate presents a baseline, it does not take into account factors such as the cost of crude, seasonality of demand or the general trend of increasing demand. Therefore, we have calculated price increases using a more sophisticated method. How far back should the analysis go? For purposes of this analysis we go back to January 1995. January 1995 was the implementation date of the Clean Air Act Amendments.37 The Clean Air Act Amendments affected refinery operations and, in turn, gasoline prices. The Clean Air Act Amendments and electricity restructuring, which began in the mid-1990s, affected natural gas markets as well.38 Moreover, a merger wave hit the industry in the second half of the 1990s. As discussed below, there is documentary evidence from the mid-1990s that oil industry executives contemplated tightening the supply side of the oil market through the merger wave. At what date does the change in behavior take place? The data itself provides an easy answer. There appears to have been a shift in the pricing behavior of domestic energy markets in mid-2000. This change in behavior escalated sharply in 2001. DOMESTIC PRICE RATCHETS Exhibit II-6 shows the domestic spread on gasoline. We use cents per gallon (rather than per million BTU) since this is the more familiar unit of analysis. The baseline fits the actual closely. Clearly, in mid-2000, prices began to rise, then they escalated sharply in 2001. Throughout the second half of the 1990s, the domestic spread fluctuated seasonally within a narrow range of 32 to 48 cents per gallon; the average domestic spread was about 39 cents per gallon. The domestic spread rose in mid-2000 and skyrocketed in early 2001. It 22

E x h ib it I I - 6 : D o m e s t ic R e f in i n g a n d M a r k e t in g S p r e a d o n G a s o l in e (P u m p P r ic e M in u s C r u d e a n d T a x e s)

90

D O M E S T IC P R IC E S H IF T 80

70

50 GALLON

CENTS PER

60

40

30

20

10

ACTUAL

M Y

S

04

JA -

M Y

S

03

JA -

M

S

-0 2

JA

M Y

S

-0 1

JA

M Y

S

00

JA -

M Y

S

99

JA -

M Y

S

98

JA -

M Y

S

97

JA -

M Y

S

96

M Y

JA -

JA

-9 5

0

H IS T O R IC A V E R A G E

S o u r c e : S e e t e x t f o r m e t h o d o lo g y . U .S . D e p a r t m e n t o f E n e r g y , E n e r g y I n f o r m a t i o n A d m in i s t r a t io n , M o n t h ly E n e r g y R e v ie w , W e e k l y P e tr o le u m S t a tu s R e p o r t ( W a s h i n g t o n , v a r io u s is s u e s a n d d a t a b a s e ) .

plummeted back to historic levels during the winter recession of 2001-2002. It began to rise again in late 2002 and has been above historic levels ever since. The average spread from January 2000 to June 2004 was about 51 cents per gallon. Compared to the historic average, the increased cost to consumers since January 2000 for the domestic spread has been about $77 billion. The picture is similar for natural gas (see Exhibit II-7). The trend fits well until mid2000. There was a run-up in prices in mid-2000 and a peak in early 2001. Prices tumbled during the 2001-2002 recession, but have mounted again and stabilized at over twice the level of the late 1990s. The total increase in the wellhead price of natural gas above the historic relationship to crude was about $104 billion in the 2000-2004 period. 23

E x h ib it I I -7 : D o m e s t ic P r ic e S h if t i n N a t u r a l G a s ( I n c r e a s e i n W e l lh e a d P r i c e A b o v e H i s t o r i c R e l a t i o n s h ip t o C r u d e ) 9

D O M E S T IC P R IC E S H I F T

8

7

6

$/MCF

5

4

3

2

1

AC TU AL

M Y

S JA -0 4

M Y

S JA -0 3

M Y

S

-0 2

JA

M Y

S

-0 1

JA

M Y

S JA -0 0

M Y

S JA -9 9

M Y

S JA -9 8

M Y

S JA -9 7

M Y

M Y

S JA -9 6

JA

-9 5

0

H IS T O R I C G A S / C R U D E R A T IO

S o u r c e : S e e t e x t f o r m e t h o d o l o g y . U .S . D e p a r t m e n t o f E n e r g y , E n e r g y I n f o r m a t io n A d m i n i s t r a t i o n , M o n t h ly E n e r g y R e v i e w , N a t u r a l G a s ( W a s h i n g t o n , v a r i o u s is s u e s a n d d a ta b a se ).

Exhibit II-8 shows the domestic spread for heating oil. The pattern parallels gasoline, with the winter season being the peak. In the January 1995 to December 1999 period, the heating oil domestic spread varied in the narrow range of 40 cents to 60 cents per gallon and averaged 48 cents. Since January 2000 it has varied in a much wider range (40 cents to 80 cents) and averaged 62 cents. This increased costs to consumers by $2 to $3 billion per year. The other fuel used by residential consumers – propane – exhibited a similar pattern. The spread moved up in 2000 and peaked in 2001. It moderated somewhat in 2002, but rose again and remained well above historic averages in 2003 and 2004. THE ROLE OF CRUDE Exhibit II-9 plots crude oil costs and the domestic spread on the same axes. It is interesting to note that prior to January 2000, there was virtually no relationship between the domestic spread and the price of crude. Nor is there any reason to believe that there should 24

E x h ib it II-8 : D o m e stic H e a tin g O il S p r ea d 90

80

70

60

CENTS/

GALLON

50

40

30

20

10

S

-0 4 JA

M Y

S

-0 3 JA

M Y

S

-0 2

JA

M Y

S

-0 1

JA

M Y

S

-0 0 JA

M Y

S

-9 9 JA

M Y

S

-9 8 JA

M Y

S

-9 7 JA

M Y

S

-9 6 JA

-9 5 JA

M Y

0

S o u rce : E n e rg y In fo r m a tio n A d m in istr a tio n , P e tro leu m M a rk e tin g M o n th ly a n d M o n th ly E n erg y R evie w (W a sh in g to n , v a rio u s issu es a n d d a ta b a se).

have been. In fact, the correlation for January 1995 to January 2000 was slightly negative, though not statistically significant. After January 2000, there was a positive and statistically significant relationship. Changing the historic pattern, the domestic spread rose with crude prices. Thus, the record prices we see today are the result of the combination of historic highs in both crude oil prices and the domestic spread. Exhibit II-10 plots crude oil costs (at the historic ratio) and natural gas wellhead prices. Again, prior to January 2000, the relationship between natural gas and crude oil prices was weak and statistically not significant. While natural gas averaged about 67 percent of crude, it did not follow the price movements of crude very closely. Since January 2000, the relationship has been larger (the regression coefficient is four times as large) and statistically 25

E xh ib it II-9: C ru d e O il an d D om estic G asolin e S p read C om p ared to H istoric A verages 100

90

80

70

GALLON

CENTS PER

60

50

40

30

20

10

H IS T O R IC C R U D E

ACTUAL CRUDE

M Y

S JA -0 4

M Y

S JA -0 3

2

H IS T O R IC M A R G IN

M Y

S

-0

JA

1

M Y

S

-0

JA

M Y

S JA -0 0

M Y

S JA -9 9

M Y

S JA -9 8

M Y

S JA -9 7

M Y

S JA -9 6

5 -9 JA

M Y

0

A C T U A L M A R G IN

S ou rce: S ee text for m eth od ology. U .S . D ep artm en t of E n ergy, E n ergy In form ation A d m in istration , M on th ly E n ergy R eview , W eekly Petroleu m Statu s R eport (W ash in gton , variou s issu es an d d atab ase).

significant. Since January 2000, the natural gas wellhead price has been about 90 percent of the price of crude. It would appear that the domestic industry seized the opportunity of rising crude prices to increase its share of the delivered price of energy. In order to accomplish this, of course, industry firms had to have market power. Chapters IV and V argue that the consolidation resulting from the 1997-2002 merger wave created that market power. If we use January 1995 to December 1999 as the base period, as was done above, the average price of crude was $17.40 per barrel. The total increase in the cost of crude oil as an input for gasoline since December 1999 would be approximately $133 billion. This should be 26

E xh ib it II-10 : D o m estic P rice S h ift in N a tu ra l G a s C o m p a red to H isto ric C ru d e P rice 9

8

7

6

$/MCF

5

4

3

2

1

H IS T O R IC G A S /C R U D E R A T IO

Y M

JA -0 4

Y

S

M

JA -0 3

Y

2

S

M

-0

JA

Y

1

S

M

-0

JA

Y

S

M

JA -0 0

Y

S

M

JA -9 9

Y

S

M

JA -9 8

Y

ACTUAL

S

M

JA -9 7

Y

S

M

Y

S

M

JA -9 6

JA

-9

5

0

H IS T O R IC C R U D E P R IC E

S o u rce: S ee tex t fo r m eth o d o lo g y. U .S . D ep a rtm en t o f E n erg y, E n erg y In fo rm a tio n A d m in istratio n , M o n th ly E n erg y R eview , N atu ra l G a s (W a sh in gto n , vario u s issu es a n d d a tab ase).

compared to the $77 billion estimate of the increase in the domestic spread based on the historic average prices since it is based on the same average historic cost approach. The domestic price shift accounts for about 37 percent of the total. In addition, of the total increase in crude costs of $130 billion, about $53 billion went to domestic crude producers. Combining domestic market structure changes and domestic price following, we find that just under $130 billion, or 62 percent of the total increase went to domestic petroleum companies. For gasoline, we find the role of domestic refining and marketing to be two-and-onehalf times larger than the FTC claims. The total domestic role (price shift and price following) in gasoline price increases is over four times as large as the FTC claims.

27

Applying the crude oil price assumptions to natural gas, we find that natural gas price following resulted in an increase of about $119 billion in the period of January 2000 to June 2004. Thus, the domestic shift and the domestic price following totaled to about $223 billion. About 46 percent of the total is attributable to the domestic shift. Ninety percent of natural gas is domestic, so domestic gas producers took about $107 of the crude-driven price increase and another $94 billion in the domestic price shift. Combining these two estimates, we conclude that out of an increase in prices of just over $422 billion, about 42 percent was caused by the domestic price shift and about 36 percent by domestic price following. Thus, of the total, about 78 percent went to domestic companies and 22 percent went to foreign energy suppliers. CONCLUSION The bottom line is clear. The domestic price shifts are important under any scenario. The domestic share of total price increases, combining domestic price shifts and price following, are dominant. Foreign crude price changes are certainly also important, but they have received far too much attention. From the perspective of this analysis, Chairman Greenspan’s comment about ‘unusually wide margins’ in recent months is a vast understatement. For May and June, the domestic spread in gasoline was about 80 cents per gallon, compared to an average of just under 45 cents for May and June during the base period (1995-1999). In the second quarter of 2004 alone, the unusually wide margin cost consumers over $10 billion. In the second quarter of 2002, the domestic shift in natural gas added about $7 billion to the national bill. If we add in the domestic price following, we find an additional $17 billion in price following for gasoline and natural gas in the second quarter of 2004. To put this in perspective, in the early spring, when uncertainty about the impact of oil prices was still being expressed, The New York Times ran a front-page business section story under the headline, “Drivers Tend to Shrug Off High Gas Prices, for Now.”39 It cited figures that indicated “the tax cut gave consumers about $70 billion in additional spending power this year, while the rise in crude oil prices… has so far cost Americans only about $35 billion.” By that measure, the second quarter whipped out what was left of the tax cut. The estimates in this chapter are quite conservative. The analysis has focused on gasoline and household fuels because those costs are paid directly by consumers. The analysis covers only about half of the products that come from crude oil. Many of these, like diesel oil for transportation and jet fuel have exhibited pricing patterns similar to those of gasoline. Thus, the total increase in cost to the economy has already been well over half a trillion dollars. Looking at the entire barrel the burden compared to the historical baseline may be increasing as much as $50 billion per quarter.

28

III. ANALYZING MARKETS AND EVALUATING MERGERS To what can we attribute the dramatic shift in domestic pricing behavior? We argue that concentration in the petroleum industry contributed substantially to conditions for the exercise of market power over price. That concentration was the result of lax antitrust law enforcement by both the Clinton and Bush Administrations. They have allowed too many mergers because they did not take the unique characteristics of the energy industry into account. Under antitrust laws, the Federal Trade Commission reviews mergers on a prospective, case-by-case basis. It applies certain analytic screens to determine which mergers to investigate, looks at details of individual markets and may oppose mergers or require conditions where it sees a threat to competition. In a sense, it looks in a very detailed way at the individual trees in a small part of the forest to make a prediction about the future for that local area. In part the problem stems from the fact that the FTC views the situation through the very narrow lens of antitrust. In the case of a price spike, it is looking for collusive behavior that drove prices up, but these markets do not require collusion to be manipulated. When Chairman Pitofsky found that long-term unilateral strategic actions have tightened the market and that short-term tactics take advantage of this tightness, he identified a public policy problem that is not strictly an antitrust problem at one level. Things may be bad, but there is nothing antitrust authorities can do about it. At another level, however, there is a fundamental flaw in the approach taken by the FTC. As the agency responsible for evaluating mergers in the industry, it has allowed the concentration to take place. If it has taken a broader view and a more vigorous approach, it might have prevented the problem. In contrast to the FTC, the GAO took a broader view and looked back at what happened after the mergers were approved. It looked both within the local markets affected by the merger and in the industry at large. Because it pursued a retrospective look at many mergers in a statistical approach, it did not quantify every aspect of each market. Looking from a higher level at the trees and the forest, it found that mergers had resulted in increased prices and that increasing concentration in the industry was associated with higher prices.40 Because the two agencies approached the problem from different perspectives and used different methodologies, it is conceivable that they could reach different conclusions without actually contradicting one another. The FTC’s qualitative, before-the-fact analysis could differ from the GAO’s quantitative, after-the-fact analysis. The FTC has refused to accept that possibility, even though it has not yet presented any backward looking econometric evidence of its own that contradicts the GAO findings. Instead, it has attacked the GAO methodology repeatedly and published a lengthy defense of its theory of how the oil market works.

29

It is easy to see why the FTC has reacted this way. If the GAO is right, the FTC might have to change the way it looks at mergers in the oil industry or propose policies that protect the public where antitrust cannot. We believe that there are good reasons that the FTC has missed the mark. To appreciate the difference between the two, we must understand the analytic framework applied to market structure for purposes of merger review, which is the topic of this chapter. The next chapter applies the analytic framework to the petroleum industry. Finally, we review the empirical evidence on the impact of mergers on the gasoline industry. MERGER ANALYSIS Antitrust practice is based on the structure, conduct, performance paradigm (SCP), which has been the dominant approach for almost three-quarters of a century.41 The central concern is with market performance, since that is the outcome that affects consumers most directly. The concept of performance is multidimensional. The measures of performance to which we traditionally look are pricing, quality and profits. Pricing and profits address both efficiency and fairness. They are the most direct measure of how society’s wealth is being allocated and distributed. The performance of industries is determined by a number of factors, most directly the conduct of market participants. Do they compete? What legal tactics do they employ? How do they advertise and price their products? Conduct is affected and circumscribed by market structure. Market structure includes an analysis of the number and size of firms in the industry, their cost characteristics and barriers to entry. Basic conditions of supply and demand also deeply affect market structure. The focal point of market structure analysis is the ability of markets to support competition, which “has long been viewed as a force that leads to an ideal solution of the economic performance problem.”42 Pure and perfect competition is rare, 43 but a great deal of attention has been focused on the relative competitiveness of markets and the conditions that make markets more competitive or workably competitive.44 The problem is that the FTC has failed to recognize the unique economics of the energy industries. Because of the conditions of supply and demand in energy markets, market power can be abused at much lower levels of concentration than is normally the case. The Merger Guidelines issued by the Department of Justice and the Federal Trade Commission invite just such an analysis; the FTC has failed to consider the possibility. Confronted with a market structure in which consumers are being abused, instead of taking a narrow view, the FTC should consider how to address the problem. METHODOLOGY For the purpose of merger analysis, antitrust officials define markets by the substitutability of products.45 Products have to be good substitutes and readily available in a given geographic area to be included in the market. After the market is defined, the analyst looks at the size of the firms in the market as a first screen in assessing the likely impact of a 30

merger. When the number of firms in a market is small, or a single firm is very large, there is a concern that market power can be exercised. Prices can be raised or quality reduced to increase profits by coordinated or parallel actions among a small number of firms, or the unilateral acts of a single dominant firm. The Merger Guidelines describe this concern as follows: Market power to a seller is the ability profitably to maintain prices above competitive levels for a significant period of time. (Sellers with market power also may lessen competition on dimensions other than price, such as product quality, service or innovation.) In some circumstances, a sole seller (a “monopolist”) of a product with no good substitutes can maintain a selling price that is above the level that would prevail if the market were competitive. Similarly, in some circumstances, where only a few firms account for most of the sales of a product, those firms can exercise market power, perhaps even approximating the performance of a monopolist, by either explicitly or implicitly coordinating their actions. Circumstances also may permit a single firm, not a monopolist, to exercise market power through unilateral or noncoordinated conduct — conduct the success of which does not rely on the concurrence of other firms in the market or on coordinated responses by those firms. In any case, the result of the exercise of market power is a transfer of wealth from buyers to sellers or a misallocation of resources.46 The identification of when a small number of firms can exercise this power is not a precise science. Nevertheless, when the number of significant firms falls into the single digits there is cause for concern, as the following summary of empirical and theoretical findings in the industrial organization literature suggests: Where is the line to be drawn between oligopoly and competition? At what number do we draw the line between few and many? In principle, competition applies when the number of competing firms is infinite; at the same time, the textbooks usually say that a market is competitive if the cross effects between firms are negligible. Up to six firms one has oligopoly, and with fifty firms or more of roughly equal size one has competition; however, for sizes in between it may be difficult to say. The answer is not a matter of principle but rather an empirical matter.47 Specific measures of the extent of market power based on elasticities of supply and demand and market concentration (measured by the market shares of firms) have been developed.48 In order to assess the potential for the exercise of market power resulting from a merger, the Department of Justice analyzes the level of concentration as measured by the Herfindahl-Hirschman Index (HHI) (see Exhibit III-1). This measure takes the market share of each firm, squares it, and sums the result.49 A second method frequently used by economists to quantify market concentration is to calculate the market share of the largest four firms (four firm concentration ratio or CR4). 31

E xhibit III-1: D escribing M arket Structures D E P AR TM E N T O F JU S TIC E M E R G E R G U ID E LIN E S

H IG H LY C O N C E N TR ATE D

TY PE O F M AR K E T

E Q U IVALE N TS IN TE R M S O F E Q U AL SIZE D FIR M S

TY PIC A L HHI

4-F IR M SH AR E

M O N O PO LY

1a

53 00+

~100

D U O P O LY

2b

30 00 50 00

~100

5

20 00

TIG H T O LIG O PO L Y

80

18 00 OR M ORE

M O D E R ATE LY C O N C E N TR ATE D

6

U N C O N C E N TR A TE D LO O SE O LIG O PO LY

10

10 00

40 c

50

20 0

8c

A TO M ISTIC C O M PE TITIO N

1667

67

a = A ntitrust practice finds m onopoly firm s w ith m arket share in the 65% to 75% range. Thus, H H Is in “m onopoly m arkets” can be as low as 4200. b = D uopolies need not be a perfect 50/50 split. D uopolies with a 60/40 split w ould have a higher H H I. c = V alue falls as the num ber of firm s increases.

Sources: U .S. D epartm ent of Justice, H orizontal M erger G uidelines (W ashington, revised A pril 8, 1997), for a discussion of the H H I thresholds; W illiam G. Shepherd, T he E conom ics of Industrial O rganization (Englew ood Cliffs, N J: Prentice H all, 1985), for a discussion of four firm concentration ratios.

The HHI has an easy interpretation.50 A market that is made up of 10 equal-sized firms will have an HHI of 1000. Each firm has a 10 percent market share. Squaring the share yields 100 points for each firm, times 10 firms (10 x 10 x 10). In such a market, the four firm concentration ratio would be 40 percent. The Department of Justice (DOJ) considers a market with fewer than 10 equal-sized firms to be concentrated. The DOJ considers an HHI of 1800 as the point at which a market is highly concentrated. This level falls between five and six equal-sized competitors. Thus, it considers a market with fewer than the equivalent of approximately 5.5-equal sized firms to be highly concentrated. At this level of concentration, the four firm concentration ratio would be about

32

72 percent. Markets with an HHI between 1000 and 1800 are considered moderately concentrated. William Shepherd describes these thresholds in terms of four firm concentration ratios as follows: Tight Oligopoly: The leading four firms combined have 60-100 percent of the market; collusion among them is relatively easy. Loose Oligopoly: The leading four firms combined have 40 percent or less of the market; collusion among them to fix prices is virtually impossible.51 Shepherd refers to collusion in his discussion, but it is important to note that it is not the only concern of market power analysis or the Merger Guidelines. The DOJ Merger Guidelines are oriented toward conditions under which a broad range of types of anticompetitive behaviors are sufficiently likely to occur as to require regulatory action. The Merger Guidelines recognize that market power can be exercised with coordinated, or parallel, activities and even unilateral actions in situations where there are small numbers of market players.52 The area of non-collusive, oligopoly behavior has received a great deal of attention. A variety of models have been developed in which it is demonstrated that small numbers of market participants interacting in the market, especially on a repeated basis, can learn to signal, anticipate, and parallel one another to achieve outcomes that capture a substantial share of the potential monopoly profits.53 The Merger Guidelines identify the types of mergers that will raise competitive concerns as follows: Mergers producing an increase in the HHI of more than 50 points in highly concentrated markets post-merger potentially raise significant competitive concerns… Mergers producing an increase in the HHI of more than 100 points in moderately concentrated markets post-merger potentially raise significant competitive concerns.54 The competitive concern is the potential for the exercise of market power. The Merger Guidelines define market power as “the ability profitably to maintain prices above competitive levels for a significant period of time [or]…lessen competition on dimensions other than price, such as product quality, service or innovation.”55 While concerns exist in all concentrated markets, the Merger Guidelines note that in highly concentrated markets, mergers “are likely to create or enhance market power or facilitate its exercise.” To appreciate the nature of these thresholds, a firm with a 15 percent market share that sought to buy another with a two percent market share would violate the 50-point threshold. If the firm being acquired had a market share of just over three percent, it would violate the 100-point threshold. The magnitude of the price increase that is of concern is identified as a “small but significant and nontransitory increase in price (SSNIP).”56 33

The Merger Guidelines suggest asking the question using a 5% SSNIP – that is asking whether a nontransitory price increase of 5% or more would be profitable for a hypothetical monopolist… Nonetheless, the Merger Guidelines explicitly recognize that “the nature of the industry” may lead enforcement agencies to use some other, more appropriate price standard. The FTC staff frequently has used a one-cent-per-gallon price increase in defining relevant market for petroleum mergers.57 MODERATE CONCENTRATION IN THE PETROLEUM INDUSTRY CREATES MARKET POWER Two leading conservative analysts argued in a seminal article a quarter of a century ago that elasticities of supply and demand are critical to the analysis of market power. In “Market Power in Antitrust Cases,” William M. Landes and Richard A. Posner declared “Market Share Alone is Misleading…The proper measure will attempt to capture the influence of market demand and supply elasticity on market power.” 58 Landes and Posner use the Lerner index, which measures the amount by which prices can be set above costs as the result of the exercise of market power, and is directly related to the HHI.59 This is the approach of the Merger Guidelines. Landes and Posner underscore the importance of the elasticity of demand.60 They point out that when demand elasticities are low, market power becomes a substantial problem. In their words, the Lerner Index “comes apart.” [T]he formula “comes apart” when the elasticity of demand is 1 or less. The intuitive reason is that a profit-maximizing firm would not sell in the inelastic region of its demand curve, because it could increase its revenues by raising price and reducing quantity. Suppose, for example, that the elasticity of demand were .5. This would mean that if the firm raised its price by one percent, the quantity demanded of its product would fall by only one-half of one percent. Thus its total revenues would be higher, but its total costs would be lower because it would be making fewer units of its product. Raising price in these circumstances necessarily increases the firm’s profits, and this is true as long as the firm is in the inelastic region of its demand curve, where the elasticity of demand is less than 1. If the formula comes apart when the elasticity of demand facing the firm is l or less, it yields surprising results when the elasticity of demand is just a little greater than 1. For example, if the elasticity of demand is 1.01, equation (la) implies that the firm’s price will be 101 times its marginal cost. There is a simple explanation: a firm will produce where its demand elasticity is close to one only if its marginal cost is close to zero, and hence a relatively low price will generate a large proportional deviation of price from marginal cost.61

34

Leonard Waverman notes that by comparison to most industries and standard antitrust practice, the elasticity of demand in energy industries is quite low: Arguing that a CED [cross elasticity of demand] of 1 is ‘high’ is equivalent to arguing that an own-price elasticity of 1.0 is high, an argument which would not generally be made. In anti-trust economics own price elasticities well above one are considered as connoting a lack of market power. In his survey of the empirical literature in the field of industrial organization, “a firm with such an elastic demand curve [elasticity of demand about 12] has little market power.”62 Landes and Posner provide an example to illustrate their concern that market fundamentals are not considered (see Exhibit III-2). The example illustrates the fact that: a high market elasticity of demand implies there are good substitutes for the product the industry sells, and the existence of such substitutes limits the firm’s market power… The higher the elasticity of supply of the competitive fringe, other things constant, the higher the elasticity of demand facing [the] firm will be and hence the smaller its market power.63

Exhibit III-2: Landes and Posner Example of The Sensitivity of Market Power to Supply and Demand Elasticities Elasticity of Supply

Elasticity of Demand High 2.5 High

2.5

Low

1

Low

High 3

Low .5

x x x

1

x

Market Share Necessary for Firm to Charge Price Above Marginal Cost of: 20% 10% 5%

61

32

15

46

23

12

44

22

11

23

12

6

Source: William M. Landes and Richard A. Posner, “Market Power in Antitrust Cases,” Harvard Law Review, 94: 1981, p. 958. Landes and Posner made the calculation only for a 20 percent price increase, but we have extended it to include a 5 percent increase, since the FTC and the Department of Justice 35

concern themselves with price increases as low as 5 percent,64 particularly in an industry where the dollar value of output is very large, as is true with petroleum products. In the face of low elasticities of supply and demand, firms gain market power with relatively small market shares and at low levels of concentration. Under the assumptions of low elasticities of supply and demand, markets shares around 10 percent yield market power to raise price significantly. As discussed in the next chapter, gasoline markets have notoriously low elasticities of demand, so low in fact that they are a textbook example. John Taylor, an economist with the Bush Administration and author of a widely used introductory economics text, points out that “the elasticity for gasoline is also low,”65 giving a figure of .2. The supply elasticity in the gasoline market is also quite low. Indeed, as noted earlier, in the FTC’s first report on the gasoline market after much of the merger wave had been completed, the FTC issued a warning about the tightening supply. Instead of taking these facts into account, the FTC appears to have moved in the opposite direction. Exhibit III-3 shows the thresholds that the FTC has applied in the 19962003 period. It has done nothing at HHIs below 1400 in larger transactions. For smaller transactions, it has taken no action at HHIs below 2000.66 An HHI of 1400 would equal a market of approximately seven equal-sized firms, giving each firm a market share of about 14 percent. Given the relatively low level of supply and demand elasticities, it is plausible that the FTC has allowed mergers that result in a significant increase in market power. Exhibit III-3: The Federal Trade Commission Applies a Lax Standard in Merger Review Merger Guidelines Post-merger Merger HHI HHI Change Moderately Concentrated

Highly 1800 Concentrated

1000

FTC Practice Post-merger Merger Induced HHI HHI Change

100 Large Mergers

1400

100

Small Mergers

2000

100

50

Source: Federal Trade Commission, The Petroleum Industry: Mergers Structural Change and Antitrust Enforcement (Washington, Staff Study, August 2004), pp. 27-28. 36

In short, moderately concentrated markets should be a source of concern. This is not a far fetched idea. The FTC recognizes that it was the policy at the agency to apply a more rigorous standard not so long ago. “In the early 1980s, the Commission presumptively sought wholesale divestitures in oil mergers when the HHI exceeded 1,000 and the change in the HHI exceeded 100.”67 In other words, the guidelines were enforced rigorously a couple of decades ago, but the agency abandoned that approach. Had it not done so, the industry would be far less concentrated today.

37

IV. THE MERGER WAVE IN THE PETROLEUM INDUSTRY

WEAK MARKET FUNDAMENTALS PUT ENERGY CONSUMERS AT RISK The multidimensional view of markets offered by the SCP framework fits the fundamental economic traits of energy production and consumption well. Energy markets are highly complex. Their volatility poses particular challenges for policy and economic analysis. Contrasting energy commodities to financial instruments like stocks and bonds, a recent book entitled Energy Risk identified the uniqueness of energy markets. The key elements are the supply-side difficulties of production, transportation and storage, and the demand-side challenges of providing for a continuous flow of energy to meet inflexible demand, which is subject to seasonal consumption patterns. [T]he deliverables in money markets consist of a “piece of paper” or its electronic equivalent, which are easily stored and transferred and are insensitive to weather conditions. Energy markets paint a more complicated picture. Energies respond to the dynamic interplay between producing and using; transferring and storing; buying and selling – and ultimately “burning” actual physical products. Issues of storage, transport, weather and technological advances play a major role here. In energy markets, the supply side concerns not only the storage and transfer of the actual commodity, but also how to get the actual commodity out of the ground. The end user truly consumes the asset. Residential users need energy for heating in the winter and cooling in the summer, and industrial users’ own products continually depend on energy to keep the plants running and to avoid the high cost of stopping and restarting them. Each of these energy participants – be they producers or end users – deals with a different set of fundamental drivers, which in turn affect the behavior of energy markets… What makes energies so different is the excessive number of fundamental price drivers, which cause extremely complex price behavior.68 Prices run up quickly because of even slight disruptions in the supply-demand balance. Producers are slow to react because they do not fear that others can bring product to market and steal their business. Consequently, prices are said to be “sticky downward.”69 The majority of published studies find support for the “rockets and feathers” view70 – prices rise like rockets and float down like feathers.71 When energy markets become as concentrated as they are in America, the feathers do not float all the way down.

38

DEMAND IS INELASTIC The continuous flow of large quantities of product to meet highly seasonal demand is the central characteristic of the demand side of the market. In order to design proper policies to deal with energy demand and how it affects the market, we must have an appreciation for why people use energy as they do. Examining price and income elasticities leads to the conclusion that energy is a necessity of daily life. Recognizing this fact leads to policy choices that can have the greatest impact while imposing the least cost and inconvenience on consumers. Energy consumption is determined by the physical and economic structure of daily life. People need to drive on a daily basis because of the way our communities are built and our transportation systems designed. Stores are far from homes. Homes are far from work. Social and after-school activities are dispersed. In most communities, mass transit is scarce and inconvenient. It is necessary to drive to get from here to there. We own more cars and drive more miles on a household basis over time. These trends and patterns have become stronger and more deeply entrenched as our society has become wealthier and the tendency for two-earner households has grown. For the past three decades there has been an almost perfect, one-to-one correspondence between economic growth and the growth of total miles driven.72 People consume natural gas for heating primarily and, increasingly, indirectly for electricity. The amount they consume is dictated in large part by the kinds of buildings in which they live and work and the energy efficiency of the appliances they use. Natural gas has become the fuel of choice in many residential uses. It has been the favorite of the electricity industry for about a decade. The result of the underlying socioeconomic determinants of automobile travel is to render gasoline demand “inelastic.” The demand elasticity for gasoline has been studied hundreds of times in the U.S. and abroad. The best estimate of short-term elasticity (usually measured by demand response in a period of about a year) is -.2.73 In other words, when prices increase by 10 percent, demand declines by only 2 percent. The best estimate of the long-term elasticity is about -.4.74 Both of these are quite low. While fewer estimates of the elasticity of demand for natural gas have been made, the results are similar.75 Short-term elasticities are in the range of -.3; long-term elasticities are in the range of -.6. An occasional estimate of long-term elasticity is in the neighborhood of -1.0, which is not sufficient to discipline market power. The low elasticity of demand is the critical factor in rendering energy markets volatile and vulnerable to abuse. When demand is inelastic, consumers are vulnerable to price increases, since they cannot cut back on or find substitutes for their use of the commodity. When the most important market force in disciplining market power, demand elasticity, is as low as observed for gasoline and natural gas, there are many opportunities to exercise market power.

39

Exhibit IV-1: Gasoline Consumption 10000

9000

8000

THOUSAND BARRELS PER DAY

7000

6000

5000

4000

3000

2000

1000

JA-04

S

MY

JA-03

S

MY

S

JA -02

MY

S

JA -01

MY

S

JA - 00

MY

JA - 99

S

MY

JA -98

S

MY

S

JA -97

MY

S

JA -96

MY

JA -95

0

MONTHS AND YEAR

Source: U.S. Department of Energy, Energy Information Administration, Monthly Energy Review, various issues and database.

Demand is generally predictable in a seasonal pattern (as shown in Exhibits IV-1 and IV-2). With demand quite predictable and inelastic, price is determined by supply. The flow of product and stockpiles are critical. Supplies must be adequate to deal with shifts in demand. Demand may help to set the stage, but it is supply that provides the action. The ability of producers to exercise market power on the supply side is magnified immensely when the supply-demand balance is tight. High levels of demand strain resources and make it difficult to maintain stocks. During the 1990s, America shot itself in the pocketbook by building two fleets of gas-guzzlers that are helping to keep energy markets tight – low mileage Sport Utility Vehicles/light trucks and natural gas-fired power plants.

40

E xh ib it IV -2: Season ality of N atural G as C onsu m ption

3000

2500

MCF

2000

1500

1000

ALL USAGE

JA-04

S

M

JA-03

S

M

JA -02

S

MY

S

JA -01

MY

S

JA-00

MY

S

JA-99

MY

S

JA-98

MY

S

JA-97

MY

S

JA-96

MY

0

JA -95

500

ALL TREND

S ou rce: U .S . D ep artm en t of E n ergy, E nergy Inform ation A d m in istration, M onthly E n ergy R eview , various issu es and d atabase.

Exhibit IV-3 shows that improvement in average gas mileage stopped in the 1990s, primarily because of the increasing use of light trucks, whose fuel efficiency has declined. Overall, average mileage has declined because of the increased use of less efficient SUVs and light trucks. If the rate of improvement in the fleet fuel efficiency had been maintained at historical levels throughout the 1990s, America would be consuming over one million barrels per day less of gasoline.76 Gasoline savings of that magnitude would have offset the entire decline of domestic production during the 1990s,77 a figure that would have alleviated tight gasoline

41

Exhibit IV-3: M otor V ehicle Fuel Efficiency

25

MILES PER GALLON

20

15

10

5

20 01

19 99

19 97

19 95

19 93

19 91

19 89

19 87

19 85

19 83

19 81

19 79

19 77

19 75

19 73

0

YEAR PASSENG ER CARS LIGHT TRUCKS ALL VEHICLES (Includes All Trucks)

Source: U. S. Departm ent of Energy, Energy Information Administration, M onthly Energy Review (W ashington, various issues) Table 1.10.

markets and made them much less vulnerable to price shocks. Determined efforts can achieve a much higher level of efficiency in the automobile fleet. Exhibit IV-4 shows the consumption of natural gas. Overall consumption grew because of the increased consumption in the electricity sector. This increased consumption by gas-fired generating plants shifted the pattern of demand more heavily into the summer months. As a result, it has become more difficult to put gas in storage in preparation for the winter heating season. The increase in natural gas consumption in the electricity sector is equal to about ten percent of total production and 50 percent of natural gas imports.78 Here too, vigorous promotion of efficiency could substantially reduce consumption and alleviate pressure on natural gas markets.79 42

Exhibit IV-4: Natural Gas Consumption

25000

TRILLION CUBIC FEET

20000

15000

10000

5000

19 85 19 86 19 87 19 88 19 89 19 90 19 91 19 92 19 93 19 94 19 95 19 96 19 97 19 98 19 99 20 00 20 01 20 02

0

TOTAL

TOTAL MINUS ELECTRICITY

Source: U. S. Department of Energy, Energy Information Administration, Monthly Energy Review (Washington, various issues) Table 4.4.

SUPPLY IS INELASTIC Short-term supply in the energy industry is also extremely inelastic. That is, it cannot be quickly increased due primarily to difficulties of production, transportation and storage for providing for a continuous flow of energy.80 Because of the nature of the underlying molecules, the production, transportation and distribution networks are extremely demanding, real time systems. Energy is handled at high pressure, high temperature and under other physical conditions that are, literally, explosive. These systems require perfect integrity and real time balancing much more than other 43

commodities. Transportation and distribution infrastructure is extremely capital intensive and inflexible. Many sources of energy are located far from consumers, requiring transportation over long distances. The commodities are expensive to transport and store. They are delivered over a network that is sunk in place with limited ability to expand in the short or medium term. Refineries, storage facilities and pipelines are not only capital intensive, but they take long lead times to build. They have significant environmental impacts. In the short term, their capacity is relatively fixed. Refineries must be reconfigured to change the yield of products. Although pipelines have largely depreciated their historic, sunk costs, expansion would be capital intensive. Thus, pipeline capacity is generally a fixed capacity as well. Accidents have a special role in networks such as these. Because of the demanding physical nature of the network, accidents are prone to happen. Because of the volatile nature of the commodity, accidents tend to be severe. Because of the integrated nature of the network and demanding real time performance, accidents are highly disruptive and difficult to fix. These physical and economic characteristics render the supply-side of the market inelastic.81 Given the basic infrastructure of supply in the industry, the availability of excess capacity and stocks to meet changes in demand is the critical factor in determining the flexibility of supply. Since output is slow to respond to price, stockpiles, storage and importation of product become critical elements of energy markets.82 Stocks are the key factor in policy responses to market power where supply is inelastic: Economic frictions (including transportation, storage, and search costs) which impede the transfer of the underlying commodity among different parties separated in space or time can create the conditions that the large trader can exploit in order to cause a supracompetitive price… Although the formal analysis examines transportation costs as the source of friction, the consumption distortion results suggest that any friction that makes it costly to return a commodity to its original owners (such as storage costs or search costs) may facilitate manipulation. The extent of market power depends on supply and demand conditions, seasonal factors, and transport costs. These transport cost related frictions are likely to be important in many markets, including grains, non-precious metals, and petroleum products. Transportation costs are an example of an economic friction that isolates geographically dispersed consumers. The results therefore suggest that any form of transaction costs that impedes the transfer of a commodity among consumers can make manipulation possible… All else equal, the lower the storage costs for a commodity, the more elastic its demand.83 44

Every investigation of every product price spike in the past several years points to “unusually low stock” as a primary driver.84 But stock levels are no accident; they are the result of business decisions. Business decisions reflect the competitive conditions in the industry, which the next section shows have deteriorated dramatically as a result of the merger wave. CONSOLIDATION It was becoming obvious by mid-2000 that the industry was becoming sufficiently concentrated in several parts of the country that competitive market forces were weak. The problem afflicted both the production of oil and gas and the downstream operations of the oil industry. The Department of Energy analyzes major U.S.-based energy producing companies in a program called the Federal Reporting System (FRS). Tracking the “Recent Mergers Affecting Oil and Gas Producers,” the FRS report identified a total of 34 companies that merged into 13 (see Exhibit IV-5) from 1997 to 2002.85 The previous year, the report identified 15 refining companies that had shrunk to seven (see Exhibit IV-6).86 Of the 31 companies listed in the sector by Business Week in 1995, 21 engaged in mergers with other companies between 1997 and 2002. Of the 21 listed by Business Week in 2003, 15 had engaged in mergers in the previous five years. Almost all of the mergers involved large companies that had previously been listed in the sector. The big got bigger and domestic prices started ratcheting up soon thereafter. There are two clearly identifiable trends affecting the supply side of the gasoline market – a reduction in capacity relative to demand and an increase in concentration. These trends result from the business decisions of oil companies. Even the National Energy Policy Development Group recognized that the reduction in capacity was the result of business decisions of oil companies. Government did not choose to close refineries and carry much lower stocks, private businesses did.87 Ongoing industry consolidation, in an effort to improve profitability, inevitably leads to the sale or closure of redundant facilities by the new combined ownership. This has been particularly true of terminal facilities, which can lead to reductions in inventory and system flexibility. While excess capacity may have deterred some new capacity investments in the past, more recently other factors, such as regulations, have deterred investment.88 By traditional standards, the wave of industry mergers noted above has resulted in a level of concentration that creates the basis for business behaviors and strategies that can exploit market power. Several major mergers between vertically integrated companies in the top tier of the oil industry have pushed petroleum product markets to levels of concentration that are a serious concern.

45

Exhibit IV-5: Recent Mergers Affecting FRS Oil And Gas Producers

Source: Energy Information Administration, Performance Profiles of Major Energy Producers: 2002 (Washington, February 2004), p. 20. 46

Exhibit IV-6: Genealogy Of The 2001 FRS Refiners

Source: Energy Information Administration, Performance Profiles of Major Energy Producers: 2001 (Washington, January 2003), p. 78.

47

Market concentration… has increased substantially in the downstream segments of the U.S. petroleum industry since the 1980s, partly as a result of merger activities, while changing very little in the upstream segment… In the downstream (refining and marketing) segment, market concentration in refining increased from moderately to highly concentrated in the East Coast and from unconcentrated to moderately concentrated in the West Coast; it increased but remained moderately concentrated in the Rocky Mountain region.89 Product markets are much smaller than refinery markets. That is, while refineries may serve a broad area, most consumers buy virtually all of their gasoline in the metropolitan area in which they live. Most studies of gasoline prices use the metropolitan area as the unit of analysis. While we lack data on a city-by-city basis, some data is readily available on a stateby-state basis. It confirms that the trend of increasing concentration has brought the industry to a level that is a source of concern. The GAO found that “[c]oncentration in the wholesale gasoline market increased substantially from the mid-1990s so that by 2002, most states had either moderately or highly concentrated wholesale gasoline markets.”90 The previous discussion focuses on horizontal concentration. Vertical integration between segments of the industry may have an impact as well. Vertical integration by dominant firms may create a barrier to entry requiring entry at two stages of production,91 or foreclosing critical inputs for competitors in downstream markets.92 Vertical arrangements may restrict the ability of downstream operators to respond to local market conditions.93 Vertical integration not only removes important potential competitors across stages of production,94 but also may trigger a wave of integrative mergers,95 rendering small independents at any stage extremely vulnerable to a variety of attacks.96 GAO found evidence here as well: Anecdotal evidence and economic analysis by some industry experts suggest that mergers not only affected market concentration but also enhanced vertical integration and barriers to entry… At the wholesale and retail marketing levels, industry officials point out that mergers may have exacerbated barriers to entry in some markets. For example, the officials noted that mergers have contributed to a situation where pipelines and terminals are owned by fewer, mostly integrated companies that sometimes deny access to third party users, especially when supply is tight which creates a disincentive for potential new entrants into such wholesale markets.97 Gasoline markets are vulnerable to the negative effects of vertical integration. Product must move downstream from the refinery or the tanker to the pump. Vertically integrated operations are closed to independent sources of supply. They may impose zonal pricing formulas or restrictions on sources of supply on their distribution outlets.98 With vertical integration, the market may be less responsive than it could be both in the short term, since competing product has difficulty getting into individual markets at the end of a vertically99 48

integrated chain, and in the long term because new competitors in any market may have to enter at several stages of the business. Over the course of the last decade, the number of gasoline stations has declined as well, while the number of vehicles that need to be supported has grown. The number of gasoline stations has declined by 16 percent, from 210 thousand to 176 thousand. The number of motor vehicles has increased by 11 percent, from 189 million to 210 million. As a consequence, the number of motor vehicles per station has increased by 32 percent. Each station pumps more gas, but there are fewer competitors. The GAO provides a detailed description of the changes in gasoline marketing that have worked to diminish competition: According to industry officials, two major changes have occurred in U.S. gasoline marketing since the 1990s, partly related to mergers. First, the availability of unbranded (generic) gasoline has decreased substantially. Unbranded gasoline is generally priced lower than branded gasoline, which is marketed under the refiner’s trademark…. They generally attributed the decreased availability of unbranded gasoline to one or more of the following factors: There are now fewer independent refiners, who typically supply mostly unbranded gasoline. These refiners have been acquired by branded companies, have grown large enough to be considered a brand, or have simply closed down. Partially or fully vertically integrated oil companies have sold or mothballed some refineries. As a result, some of these companies now have only enough refinery capacity to supply their own branded needs, with little or no excess to sell as unbranded.100 Moreover, independent refiners, some of whom bought refineries from the fully vertically integrated oil companies, also sell a portion of their gasoline to these companies, further reducing the amount of gasoline that the independent refiners can sell to unbranded distributors and retailers.101 The major branded refiners have increased the efficiency of their inventory management systems. Some unbranded supply came from excess production. Synergies developed through mergers have increased the industry’s ability to use just-in-time inventory management systems, which ensured that refiners produce an amount of gasoline sufficient to meet their current branded needs without producing any excess that can be sold unbranded.102 Thus, the merger process reinforced the tendency for refiners to limit production capacity to meet only internal needs, which Pitofsky and Rand noted.

49

The second change identified by industry officials is that refiners now prefer dealing with large distributors and retailers.103 Consolidation at the refining level has allowed large refiners to dictate the terms of supply contracts, including minimum volume requirements.104 Distributors said that refiners who supply them with branded gasoline preclude them from operating stations within certain proximities of major metropolitan markets where the refiners generally prefer to locate their company-owned and –operated and lessee dealer stations.105 An interesting study of cities across the country as well as the first merger in the wave of late 1990s mergers (the Tosco/Unocal merger of 1997) finds support for this concern. The study finds that both horizontal concentration and vertical integration are associated with high prices: Upstream concentration is positively correlated with price, the market share of independents is negatively correlated with price and the average market share of the vertically integrated suppliers covaries positively with wholesale price… Moreover, the incentive to raise price is also positively correlated with the geographic proximity of integrated stations to rival independents, indicating that the greater the degree of competition, or cross-price elasticity, between integrated retailers and rival independent retailers, the greater the integrated firm’s incentive to raise rivals’ wholesale costs.106 In light of these findings, the integration of refining and distribution is important. The percentage of stations owned by companies that also own refineries did not change much over the decade, but the size of the largest integrated owners increased dramatically. The integrated companies also appear to be more regionalized.107 Each company covers a smaller area more densely, resulting in less competition. STRATEGIC DECISIONS With increasing concentration, long-term strategic decisions by the industry about production capacity interact with short-term (mis)management of stocks to create a tight supply situation that provides ample opportunities to push prices up quickly. Because there are few firms in the market and because consumers cannot easily cut back on energy consumption, prices hold above competitive levels for significant periods of time. The problem is not a conspiracy, but the rational action of large companies with market power. With weak competitive market forces and high barriers to entry, individual companies have flexibility for strategic actions that raise prices and profits.108 •

Individual companies can let supplies become tight in their area and keep stocks low since there are few competitors who might counter this strategy. 50

•

Companies can simply push prices up when demand increases because they have no fear that competitors will keep their prices low to steal customers.

•

Individual companies do not feel compelled to quickly increase supplies with imports, because their control of refining and distribution ensures that competitors will not be able to deliver supplies to the markets in their area.

•

Because there are so few suppliers and capacity is so tight, it is easy to keep track of potential threats to this profit-maximizing strategy.

•

Every accident or blip in the market triggers a price shock and leads to increased profits.

GASOLINE SUPPLY The prominent role of business decisions in reducing capacity raises the concern that these decisions are intended to reduce competitive market forces and secure market power for major industry players. While mergers and acquisitions or facility closings are nominally justified by claims of efficiency gains, 109 they have a real economic effect of reducing competition. Documents from the mid-1990s indicate that industry officials and corporate officers were concerned about how to reduce capacity, with observations such as “if the U.S. petroleum industry doesn’t reduce its refining capacity, it will never see any substantial increase in refinery profits,” from a Chevron Corporation document written in November 1995. A Texaco official, in a March 1996 memorandum, said refinery overcapacity was “the most critical factor” facing the industry and was responsible for “very poor refining financial results.”110 With oil companies merging and eliminating “redundant” capacity, it should not be surprising to find that capacity has not kept up. Refinery capacity has not expanded to keep up with the growth in demand. Exhibit IV-7 shows the relationship between refinery output and demand. In 1985, refinery capacity equaled daily consumption of petroleum products. By 2002, daily consumption exceeded refinery capacity by almost 20 percent. In the early1980s, a public policy providing support for small refineries was terminated. This accounted for the loss of about 100 refineries between 1980 and 1985 (see Exhibit IV-8). Since then, scores of other refineries have been shut down. Government did not close refineries, private businesses did. In the 1990s alone, approximately 50 refineries were closed. Since 1995, over 20 refineries have been shut down. The number of operating refineries has been reduced by 13 percent since 1995. The refineries get larger, but smaller in number and are owned by fewer and fewer entities. Over the last two decades of the twentieth century, the number of firms engaged in refining in the United States declined by two-thirds.111

51

E x h ib it I V -7 : R e f in e r y C a p a c it y a n d P r o d u c t S u p p lie d

25000

THOUSAND BARRELS PER DAY

20000

15000

10000

5000

0 1975

1980

1985

1990

1995

2000

2001

2002

2003

YEAR R E F IN E R Y C A P A C IT Y

P E T R O L E U M P R O D U C T S U P P L IE S

S o u r c e : U .S . D e p a r t m e n t o f E n e r g y , E n e r g y I n f o r m a t i o n A d m i n i s t r a t i o n , P e t r o l e u m S u p p l y A n n u a l (W a s h in g to n , v a r io u s is s u e s ), T a b le s S 1 , 3 6 ; W e e k ly P e tr o le u m S ta tu s R e p o r t ( W a s h in g t o n , v a r io u s is s u e s ).

Once these trends become clear, the complaint that no new refineries have been built in recent years loses its compelling public policy impact.112 Similarly, blaming the decline of capacity relative to demand on the Clean Air Act does not stand close scrutiny. Consolidation of the refinery industry is a business decision that began long before changes in the Clean Air Act amendments of 1990 and continued after the adjustment to changes in gasoline formulation. It has become evident that stocks of product are the key variable that determines price shocks. In other words, stocks are not only the key variable; they are also a strategic variable. The industry does a miserable job of managing stocks and supplying product from the consumer point of view. Policymakers have done nothing to force them to do a better job. 113

52

E x h ib it I V -8 : R e fin e r ie s a n d R e fin e r y C a p a c ity

350

20

16

NUMBER OF REFINERIES

250

14

12 200 10 150 8

6

100

4

OPERABLE REFINERY CAPACITY (000 BARRELS PER DAY)

18 300

50 2

0

0 1970

1975

1980

1985

R E F IN E R IE S

1990

1995

2000

2003

R E F IN E R Y C A P A C IT Y

S o u r c e : U .S . D e p a r t m e n t o f E n e r g y , E n e r g y I n f o r m a t i o n A d m i n i s t r a t i o n , P e tr o l e u m S u p p l y A n n u a l ( W a s h i n g t o n , v a r io u s i s s u e s ) , T a b l e s S 1 , 3 6 .

If the industry were vigorously competitive, each firm would have to worry a great deal more about being caught with short supplies or inadequate capacity and would hesitate to raise prices for fear of losing sales to competitors. Oil companies do not behave this way because they have power over price and can control supply. The capacity and stocks of product on hand are no longer dictated by market forces, they can be manipulated by the oil industry oligopoly to maximize profits. A 2003 RAND study of the refinery sector reaffirmed the importance of the decisions to restrict supply. It pointed out a change in attitude in the industry, wherein “[i]ncreasing capacity and output to gain market share or to offset the cost of regulatory upgrades is now frowned upon.”114 In its place we find a “more discriminating approach to investment and supplying the market that emphasized maximizing margins and returns on investment rather 53

than product output or market share.”115 The central tactic is to allow markets to become tight by “relying on… existing plant and equipment to the greatest possible extent, even if that ultimately meant curtailing output of certain refined product.”116 Indeed, many RAND discussants openly questioned the once-universal imperative of a refinery not “going short” – that is not having enough product to meet market demand. Rather than investing in and operating refineries to ensure that markets are fully supplied all the time, refiners suggested that they were focusing first on ensuring that their branded retailers are adequately supplied by curtailing sales to wholesale markets if needed.117 The RAND study drew a direct link between long-term structural changes and the behavioral changes in the industry, drawing the connection between business strategies to increase profitability and pricing volatility. It issued the same warning that the FTC had offered two years earlier: For operating companies, the elimination of excess capacity represents a significant business accomplishment: low profits in the 1980s and 1990s were blamed in part on overcapacity in the sector. Since the mid-1990s, economic performance industry-wide has recovered and reached record levels in 2001. On the other hand, for consumers, the elimination of spare capacity generates upward pressure on prices at the pump and produces short-term market vulnerabilities. Disruptions in refinery operations resulting from scheduled maintenance and overhauls or unscheduled breakdowns are more likely to lead to acute (i.e., measured in weeks) supply shortfalls and price spikes.118 The structural conditions in the domestic gasoline industry have only gotten worse as demand continues to grow and mergers have been consummated. The increases in prices and industry profits should come as no surprise. The spikes in the refiner and marketer take at the pump in 2002, 2003, and early 2004 were larger than the 2000 spike that was studied by the FTC. The weeks of elevated prices now stretch into months. The market does not correct itself. The roller coaster has become a ratchet. Decisions about stockpiling of product is a business decision. Exhibit IV-9 shows the relationship between stocks and demand for gasoline. Stocks are measured as the number of days of demand for gasoline held in storage. The exhibit shows that the amount of stock above what is considered the lower operational inventory has declined. Because of the nature of operations of gasoline delivery systems, a certain level of stock is needed to keep the system running in real time (the lower operational level).119 Operations are subject to disruption should stocks fall below this level.120 It is the stocks above this level that are available to respond to shifts in demand or price. The reserves above the lower operational level have declined to very low levels. They generally are in the range of a couple of days, compared to four or five days in the early 1990s and over a week in the 1980s.

54

E x h ib it IV -9 : G a so lin e S to ck s O n H an d

7

6

5

ON HAND

DAYS SUPPLY

4

3

2

1

0 1 9 8 5 1 9 8 6 1 9 8 7 1 9 8 8 1 9 89 1 99 0 1 9 9 1 19 9 2 1 9 93 19 9 4 1 99 5 1 9 96 1 99 7 1 9 98 19 9 9 2 0 00 20 0 1 2 00 2 20 03 A B O V E L O W E R O P E R A T IO N A L IN V E N T O R Y

S o u rce: U . S . D ep a rtm e n t of E n ergy , E n erg y In fo rm a tio n A d m in istration , M o n th ly E n ergy R eview (W a sh in gto n , va rio u s issu es an d d ata b ase).

In analyzing the Midwest price spike of 2000, the Department of Energy again found stocks to be the culprit, starting an analysis entitled Supply of Chicago/Milwaukee Gasoline Spring 2000 as follows: This summer’s run-up in Midwest gasoline prices, like other recent price spikes, stemmed from a number of factors. The stage was set for gasoline volatility as a result of tight crude oil supplies, which led to low product stocks and relatively high crude oil prices. With little stock cushion to absorb unexpected events, Midwest gasoline prices surged when a number of supply problems developed, including pipeline and refinery supply problems, and an unexpectedly difficult transition to summer-grade Phase II reformulated gasoline.121

55

In explaining the early spring price run-up in 2001, the EIA cited inventories as the starting point: “Low petroleum inventories set the stage for our current situation, as they did last year both for heating oil and for gasoline.”122 After the recession of 2001/2002, industry experts and Department of Energy officials again had to wring their hands in 2003 about tight supplies, refineries that were running at capacity and difficult transitions to new fuels, but denied any wrongdoing.123 The explanations they offered were more like excuses than analysis. For example, the following excerpt from the Energy Information Administration Summer 2003 Motor Gasoline Outlook gives a flavor of the effort to gloss over fundamental problems: This summer, motor gasoline markets are expected to be tighter than last summer. Total spreads (retail price, excluding taxes, minus crude oil prices) are expected to average 55 cents per gallon compared to 41 cents per gallon in 2002. This results primarily from higher refinery utilization brought about by the increase in demand combined with low beginning-of-season inventory levels. But the projected spread is less than the 58 cents observed in the summer of 2001, when stocks were at record low levels and the Midwest suffered from ethanol-related blending problems.124 The EIA tried to soften the blow of a very high spread by comparing it to the astronomical level of 2001, rather than the level of 2002, which was itself significantly higher than the 1995-1999 average. The summer did not go as the EIA expected. The only thing that seems to be predictable is that we will not have enough stocks on hand to deal with the inevitable accidents and incidents that seem to drive up prices. The GAO found that the price elasticity of capacity utilization is in the range of .1 to .2, as large as the short run elasticity of demand (“a 1 percent increase in refinery capacity utilization rates was associated with a one-tenth to two-tenths of a percent per gallon increase in price”).125 The price elasticity of inventories is in the range of .4-.5.126 In other words, given the low elasticity of demand and tight markets, strategic supply variables play a crucial role, as Chairman Pitofsky warned over three years ago. The tight supply-demand balance that results from industry decisions to close refineries may also contribute directly to the occurrence of accidents. The extremely high capacity utilization that creates high levels of profit also puts additional stress on equipment.127 NATURAL GAS SUPPLY Behavior patterns in natural gas raise concerns as well. They cast doubt on the recent claim of the National Petroleum Council that the perception of the natural gas resource base has suddenly changed.128 First, as a factual matter, non-industry analysts disagree.129 Second, to the extent that there is a change in resource recovery, it reflects business decisions made over a number of years. 56

The move of the majors into gas changed the nature of the sector.130 Exhibit IV-10 shows a coincidence that cannot be ignored. The consolidation in the industry came hand-inhand with decisions by the majors to acquire resources through mergers and acquisitions (rather than exploration) and a shift of drilling away from exploration. 131 A couple of years later the NPC concludes that a change in the resource base is evident. Decisions about which well to produce and which well to cap, how much to inject into storage, how to use pipeline capacity and, ultimately, how to report prices are business decisions that shift resources. Decisions about which types of wells to drill may change replacement rates.132 Exhibit IV-10: Shifts In O rientation of FRS Companies In Acquisition and Development of Natural G as Resources

PERC ENT OF NA T URA L GA S W EL L S DRIL L ED FOR EXPL ORAT ION

14 12

PECENT OF WELLS COMPLETED

10 8 6 4 2 0 1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

Source: Energy Inform ation Administration, Perform ance Profiles of M ajor Energy Producers: 2002 (W ashington, February 2004), p. 82; Table B-16, Perform ance Profiles of M ajor Energy Producers: 1999 (W ashington, January 2001), Table B-16.

57

Standard and Poor’s has recently noted that this trend has continued and raised questions about it: It is unclear that producers are investing enough to grow production materially – and this follows a year [2003] in which the domestic gas production (including acquisitions) of integrated producers appears to have declined… [M]ajor integrated companies, which appear to be reinvesting only 30 to 40 percent of their domestic cash flow in the United States, have made strategic decisions to allow their shallow-water and onshore natural gas production to deplete to redeploy capital to international (mainly oil) projects.133 It is also important to recognize in the case of natural gas that the trading markets that drive the wellhead price are quite new. Most were set up in the 1990s, as part of the restructuring of the natural gas industry.134 Enron played a large role in these markets and when it collapsed, so too did much private trading.135 Today, the markets are “very thin” and that raises concerns about trading,136 but the evidence is mounting that manipulation and abusive practices have long been part of these markets.137 Thus, it should not be surprising to find that capacity has not kept up and stockpiles are chronically low, causing markets to be tight; that was the outcome the industry sought to achieve with its wave of mergers and consolidation. For natural gas we find a concern about stocks that is similar to the issue in gasoline markets. Natural gas stocks are very much influenced by the need to build stockpiles to meet the inevitable surge in demand during the winter heating season.138 One recent study found the volatility of natural gas prices to be greater than oil prices because of the nature of the infrastructure required to deliver natural gas to consumers: The dependence of natural gas on more inflexible sources of supply and the greater role of transportation opens the window to profiteering. It appears that volatility in natural gas returns is more persistent than volatility in oil returns. By itself, this result suggests that there may be a ‘larger window of profit opportunity’ for investors in natural gas than in oil…. [N]atural gas return volatility responds more to unanticipated events (e.g. supply interruptions, changes in reserves and stocks, etc.), regardless of which market they originate in… For example, a major event-causing shock will lead to an immediate increase in volatility in natural gas returns and culminate in a (relatively) prolonged period of volatility. If prices and thus returns rise in response to volatility, there may be immediate profit opportunities in natural gas following shocks in either market.139 The long-term trend to much lower stocks relative to demand is clear in natural gas (see Exhibits IV-11 and IV-12). Compared to the decade of 1985-1994, stocks were about 25 58

E xh ib it IV -11: N atu ral G as S torage S in ce 1985

4 ,0 0 0 ,0 0 0

3 ,5 0 0 ,0 0 0

Million Cubic Feet

3 ,0 0 0 ,0 0 0

2 ,5 0 0 ,0 0 0

2 ,0 0 0 ,0 0 0

1 ,5 0 0 ,0 0 0

1 ,0 0 0 ,0 0 0

5 0 0 ,0 0 0

0

A p ril August Decem ber

M ay S e p te m b e r J a n u a ry

June O cto b er F e b ru a ry

J uly Novem ber M a rch

S ou rce: E n ergy In form ation A d m in istration , N atu ral G as S torage: H istorical D ata, d atab ase.

percent lower in the 1995-1999 period. During the price spikes of the new millennium, the second half of 2000 and the first half of 2001 and 2003, stocks were 40 to 50 percent lower than in the 1985-1994 period and 25 percent lower than in the 1995-1999 period. These declines came during a period of a small increase in consumption. Exhibit IV-12 can be used to make another point. By the fall of 2003, stocks of natural gas had rebounded to typical levels of previous years, yet prices did not moderate. This set off another round of complaints about market manipulation.140 There are now investigations into the misreporting of gas in storage.141 The court ruling in the lawsuit against Enron highlights how companies can manipulate prices as a result of increased concentration. “Enron was positioned to yank prices up because its Enron Online [EOL] trading platform controlled fully 40 percent of average 59

E x h ib it IV -1 2 : W o rk in g G a s S to ck s S in ce 1 9 9 5

3500

3000

BILLIONS OF CUBIC FEET

2500

2000

1500

1000

500

P rice S p ik es

Jan. 04

Jan. 03

Jan. 02

Jan. 01

Jan. 00

Jan. 99

Jan. 98

Jan. 97

Jan. 96

Jan. 95

0

S o u rce: E n erg y In fo rm a tio n A d m in istra tio n , N a tu ra l G a s S to ra g e: H isto rica l D a ta , d a ta b a se.

daily trading on the Henry Hub natural gas spot market. Further, other traders in that market ‘routinely looked to EOL and Enron for current [Henry Hub] spot market pricing information,’ according to the CFTC complaint.”142 The Henry Hub is the most important price setting spot market in the nation. That would virtually ensure that the hub was highly concentrated at that time. These levels of concentration would cause concern in any industry, but in the energy industries they are of extreme concern because the underlying market forces are weak. Because the supply and demand elasticities for gasoline and natural gas are so low143 and the expenditures on energy are so large,144 we believe these industries should be held to close scrutiny because the exercise of market power results in higher prices.145 Antitrust authorities have failed to exercise proper caution to protect the public interest and consumers are suffering as a result. 60

V. THE IMPACT OF MERGERS ON MARKET CONCENTRATION AND PRODUCT PRICES THE IMPACT OF LAX MERGER POLICY ON MARKET CONCENTRATION The FTC’s focus on highly concentrated markets and large changes in HHI is evident in its recent (1996-2003) merger review activities (see Exhibit V-1). The action the FTC claims to take is to generally restore the competitive landscape to its pre-merger levels, where it perceives a threat of market power. However, if it is using the wrong standard, it may allow mergers that increase market power.

Exhibit V-1: Federal Trade Commission Action and Inaction on Oil Company Mergers Post-Merger HHI

Up to 1399 1400 – 1799 1800 – 7000+ Total

Threshold Not Violated No Action Needed

Threshold Violated No Action Taken

Conditions Imposed

9 5 0

11 15 26

0 55 153

14

54

208

Source: Federal Trade Commission, The Petroleum Industry: Mergers, Structural Change and Antitrust Enforcement (Washington, Staff Study, August 2004), Table 2-6.

Looking at the combination of post-merger concentration and merger-induced change, we identify over 50 situations, or about one-fifth of the total, in which the FTC took no action but should have. It took no action in mergers where the HHI was below 1400. It took no action in one-fifth of the cases when the post-merger HHI was in the range of 1400 to 1799. It took no action in one-sixth of the mergers where the post-merger market was highly concentrated (HHI of 1800 or higher). This lax view of market concentration pervades the FTC’s analysis. Consider the following FTC analysis that accompanied Exhibit V-2:

61

Exhibit V-2: Increasing Concentration of Refining and Wholesale Gasoline Markets AREA PADD I CT DC DE FL GA MA MD ME NC NH NJ NY PA RI SC VA VT WV PADD I PADD II IL IN KY MI OH WI UPPER MIDWEST IA KS MN MO ND NE OK SD TN PADD II PADD III AL AK AR LA MS NM TX PADD III

MARKET 1990

1994

Wholesale Wholesale Wholesale Wholesale Wholesale Wholesale Wholesale Wholesale Wholesale Wholesale Wholesale Wholesale Wholesale Wholesale Wholesale Wholesale Wholesale Wholesale Refining 1225

1089 3374 876 869 720 937 1142 1208 847 777 816 1064 1024 1046 829 893 1163 1573

Wholesale Wholesale Wholesale Wholesale Wholesale Wholesale Refining 1102

1154 1589 1412 1173 1576 975

Wholesale Wholesale Wholesale Wholesale Wholesale Wholesale Wholesale Wholesale Wholesale Refining

744 880 1203 724 1605 897 922 812 770

Wholesale Wholesale Wholesale Wholesale Wholesale Wholesale Wholesale Refining

2003

CHANGE

1394 2552 1628 1019 1169 1432 1185 1550 1178 1154 1240 1036 1612 1512 991 1086 1153 1390

305 -822 752 150 449 495 43 342 331 377 424 -28 588 466 162 193 -10 -183 718

1272 2303 2492 2017 2025 1307

118 714 1080 844 449 332 630

910 1343 1368 1328 2496 1445 1335 1176 1245

166 463 165 604 891 548 413 364 475 388

1143 3015 975 1203 960 1475 1145

424 530 301 279 225 535 382 440

1943

1732

675

1063 719 2485 674 924 735 940 763

578

2004

1018

62

Exhibit VI-2: Continued AREA

MARKET 1990

PADD IV CO ID MT UT WY PADD IV PADD V CA CA AZ HI NV OR VT WA PADD V

1994

Wholesale Wholesale Wholesale Wholesale Wholesale Refining

1080

Wholesale Refining

1184

Wholesale Wholesale Wholesale Wholesale Wholesale Wholesale Refining

2003

2004

1024 1264 2306 1220 1138

1369 1240 2175 1439 1283

345 -24 -131 219 145 -136

1538

393 291

1074 3451 1783 1657 1153 1578

12 931 349 -117 -10 106 281

944 1145 1475 1062 2520 1434 1774 1163 1472

965

CHANGE

1246

Source: Federal Trade Commission, The Petroleum Industry: Mergers Structural Change and Antitrust Enforcement (Washington, Staff Study, August 2004), Table 9-6. Prime suppliers at the state level in March 2004 were either unconcentrated or moderately concentrated (by Merger Guidelines standards) in all but eight states and the District of Columbia. While state-level HHI tended to increase between December 1994 and March 2004, these changes have not resulted in HHI in the highly concentrated range.146 This interpretation of the data is a perfect example of the bias in favor of concentrated markets. Nothing matters but highly concentrated markets. Contrast the FTC’s discussion to the GAO discussion of the numbers in Exhibit V-3. The unit of analysis is exactly the same – state wholesale gasoline markets (grouped by Petroleum Administrative Defense Districts or PADDs). The time period is approximately the same 1994 to 2002. The discussion is quite different:

63

Exhibit V-3: Effects of Mergers on Concentration in State Wholesale Gasoline Markets CHANGE IN NUMBER OF STATES

MERGERS AFFECTING MARKET

Unconcentrated Moderately Highly Concentrated Concentrated PADD I

-9

9

0

Exxon-Mobil, BP-Amoco, Shell-Texaco (Motiva)

PADD II

-6

1

5

Marathon-Ashland, BP-Amoco Marathon-Ultramar Diamond Shamrock (UDS), UDS-Total Shell-Texaco (Equilon)

PADD III

-5

5

0

Exxon-Mobil, Shell-Texaco (Motiva), Marathon-Ashland, Valero, UDS

PADD IV

0

0

0

Shell-Texaco (Equilon), Phillips-Tosco, Conoco-Phillips UDS-Total

PADD V

0

-1

1

Tosco-Unocal, Chevron-Texaco Shell-Texaco (Equilon), Phillips-Tosco, Valero-UDS

Source: General Accountability Office, Energy Markets: Effects of Mergers and Market Concentration in the U.S. Petroleum Industry (Washington, May 2004), p. 61.

As can be observed, the wholesale gasoline markets in 16 states in PADD I (the East Coast) were moderately concentrated in 2002, compared to 7 states in 1994. Also, in PADD I, the number of states that had unconcentrated wholesale gasoline markets decrease from 10 in 1994 to just 1 in 2002. Some key mergers that affected PADD I during this period include Exxon-Mobil, BPAmoco, and Shell-Texaco (Motiva).

64

In PADD II (The Midwest) the wholesale gasoline markets in 5 states were highly concentrated, 8 were moderately concentrated, and 2 were unconcentrated as of 2002. By comparison, in 1994, there were no highly concentrated markets, 7 states were moderately concentrated, and 8 states were unconcentrated in this PADD. Some key mergers that affected PADD II during this period included Marathon-Ashland, Marathon-Ultramar Diamond Shamrock (UDS), BP-Amoco, Shell-Texaco (Equilon) and UDS-Total. The wholesale gasoline market in all the states in PADD III (the Gulf Coast Region) except one had become moderately concentrated in 2002, compared to 1994 when all were unconcentrated. Key mergers that affected PADD III during the period include Exxon-Mobil, Shell-Texaco (Motiva), MarathonAshland, and Valero-UDS. For the States included in PADDs IV and V (the Rocky Mountain and West Coast, respectively), wholesale gasoline markets remain in the moderately or highly concentrated range in 2002 as in 1994. Within this range, concentration levels increased in all but one state in PADD V between 1994 and 2002. Key mergers that affected PADD IV during this period included Shell-Texaco (Equilon), Phillips-Tosco, Conoco-Phillips, and UDS-Total. Key mergers that affected PADD V during the period included Tosco-Unocal, Shell-Texaco (Equilon), Chevron-Texaco, Phillips-Tosco, and Valero-UDS.147 Unlike the FTC, which essentially took the ideological position that even substantial changes in concentrations in the bottom half of the moderately concentrated markets do not matter, the GAO examined changes throughout the full range of market concentrations (see Exhibit V-4). The GAO observes a tremendous shift toward moderately concentrated markets. In 1994, 47 percent of states were unconcentrated, while 43 percent were moderately concentrated and 10% were concentrated. By 2002, only 8 percent of markets were unconcentrated, while 75 percent were moderately concentrated and 18 percent were highly concentrated. In the aggregate, we observe that only four of the 51 markets analyzed by the FTC are unconcentrated, while 9 are highly concentrated. In 30 markets, the increase in concentration was over 300 points in markets that were in the moderately concentrated range. In another 8 markets, the increase was over 100 points in markets that were in the moderately concentrated range. Thus, three-quarters of the markets experienced increases in concentration that could have resulted in an unacceptable increase in market power, if the supply and demand elasticities we have identified are taken into account. Exhibit V-2 also includes the changes in the refining markets at the level of petroleum administrative defense districts, the traditional market for refining. It includes two submarkets that the FTC identified separately – the Upper Midwest and California. The FTC merger analysis shows that the last “condition” placed on a merger prior to the 1990 merger wave was in 1988. The FCC next imposed conditions in 1996. Four of the five PADDs experience a 65

E xh ib it V -4 : C o n cen tra tio n o f S ta te W h o lesale G aso lin e M a rk ets

80

70

60

MARKETS

PERCENT OF

50

40

30

20

10

0 1 99 4 UNCONCENTRATED

2002

M O DERATELY CO NCENTRA TED

H IG H L Y C O N C E N T R A T E D

S o u rce: G en eral A cco u n ta b ility O ffice, E n erg y M a rk ets: E ffects of M erg ers an d M arket C on cen tra tio n in th e U .S . P etro leu m In d u stry (W ash in g to n , M a y 2 00 4 ), F ig u re 18 .

substantial increase in concentration. Three of the five fall in the moderately concentrated range; one falls in the highly concentrated range. Both the submarkets exhibited a substantial increase in concentration and fall in the moderately concentrated range. During the merger wave, five divestitures were required that affected PADDs IV and V. The former ended the period just below the unconcentrated threshold; the latter was above it. In short, the FTC allowed a large increase in concentration in the moderately concentrated range. Even at the national level, a problem can be perceived, if the market is vulnerable as indicated by supply and demand elasticities (see Exhibit V-5). The FTC data shows that mergers allowed 15 companies that accounted for 57 percent of domestic refining capacity in 1996 to shrink to six, accounting for about the same amount of capacity in 2003. All of these 66

mergers are identified by the GAO as affecting state markets. Another way to look at the mergers is to note that the top four firms accounted for 27 percent of refining capacity in 1996, but 44 percent by 2003. The market shares, even at the national level, of the largest firms had grown to ten percent and above, from 6 or 7 percent. Given the vulnerability of gasoline markets, these are threshold levels that should trigger concerns.

Exhibit V-5: Mergers in the Refining Sector Company

1996 Market Share

2003 Market Share

Exxon Mobil

6.7 6.3

11.5

BP Amoco ARCO

3.7 6.7 3.2

9.0

Shell Texaco/Star

7.6 6.3

10.7

Phillips Tosco Unocal Conoco

2.3 3.1 1.6 3.2

13.1

Marathon Ashland

3.8 2.3

5.6

Valero UDS

NA

8.3

Source: Federal Trade Commission, The Petroleum Industry: Mergers Structural Change and Antitrust Enforcement (Washington, Staff Study, August 2004), Table 7-8.

Against this background and given the nature of the industry, the enforcement actions the FCC takes might not effectively address the problem. Divesting to other large players, who are not in a particular market, might not alleviate problems, since the industry has so much multiple market contact that codes of behavior easily emerge. Divesting to a smaller 67

player within the market can have the effect of increasing the general level of concentration in the market, albeit less than merely allowing the merger to pass without divestiture. Because market forces are weak, this may result in an increase in market power and rising prices. THE IMPACT OF MERGERS AND MARKET CONCENTRATION ON PRICE The changes in market concentration underlying the GAO study are similar to those we have discussed for the FTC analysis, although the data ends in 2000 (see Exhibit V-6). In all cases, the end of period market concentration is in the moderate range. The increase in the E x h ib it V -6 : M e r g e r s a n d P r ic e I n c r e a s e s in th e G A O A n a ly s is R E G IO N

PRODUCT

C ro s s -M a rk e t A ll R e g io n s C o n v e n tio n a l B ra n d e d U n b ra n d e d R e fo rm u la te d B ra n d e d U n b ra n d e d CARB B ra n d e d U n b ra n d e d E a s te rn U .S . C o n v e n tio n a l B ra n d e d U n b ra n d e d W e s te rn U .S . C o n v e n tio n a l B ra n d e d U n b ra n d e d

POSTM ERGER HHI

C H A N G E IN HHI

1001

298

1477

1267

-.8 9 .7 0 .9 9 -1 .7 7 .4 0 1 .3 8 3 .7 1

1 2

.9 8 .8 9

a

5 5

7 .1 9 7 .9 4

a

.2 5 .1 0

a

1

.5 6 1 .2 9

a

3 7

a

302

1090

20 24

c

317

1180

B ra n d e d U n b r a n d e d

.1 5 a .3 3 a 240

148

M e r g e r -S p e c ific C O N V E N T IO N A L a R E F O R M U L A T E D s ta tis tic a lly s ig n ific a n t o r is th is s u p p o s e d to b e s o m e th in g e ls e ? ]

U D S -T o ta l M a ra th o n -A s h la n d S h e ll-T e x a c o I S h e ll T e x a c o II B P -A m o c o M A P -U D S E x x o n -M o b il T o s c o -U n o c a l

C H A N G E IN P R IC E M A R G IN S C e n ts /G a l %

B ran d ed U n b ran d ed

-1 .2 5 .3 9 1 .1 3 -1 .2 4 .9 7 2 .6 3 5 .0 0

.7 1 a

.8 6 a

-.3 9 b .5 5

.0 9 .4 0

1 .6 1 a

1 .0 1 b

b

C A R B a [ m e a n in g a ll a r e B r a n d e d U n b ra n d e d

-.6 9

-.2 4

6 .8 7

-1 .5 8

a

S ta tis tic a lly s ig n ific a n t a t th e 1 p e rc e n t le v e l S ta tis tic a lly s ig n ific a n t a t th e 5 p e rc e n t le v e l c S ta tis tic a lly s ig n ific a n t a t th e 1 0 p e rc e n t le v e l

b

S o u r c e : G e n e r a l A c c o u n ta b ility O f fic e , E n e r g y M a r k e ts : E ffe c ts o f M e r g e r s a n d M a r k e t C o n c e n tr a tio n in th e U .S . P e tr o le u m I n d u s tr y (W a s h in g to n , M a y 2 0 0 4 ), A p p e n d ix I V .

68

HHI is substantial in all cases. The price increases are generally statistically significant and, by the antitrust standards we have discussed, small but significant in several cases. In about 40 percent of the merger cases and about half of the national analyses, the GAO econometric model shows price increases that exceed the FTC’s stated thresholds – either 5 percent or 1 cent per gallon. The GAO report, however, may underestimate the impact of the merger wave in the oil industry on prices: •

The study considers only the effect on wholesale gasoline prices, but changes in retail markets may also contribute to higher prices.

•

Its data stops in 2000, when gasoline prices were just beginning to take off. Additional mergers took place and the price increases attributable to domestic refining and marketing sectors grew substantially thereafter. Learning how to behave in a tight oligopoly can raise prices.

•

It does not consider how strategic gaming in an increasingly consolidated industry raised the general price level, as the tight oligopoly of oil giants learned how to exploit its market power with experience.

•

The study shows that increased refinery utilization rates and decreased inventories of product add a great deal to price on a seasonal basis, but does not consider the fact that the trend of tightening markets across time, which company documents show was an intended consequence of the merger wave, raised the overall level of price.

•

The study shows that “supply” disruptions also have a large impact on price, but does not consider slow reactions to disruptions as a consequence of the merger wave.

In building its econometric model, the GAO sought to control for other factors that might account for any observed price differences, other than increases in concentration. It found that “low gasoline inventories, high refinery capacity utilization rates and supply disruptions increased wholesale gasoline prices.”148 The impact is substantial and we are concerned that these variables are actually the indirect effects of strategic behavior and not beyond the reach of public policy. There is ample qualitative evidence that the mergers were intended to reduce redundant capacity. While the econometric approach controls for fluctuation of capacity in the short term, it does not address the question or determine the causes for the long-term trend of increased utilization rates and reduced inventory ratios. The explanation given by the GAO for the observed effect underscores the policy concern – “We found that prices were higher because high refinery utilization rates in oil refining industry leave little room for error in predicting short run supply.”149 Because the markets are insufficiently competitive, when firms make a mistake and get caught short, they simply raise the price. There is no competitive discipline. 69

Even the supply disruptions demand further consideration, once the causes are identified. “There were supply disruptions that caused price spikes in the Midwest in 2000 and on the West Coast in 1999 and 2000. The immediate cause of the disruptions included refinery outages and pipeline ruptures and, in the case of the Midwest, changes in gasoline formulations.”150 Why a change in gasoline formulation should cause a disruption is unclear, since they are well known in advance. We have already noted that the FTC observed a strategic choice in reconfiguring refineries to meet the new formulation requirement. In this sense, tight markets are no accident. While refinery outages are not predictable with precision, they are a frequent enough occurrence, particularly in a volatile system that is under heavy utilization. Planning for such events would be prudent, including having the insurance of higher stocks, but the just-in-time mentality pushes in the opposite direction. Companies risk going short because if a mistake is made or an accident happens, they can just pass the cost through to the consumer because of insufficient competition. In a truly competitive market, an individual company that makes such a mistake pays the price, not the consumer. In this industry, just-in-time means not available when you really need it. The importance of thinking about disruptions or their impact as not entirely exogenous events or of thinking about policies that the market fails to encourage that would protect the public is readily apparent in the econometric analysis. The estimate of the price impact of concentration is much larger when the disruptions are not included in the model (see Exhibit V-7). When strategic behavior that affects the key variables of utilization, inventory and response to disruptions is taken into account, the effects of the merger wave would be much larger. Exhibit V-7: Ratio of Estimated Price Effect Regressions Without Disruption Variable Divided by Regression With Disruption Variable GEOGRAPHIC MARKET

PRODUCT

U.S. East Coast West Coast East Coast West Coast

Conventional Conventional Conventional Reformulated CARB

SALES TYPE BRANDED 3.0 1.6 1.3 1.0 1.2

UNBRANDED 1.7 2.7 1.0 1.0 1.5

Source: General Accountability Office, Energy Markets: Effects of Mergers and Market Concentration in the U.S. Petroleum Industry (Washington, May 2004), Appendix IV.

70

There are always difficult choices in econometric modeling. The GAO has exercised extreme caution in the choice of control variables. These observations are not intended as criticism, but reminders that the GAO’s basic conclusion that mergers have led to increases in prices is correct and would be reinforced by analysis that examined these as strategic variables. To close the loop on the contrast between the FTC and the GAO approaches, Table V-8 shows the level of concentration of city gasoline markets before and after the merger wave, as calculated by the FTC. It also counts the number of firms engaging in merger activities in each city market that were modeled by the GAO.

Exhibit V-8: Concentration of City Gasoline Markets

CITY

Atlanta Boston Chicago District of Columbia Dallas/Fort Worth Denver Detroit Houston Los Angeles New York Philadelphia San Francisco Seattle

NUMBER OF HHIHHIHHI TOP 5 IN GAO BEFORE AFTER MODELED (1989-1991) (2000-2002) MERGERS 2 3 4 4 2 3 4 3 4 2 4 3 4

722 1127 1163 1293 871 964 1172 1131 1134 1138 1184 2035 1685

1393 1175 1289 1324 1066 1090 1491 1265 1829 1425 1261 1943 1833

CHANGE

671 48 126 31 195 126 319 134 695 287 77 -92 148

Source: Federal Trade Commission, The Petroleum Industry: Mergers Structural Change and Antitrust Enforcement (Washington, Staff Study, August 2004), Table 9-8; General Accountability Office, Energy Markets: Effects of Mergers and Market Concentration in the U.S. Petroleum Industry (Washington, May 2004), pp. 119-120;

The mergers affected every one of these city markets. Every one of these markets ended up in the concentrated range. In two thirds of the markets the increase in concentration 71

over the period was greater than the threshold identified by the Merger Guidelines. Thus, while GAO modeled the occurrence of mergers in a before/after approach, the structural conditions for price increases it found were present, as well. CONCLUSION The GAO’s empirical analysis provides a very substantial basis for concluding that there is a market structure problem in the domestic gasoline industry. The FTC’s analysis is a mixture of theories about why competition will not be harmed and projections by oil companies about how their efficiency will be improved, devoid of any analysis of what actually happened. Economic reality has proven to be quite different from the FTC theory. Entry barriers are greater, market forces much more feeble, and the willingness and ability of industry players to respond to price increases weaker than the FTC hoped. Chairman Muris’ violent reaction against the GAO’s rigorous econometric analysis is understandable, since it thoroughly contradicts the theory of lax antitrust enforcement under which the industry was allowed to concentrate.

72

VI. PUBLIC POLICY There is no doubt that antitrust enforcement was lax during the merger wave that took place during both the Clinton and Bush Administrations. The price increases did not begin until very late in the Clinton Administration. There is also no doubt that the price problem increased dramatically after the election of November 2000. It may seem a bit odd to spend time arguing that the attitude of the Administration in Washington toward the energy industry is important. It goes without saying that it is. The close association of both the President and Vice President with the petroleum industry and the aggressive pro-industry position it has taken raises this issue to another level. First, the coincidence between the election of November 2000 and the dramatic increase in prices that followed raises a question – is there a causal link behind the correlation? Second, the search for policy in an atmosphere of crisis is deeply affected by the Administration’s attitude. POLICY ORIENTATION MATTERS There is no doubt that the Bush Administration represented a dramatic shift in policy. The National Energy Policy Development Group was formed under Vice President Cheney in the spring of 2001. As we have seen, crude oil prices were well off their historic highs at that moment, while the domestic spread was at the first of several peaks. Nevertheless, when the NEPDG released its report, the underlying problem was portrayed as one in which “overdependence on any one source of energy, especially a foreign source, leaves us vulnerable to price shocks, supply interruptions and in the worst case, blackmail.”151 The resulting policy recommendations were tilted strongly in favor of the industry.152 The Vice President quickly became embroiled in controversy over questions of excessive industry influence in the NEPDG’s deliberations.153 The high level of engagement of energy industry executives, like Enron’s CEO Ken Lay, in securing the rapid appointment of a new Chairman at the Federal Energy Regulatory Commission (FERC), which oversees the natural gas industry, and in gaining access to the policy process was another favorable signal to the industry.154 The subsequent refusal of the Administration to recognize that manipulation had played a large part in the California energy crisis and the delayed and minuscule penalties imposed sent another signal.155 The timid approach the FERC took in response to reports of natural gas price manipulation reinforced the message.156 The Bush Administration also moved quickly to roll back air conditioner efficiency standards that had been set by the Clinton Administration. These would have curbed the demand for electricity – reducing the need for as many as 50 power plants. They would have particularly affected natural gas consumption, since summer peaking demand draws heavily on natural gas.157 The Administration’s lukewarm attitude toward energy efficiency as the cornerstone of the policy response was made clear by the Vice President, when he relegated it

73

to “a personal choice,” not a policy option. The Administration recently lost a court battle over this decision, but the signal could not have been stronger. The tilt toward the industry reached its zenith in the energy bill that has been working its way through Congress over the last two years. As one long-term observer of Washington energy policy put it, “Some blame must rest with the White House and Vice President Cheney, whose task force, meeting in secret with energy industry leaders, wrote the libretto for the bill.”158 The central premise of the energy bill pushed by the administration is that energy companies need more money to boost production of domestic energy supplies. To that end, a grab bag of subsidies – totaling over $20 billion – was earmarked for the oil and gas industry, while other expensive alternatives also would receive assistance.159 On the natural gas side, the bill promotes costly backstop technologies, like liquefied natural gas imports and an Alaska natural gas pipeline, which will lock in high gas prices. These signals were in sharp contrast to the reaction of the Clinton Administration to the early signs of trouble in energy markets in 2000. As discussed above, after approving many of the mergers that led to the consolidation in the industry, Clinton appointee Robert Pitofsky issued a tough FTC report on the gasoline price spikes in the upper Midwest in the summer of 2000.160 The Department of Energy had begun to express serious concerns about the abuse of market power in the electricity industry.161 Similarly, the Clinton Administration created a heating oil reserve for the Northeast, another sign that it would take a stronger stance against the industry. Lately, the FTC has gone to considerable lengths in attempting to deflect criticism of the industry. While there has been a general drift in antitrust to allowing markets to have a smaller number of players, it is one thing to defend more concentrated markets when there is no evidence of consumer harm, but quite another to apply lax standards when the evidence of harm has been mounting for years. The problem can no longer be dismissed as a couple of short-term disruptions, it looks much more like a permanent condition of abuse of market power. The “blind spot” at the FTC to the unique characteristics of petroleum markets is costing consumers hundreds of billions of dollars. It is time to re-examine the antitrust standards being applied (or not) to the industry. Given the immense pain that “unusually high margins” and record oil prices are imposing on consumers and the economy, it is also time to pursue a much more vigorous energy and consumer protection policy beyond antitrust. This analysis informs that debate as well. THE WRONG EXPLANATIONS LEAD TO THE WRONG POLICY The explanation for the high and volatile price of gasoline offered by the industry and the Bush Administration is so oversimplified and incomplete that it must be considered at best misleading. At worst, it is wrong because it points to policies that do not address important underlying causes of the problem and therefore will not provide a solution.

74

This explanation has serious flaws regarding petroleum markets. •

Blaming high gasoline prices on high crude oil prices ignores the fact that over the past few years the domestic refining and marketing sectors have imposed larger increases on consumers at the pump than crude price increases would warrant.

•

Blaming natural gas price increases on crude oil prices ignores the fact that natural gas wellhead prices have increased much faster than the price of oil.

•

Blaming tight refinery markets on Clean Air Act requirements to reformulate gasoline ignores the fact that in the mid-1990s the industry adopted a business strategy of mergers and acquisitions to increase profits that was intended to tighten refinery markets and reduce competition at the pump.

•

Blaming high natural gas prices on a reevaluation of the resource base ignores the fact that the merger wave led by the major petroleum companies has changed the way the resource base is developed.

•

Claiming that antitrust laws have not been violated in recent price spikes ignores the fact that forces of supply and demand are weak in energy markets and that local gasoline markets have become sufficiently concentrated to allow unilateral actions by oil companies to raise prices faster and keep them higher longer than they would be in vigorously competitive markets.

•

No such claim can be made in the natural gas industry, where clear evidence of abuse exists, although the investigation and prosecution of this abuse has been moving at a glacial pace.

•

Eliminating the small gasoline markets that result from efforts to tailor gasoline to the micro-environments of individual cities will not increase refinery capacity or improve stockpile policy to ensure lower and less volatile prices if the same handful of companies dominate the regional markets.

The obsession with domestic drilling is misguided. Because domestic resources represent a very small share of the global resources base and are relatively expensive to develop, it is folly to pursue a supply-side solution to the energy problem: This policy will not increase significantly the US production of crude oil, will not reduce significantly OPEC’s influence, and it will distort the US macroeconomy. These outcomes are caused by a policy that is not consistent with the depleted state of the domestic resource base and with the economics of international oil. In any plausible scenario, however, the actual effect will be close to zero. If OPEC correctly anticipates production from ANWAR (the Arctic Natural Wildlife Reserve), which would not be difficult given its long lead times, 75

OPEC could slow additions to capacity very modestly such that its utilization rate (and its effect on price) would be changed relative to a scenario in which no oil is produced from the ANWR… Regardless of OPEC behavior, the 1-2 mbd [million barrels per day] from ANWR would reduce the OPEC’s share of the world oil market by 2-3 percent. Such a change would be virtually undetectable given the large fluctuation in crude oil prices.162 The increase in the amount of oil and gas produced in America will not be sufficient to put downward pressure on world prices; it will only increase oil company profits, especially if large subsidies are provided, as contemplated in recent energy legislation. With a depleted, costly resource base that represents a very small share of the global total, domestic production simply cannot discipline the world price of oil.163 Further boosting the profitability of the petroleum industry with subsidies and access to resources in environmentally sensitive areas would not increase production a great deal, nor will it decrease prices to consumers. Over the past three years, the domestic oil and gas industry has enjoyed a huge increase in profitability, but the pricing abuse has gotten worse, not abated. Increasing profitability resulting from the price run-up of recent years has not elicited commensurate increases in exploration (see Exhibit VI-1). As the Wall Street Journal noted, “with prices soaring as much as 50%… oil Titans from Texas to Tehran are awash in record revenue. But as the money floods in, they are spending little extra in finding and extracting more petroleum.” Looking at the top ten publicly traded firms, an increase of about $200 billion in cash flow has led to only a $50 billion increase in spending on exploration and production.164 Just as we have seen in the refining sector, where companies will not invest to expand refinery capacity, that might put downward pressure on price, the same mentality afflicts the companies in the production sector. The companies call it “capital discipline,”165 but it means a tight market and a permanent condition of excess profits. The Wall Street Journal cites a Chevron/Texaco spokesperson, defending the fact that “the company has made no major shifts in investment plans because of the price boom. ‘Our long-term price guidelines are around the low $20s’ for U.S. benchmark crude.”166 The Journal points out that this is “well below the average of $29 at which oil has traded since 2000.”167 The result of the refusal to invest in production capacity has “led to one of the biggest potential disconnects between supply and demand in the 150-year history of the oil business.”168 Other industry analysts have similar concerns. “For several years oil producers have proved reluctant to match their spending to expected demand, says John Westwood, chief executive of British energy industry consultant Douglas-Westwood. Mr. Westwood traces part of the dearth in spending to oil companies’ recent merger binge, where they bought growth through acquisitions rather than exploration… As far as we’re concerned, this is not a real [supply] crunch. This is just a practice.”169

76

E xh ib it V I-1: In creases in C ash F low F ar E x ceed S p en d in g on E xp loration an d P rod u ction

$ 14 0

$ 12 0

$ 10 0

BILLIONS

$8 0

$6 0

$4 0

$2 0

$0

1998

1999

2000

C A S H F LO W

2001

2002

2 00 3

2004p

E XP LO R A T IO N & P R O D U C T IO N S P E N D IN G

S ou rce: “A w ash in a G u sh er of C ash , O il F irm s A re R elu ctan t In vestors, W all S treet Jou rn al, A u gu st 26, 2004, A -1.

The curious behavior caught the eye of the popular press (see Exhibit VI-2). The New York Times underscored the consternation of some with a front page headline “An Oil Enigma: Production Falls Even as Reserves Rise: No Clear Picture Emerges to Explain Discrepancy.”170 Ironically, it selected Chevron/Texaco to illustrate the fact that oil companies were producing less of their reserves. The turning point was 2000. This pattern of behavior presents a fundamental challenge to the claim that the industry needs subsidies or access to more acreage to solve the dependence problem. There is no guarantee that the oil companies will look for oil or produce it, in the event that they find it.

77

Exhibit VI-2: An Odd Pattern or Withholding Supply?

Source: New York Times, June 12, 2004, B-3. Tight markets in the U.S. can only be addressed by relieving pressure on the demand side, yet the energy bill being considered by Congress does little to relieve that pressure. Additionally, the legislation fails to take serious measures to reduce demand by boosting the efficiency requirements for the most important energy consuming equipment – like automobiles and air conditioners. As one recent analysis concluded: It is not dependence on imported oil per se that makes the economy vulnerable to price swings, but the dependence on oil itself… A reduction in our vulnerability to swings in the price of oil requires a reduction in our use of oil, regardless of where on the planet it is produced.171 78

Moreover, even if the U.S. could affect the market price of basic energy resources, which is very unlikely, that would not solve the structural problem in domestic markets. The energy legislation fails to address the factors that have led to the creation of a concentrated market and the industry’s consequent failure to respond to increased demand in a responsible manner. The legislation is silent on the market power problem flowing from the high degree of concentration on the supply-side of the market. In fact, in some ways it will make matters worse. It contains language that could make it more difficult to punish fraud in energy commodity markets. In addition, the repeal of the Public Utility Holding Company Act would allow the large oil and gas producers to buy up electric utilities, thereby integrating their natural gas production with consumption. The result would be to further diminish market forces in the industry, exacerbating problems that are already too painfully evident. POLICY THAT REFLECTS THE DOMESTIC REALITY If the U.S. is to both reduce the market power of energy producers and stem the flow of imports, public policy must start immediately and aggressively on an efficiency path to lower energy consumption.172 It is time for public policy to seek permanent institutional changes that both reduce the chances that markets will be tight and reduce the exposure of consumers to the opportunistic exploitation of markets when they become tight. To achieve this reduction of risk, public policy should be focused on achieving four primary goals: •

Restore reserve margins by developing efficiency (demand-side) and expanding refinery capacity (supply-side).

•

Increase market flexibility through stock and storage policy.

•

Discourage private actions that make markets tight and/or exploit market disruptions by countering the tendency to profiteer by withholding of supply.

•

Promote a more competitive industry.

A goal of achieving an improvement of vehicle efficiency (increase in fleet average miles per gallon) equal to economy-wide productivity over the past decade (when the fleet failed to progress) would have a major impact on demand. It would require the fleet average to improve at the same rate it did in the 1980s. It would raise average fuel efficiency by five miles per gallon, or 20 percent. This is a mid-term target. This rate of improvement should be sustainable for several decades. This would reduce demand by 1.5 million barrels per day within a decade.173 This would return consumption to the level of the mid-1980s. Expanding refinery capacity by 10 percent equals approximately 1.5 million barrels per day. This would require 15 refineries, if the average size equals the refineries currently in use. This is less than one-third the number shut down in the past ten years and less than onequarter of the number shut down in the past fifteen years. Alternatively, a ten percent increase

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in the size of existing refineries, which is the rate at which they increased over the 1990s, would do the trick, as long as no additional refineries were shut down. Placed in the context of redevelopment of recently abandoned facilities or expansion of existing facilities, the task of adding refinery capacity does not appear daunting. Such an expansion of capacity has not been in the interest of the businesses making the capacity decisions. Therefore, public policies to identify sites, study why so many facilities have been shut down, and establish programs to expand capacity should be pursued. This combination of demand-side and supply-side policies to improve the long run market balance would restore the supply/demand balance to levels that typified the mid-1980s. It has become more and more evident that private decisions on the holding of stocks will maximize short-term private profits to the detriment of the public. Increasing concentration and inadequate competition allows stocks to be drawn down to levels that send markets into price spirals. While the strategic petroleum reserve has been developed as a strategic stockpile and companies generally take care of operating stocks, the marketplace is clearly not attending to economic stockpiles. Companies will not willingly hold excess capacity for the express purpose of preventing price increases. They will only do so if they fear that a lack of supply or an increase in brand price would cause them to lose business to competitors who have available stocks. Regional gasoline markets appear to lack sufficient competition to discipline anti-consumer private stock policies. Public policy must expand stocks. Participants in the distribution of gasoline could be required to hold stocks at a percentage of retail sales. Public policy could also either directly support or give incentives for private parties to keep storage. It could lower the cost of storage through tax incentives by drawing down stocks during seasonal peaks. Finally, public policy could directly underwrite stockpiles. We now have a small Northeast heating oil reserve. It should be continued and sized to discipline price shocks, not just prevent shortages. Similarly, a Midwest gasoline stockpile should be considered. In the short term, government must turn the spotlight on business decisions that make markets tight or exploit tight markets. Withholding of supply should draw immediate and intense public scrutiny, backed up with investigations. Since the federal government is likely to be subject to political pressures not to take action, state governments should be authorized and supported in market monitoring efforts. An ongoing joint task force of federal and state attorneys general could be established. The task force should develop databases and information to analyze the structure, conduct and performance of gasoline markets. As long as huge windfall profits can be made, private sector market participants will have a strong incentive to keep markets tight. Market manipulation could and should be made illegal. The pattern of repeated price spikes and volatility has now become an enduring problem. Because the elasticity of demand is so low – because gasoline is so important to 80

economic and social life – this type of profiteering should be discouraged. A windfall profits tax that kicks in under specific circumstances will take the fun and profit out of market manipulation. Further concentration of these industries is quite problematic. The Department of Justice Merger Guidelines should be rigorously enforced. Moreover, the efficiency defense of consolidation should be looked at skeptically, since inadequate capacity is a market problem resulting from consolidation/or some other clearer explanation. Restrictive marketing practices, such as zonal pricing and franchise restrictions on supply acquisition, should be examined and discouraged. These practices restrict flows of product into markets at key moments. Markets should be expanded by creating more uniform product requirements. These should not result in a relaxation of clean air requirements. Decisions by the oil cartel to increase crude prices have cost consumers, but private business decisions about production capacity, stocks and product supply and the failure of public policy to slow the growth of demand by promoting efficiency have cost much more.174 Given the importance of energy in the economy, “consumers of petroleum products in the United States expect that, as with water and electricity, public officials will ensure the reliability and affordability of supplies.”175 Americans have come to believe that the price spikes are the result of industry manipulation.176 This paper shows that there are important ways that this suspicion is well-founded. Over the past four years, policymakers have failed to provide consumers with a stable market and things are getting worse, not better.

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ENDNOTES 1

On May 4, 2004, The New York Times ran a front-page business section story under the headline, “Drivers Tend to Shrug Off High Gas Prices, for Now,” Banerjee, Neela, 2004, C-1. It reported that consumers had not yet reacted strongly to record high prices, in part because the tax cut had cushioned the blow. Ironically, on the very same day that the Times was concluding that consumers were shrugging of the increases, The Washington Post saw more pain in high gasoline prices under the headline “Caught Over a Barrel: Soaring Gas Prices Have Motorists’ Wallets Running on Empty,” Oldenburg, Don, May 4, 2004, p. C-1. It recounted the lengths to which consumers were going to “save a nickel a gallon. 2 Among the largest downstream operators who reported second quarter company records were Exxon-Mobil, Chevron/Texaco, Sunoco, Murphy, Valero, and Premcor. Energy Information Administration, Financial New for Major Energy Companies (August 13, 2004). This analysis focuses on oil company profits. It has no become clear that an additional factor, speculation is also driving prices. As the Wall Street Journal, August 24, 2004, p. A-1, noted in a story entitled, Oil Brings Surge in Speculators Betting on Prices: Large Investors Playing Ongoing Rise is Increasing Demand and Price Itself, page A-1. “Oil has become a speculator’s paradise. Surging energy prices have attracted a horde of investors – and their feverish betting on rising prices has itself contributed to the climb. “These investors have driven up volume on commodities’ exchanges and prompted a large push among Wall Street banks and brokerage firms to beef up energy trading capabilities. AS the action picked up in the past year, those profiting include large, well-known hedge funds, an emerging group of high-rollers, as well as descendants of once-high flying energy-trading shops such as Enron Corp. “Enron alumnus John Arnold now runs a $600 million hedge fund, Centaurus Energy LP, which has racked up more than $200 million in profits in the past year alone thanks to big bets on oil and natural gas, according to investors. Oil-industry veteran Boone Pickens runs two hedge funds that are among the biggest players in oil and natural gas, and have scored gains of more than $550 million in the past two years… “The marked rise in the net long positions of noncommercial investors in oil futures and options since May 2003 has increased net claims on an already diminished global level of commercial crude and produce inventories,’ said Federal Reserve Chairman Alan Greenspan in June of this year. Oil prices accordingly have surged.” 3 Ip, Greg and Jackie Calmes, “Thanks to Oil, Economy Faces Headwinds in Political Season,” The WallSstreet Journal, August 9, 2004; White, Ben, “Jobs Data Send Markets Tumbling,” The Washington Post, August 6, 2004; Porter, Eduardo, “Economy slowed in 2dn Quarter, U.S. Report Says,” The New York Times, July 31, 2004. 4 Leonhardt, David “Slow Job Growth Raises Concerns on U.S. Economy,” The New York Times, August 7, 2004, B2. 5 Hagerty, James and Greg Ip, “Economy Is Expected to Gain Momentum in Second Half,” The Wall Street Journal, August 2, 2004, p. A2. 6 Energy Information Administration, Short Term Outlook (August 2004). 7 General Accountability Office, Energy Markets: Effects of Mergers and Market Concentration in the U.S. Petroleum Industry (Washington, May 2004) (hereafter, GAO). 8 General Accountability Office, Highlights: Energy Markets: Mergers and Other Factors that Affect the U.S. Refining Industry (Washington, July 15, 2004), p. 1. 9 Federal Trade Commission, Midwest Gasoline Price Investigation (Washington, March 29, 2001). 10 Federal Trade Commission, Midwest Gasoline, pp. i... 4. 11 Statement of Federal Trade Commission Chairman Timothy J. Muris on the GAO Study on 1990s Oil Mergers and Concentration, May 27, 2004. 12 GAO, Energy Markets, Appendices V and VI. 13 Statement of Commissioner Mozelle Thompson Concerning the FTC’s Merger Enforcement Action in the Oil Industry, June 3, 2004. 14 Kovacic, William E., “Prepared Statement of the Federal Trade Commission,” Market Forces, Anticompetitive

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Activity and Gasoline Prices—FTC Initiatives to Protect Competitive Markets, Subcommittee on Antitrust, Competition Policy and Consumer Rights, Committee on the Judiciary, United States Senate, April 7, 2004. 15 Energy Information Administration, Short Term Energy Outlook – March 2004, dated March 9, 2004. 16 Beattie, Jeff, “Gas Prices Still Climbing, EIA Says,” The Energy Daily, April 12, 2004, citing Gary Caruso, Administrator of the Energy Information Administration. 17 Gerth, Jeff, “Higher Oil Prices Are Damaging Global Economy, a Study Shows,” The New York Times, May 4, 2004, C-6, quoting Gary Caruso, Administrator of the Energy Information Administration. 18 Federal Trade Commission, The Petroleum Industry: Mergers Structural Change and Antitrust Enforcement (Washington, Staff Study, August 2004), p. 1. 19 Statement of Commissioner Mozelle W. Thompson Concerning the Staff Report “The Petroleum Industry: Mergers, Structural Change, and Antitrust Enforcement (August 13, 2004). 20 Statement of Commissioner Pamela Harbour Jones Regarding the Staff Report” The Petroleum Industry: Mergers, Structural Change, and Antitrust Enforcement (August 13, 2004). 21 Statement of the Federal Trade Commission Concerning the Staff Report “The Petroleum Industry: Mergers, Structural Change, and Antitrust Enforcement (August 13, 2004). 22 Pearlstein, Steven, “An FTC Tenure Worthy of Praise,”Washington Post, August 13, 2004, E-1. 23 Energy Information Administration, Financial News for Major Energy Companies, August 13, 2004, p. 1. 24 Lobenz, George, “Refiners Feast As Gasoline Prices Soar,” Energy Daily, August 16, 2004. 25 Cooper, Mark, Ending the Gasoline Price Spiral (Consumer Federation of America,Consumers Union, Washington D.C.: July 2001); Spring Break in the Oil Industry: Price Spikes, Excess Profits and Excuses (Consumer Federation of America Washington D.C.: October 2003; Fueling Profits: Industry Consolidation, Excess Profits & Federal Neglect, Domestic Causes of Recent Gasoline and Natural Gas Price Shocks (Consumer Federation of America, consumers Union, Washington, D.C.: May 2004). 26 Available at http://www.bls.gov/cex/home.htm. Exhibit II-9 uses the average for all households. The Energy Information Administration, Residential Energy Consumption Survey, allows one to calculate the average for households that use a fuel, as well as for all households. 27 EIA, Residential. 28 Public Citizen, Record Oil Company Profits Underscore Market Consolidation, May 31, 2001; Fortune 500, July 18, 2001; Business Week, First Quarter Results, May 21, 2001. 29 Fortune 500, July 18, 2001. 30 Business Week, Spring 2001, p. 92. 31 U.S. Department of Energy, Energy Information Administration, Performance Profile (Washington, 2001), pp. 7-8. 32 “A Record Setting Year,” National Petroleum News, March 2004. 33 Industrial Energy Consumers of America, 41 Month Natural Gas Crisis Has Cost U.S. Consumers $111 Billion, Washington, December 3, 2003 (IECA). 34 Energy Information Administration, Summer 2003 Motor Gasoline Outlook (Washington, April 2003), analyzes the spread. 35 The evidence indicates that natural gas markets are regional rather than global because of “the existence of a capital intensive and inflexible transportation system,” (Soderholm, P., “Fuel Flexibility in Western European Power Sector,” Resource Policy, 26, 2000, p. 162, cited in Ewing, Bradley T., Farooq Malik and Ozan Ozfidan, “Volatility Transmission in the Oil and Natural Gas Markets,” Energy Economics, 24, 2002, p. 536. The authors also cite Energy Information Administration, Performance Profiles of Major Energy Producers [Washington, 1998]). Thus, we find significant direct and indirect transmission of volatility from the natural gas sector to the oil sector. Our results do not indicate that volatility in the oil returns is affected by shocks originating either in the oil sector… or the gas sector… In addition, the estimated coefficient on the cross error term is insignificant, suggesting the absence of an indirect effect of shocks in the natural gas sector on the oil sector. 36 IECA. 37 The Clean Air Act of 1990 started the shift to natural gas in the electricity sector. 38 In fact, at the time of the 1995 changes in Clean Air Act requirements, the Department of Energy conducted a study of the impact of environmental requirements on the refining industry. It concluded that “pollution abate-

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ment operating costs have been and continue to be a small part of overall operating costs.” (U.S. Department of Energy, Energy Information Administration, The Impact of Environmental Compliance Costs on U.S. Refining Profitability [Washington, October 1997], p. 3). The study shows operating costs per gallon associated with pollution abatement at about $.01 per gallon and large capital costs for a short period of time to meet new requirements, but these had already begun to decline by 1995. The impact of capital expenditures must also be small, in the range of a penny per gallon. Other studies lead to similar estimates of costs associated with pollution abatement of a few cents per gallon; see Nadim, Farahad, et al., “United States Experience with Gasoline Additives,” Energy Policy, 29, 2001. Similarly, general reviews of the industry at the time concluded that “a close examination reveals that the change in refining costs attributable to RFG had no major impact on margin behavior between 1993 and 1995” (U.S. Department of Energy, Energy Information Administration, Petroleum 1996: Issues and Trends [Washington, September 1997], p. 137). In fact, overall operating costs have been declining. Peterson, D.J. and Sergej Mahnovski, New Forces at Work in Refining: Industry Views of Critical Business and Operations Trends (Santa Monica, CA: RAND Corporation, 2003), p. xv, note that following “a wave of mergers, acquisitions, joint ventures and selective divestitures… [whose] aim was cutting costs, gaining economies of scale, increasing returns on investment, and boosting profitability…” consolidation and restructuring appear to have had the salutary effect executives intended, “EIA data indicates that mid and large-size refiners reduced their per barrel operating costs.” 39 Banerjee, Neela, “Drivers Tend to Shrug Off High Gas Prices, for Now,” The New York Times, May 4, 2004, C-1. 40 GAO, p. 12, points out that when the FTC was asked to provide market definitions for a broad scale study, the “FTC indicated it could not provide specific evidence on what the actual geographic markets for wholesale gasoline were across the United States because, when analyzing potential mergers, FTC focuses on a limited geographic area and relies substantially on proprietary company data.” 41 Scherer, F. M. and David Ross, Industrial Market Structure and Economic Performance (Boston: Houghton Mifflin, 1990). Shepherd, William G., The Economics of Industrial Organization (Englewood Cliffs, NJ: Prentice Hall, 1985). 42 Scherer and Ross, p. 15. 43 Scherer and Ross, pp. 16…17. 44 Summarizing the literature, Scherer and Ross, pp. 53-54, develop a long list of characteristics. 45 U.S. Department of Justice and the Federal Trade Commission, Horizontal Merger Guidelines, 1997. 46 Merger Guidelines, section 0.1. 47 Friedman, J.W., Oligopoly Theory (Cambridge: Cambridge University Press, 1983), p. 8-9. 48 Landes, W. M. and R. A. Posner, “Market Power in Anti-trust Cases,” Harvard Law Review, 19: 1981, two prominent conservative economic analysts offer a similar concept. The most frequent starting point for a discussion of the empirical measurement of the price impact of monopoly power is the Lerner Index. As Scherer and Ross (pp. 70…71) note, the Lerner Index is defined as: L = (Price – Marginal Cost)/ Price. Its merit is that it directly reflects the allocatively inefficient departure of price from marginal cost associated with monopoly. Under pure competition, [Ll]=0. The more a firm’s pricing departs from the competitive norm, the higher is the associated Lerner Index value. A related performance-oriented approach focuses on some measure of the net profits realized by firms or industries. Landes and Posner (pp. 938-945) state the price cost margin as the firm’s elasticity of demand. They then transform the index into an expression that uses market shares of firms and the market elasticity of demand and supply: We point out that the Lerner index provides a precise economic definition of market power, and we demonstrate the functional relationship between market power on the one hand and market share, market elasticity of demand, and supply elasticity of fringe competitors on the other.

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L= (P – C) ______ d P

=

1 ___ E d

S ____________________ s e + e (1 – s ) m j i

where: S = the market share of the dominant firm d e = elasticity of demand in the market m s e = elasticity of supply of the competitive fringe j s = market share of the fringe. i In words this formula says that the markup of price over cost will be directly related to the market share of the dominant firm and inversely related to the ability of consumers to reduce consumption (the elasticity of demand) and the ability of other firms (the competitive fringe) to increase output (the elasticity of this supply). These are market characteristics and fundamentals that are accessible to economic analysts. 49 William G. Shepherd, The Economics of Industrial Organization (Englewood Cliffs, NJ: Prentice Hall, 1985), p. 389, gives the following formula for the Herfindahl-Hirschman Index (HHI):

H =

n 2 \ Si x 10,000 /__

i=1 i where n = the number of firms m= the market share of the largest firms (4 for the four firm concentration ratio) Si = the share of the ith firm. The HHI is calculated based on ratios rather than percentages and the decimals are cleared by multiplying by 10,000. For ease of discussion the Court adopts the convention of describing the calculation in percentages. 50 The HHI can be converted to equal-sized equivalents as follows: Equal-sized voice equivalents = (1/HHI)*10,000. 51 Shepherd, p. 4. 52 Horizontal Merger Guidelines, at section 0.1: “The rule of thumb reflected in all iterations of the Merger Guidelines is that the more concentrated an industry, the more likely is oligopolistic behavior by that industry.... Still, the inference that higher concentration increases the risks of oligopolistic conduct seems well grounded. As the number of industry participants becomes smaller, the task of coordinating industry behavior becomes easier. For example, a ten-firm industry is more likely to require some sort of coordination to maintain prices at an oligopoly level, whereas the three-firm industry might more easily maintain prices through parallel behavior without express coordination.” 53 Taylor, John B., Economics (Boston: Houghton Mifflin, 2001); Viscusi, W. Kip, John M. Vernon, and Joseph E. Harrington, Jr., Economics of Regulation and Antitrust (Cambridge: MIT Press, 2000), Chapter 5; Fudenberg, Jean and Jean Tirole, “Noncooperative Game Theory for Industrial Organization: An Introduction and Overview,” in Richard Schmalensee and Robert D. Willig, (eds.) Handbook of Industrial Organization (New York: North-Holland, 1989). 54 Merger Guidelines, section 1.51.

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55

Merger Guidelines, section .01. FTC, Staff Report, p. 21. 57 FTC, Staff Report, p. 22. 58 Landes and Posner, 1981; Ordover, J.A. and R. D. Willig, “Herfindahl Concentration, Rivalry, and Mergers,” Harvard Law Review, 95, 1982. 59 Viscusi, W. Kip, John M. Vernon, and Joseph E. Harrington, Jr., Economics of Regulation and Antitrust (Cambridge: MIT Press, 2000), pp. 147-150. 60 Landes and Posner, p. 947. “Since market share is only one of three factors in equation (2) that determine market power, inferences of power from share alone can be misleading… The proper measure will attempt to capture the influence of market demand and supply elasticity on market power.” 61 Landes and Posner, p. 942. 62 Waverman, Leonard, “Econometric Modeling of Energy Demand: When Are Substitutes Good Substitutes?,” Energy Demand: Evidence and Expectations (Surrey University Press, 1992), p. 16. Urga, Giovanni and Chris Walters, “Dynamic Translog and Linear Logit Models: A Factor Demand Analysis of Interfuel Substitution in US. Industrial Energy Demand,” Energy Economics, 25:2003, p. 18, concludes that “estimates of long run cross elasticities are well below the threshold of unity.” 63 Landes and Posner, p. 958. 64 FTC Staff Study, p. 22.. 65 Taylor, p. 99. 66 FTC Staff Study, p. 28. 67 FTC Staff Study, p. 28. 68 Pillipovic, Dragana, Energy Risk: Valuing and Managing Energy Derivates (New York: McGraw-Hill, 1998), p. 3. 69 Energy Information Administration, Price Changes in the Gasoline Market (Washington, March 1999), reviews several decades of studies with mixed results in the analysis of gasoline price asymmetry – the tendency of prices to increase rapidly, but fall slowly. The report concludes that there is strong evidence of pattern asymmetry (i.e. prices do rise faster than they fall) but not amount asymmetry (eventually they fall back all the way). This is not the majority view, however. 70 Reilly, Barry and Robert Witt, “Petrol Price Asymmetry Revisited,” Energy Economics, 1998. 71 Bacon, Robert W., “Rockets and Feathers: The Asymmetric Speed of Adjustment of UK Retail Gasoline Prices to Cost Changes,” Energy Economics, 1991; Galeotti, Marzio, Alessandro Lanza and Matteo Manera, “Rockets and Feathers Revisited: An International Comparison on European Gasoline Markets,” Energy Economics, 2003; Borenstein, Severin and Andrea Shepard, “Sticky Prices, Inventories and Market Power in Wholesale Gasoline Markets,” RAND Journal of Economics, 2002, p. 322; U.S. General Accounting Office, “Energy Security and Policy: Analysis of the Pricing of Crude Oil and Petroleum Products” (Washington, March 1993). Moreover, one fundamental difference between the price spikes of recent years and the “rockets and feathers” debate should be underscored. In the recent circumstances, we are not dealing with crude oil price changes alone, so the question is not whether refiner/marketer margins “catch up,” or whether some of the change in crude oil price ends up in the refiner/marketer pockets (bottom line). The recent price spikes have been significantly driven by refiner/marketer margins. Even if margins return to historic levels after the spike, there is no doubt that a net increase in marketer margins has occurred. 72 National Energy Policy Development Group, National Energy Policy (Washington D.C.: May 2001), p. 3-13 (hereafter NEPDG). 73 Espey, Molly, “Gasoline Demand Revisited: An International Meta-Analysis of Elasticities,” Energy Economics 20, 1998, 273-295, identifies 363 estimates of short-term elasticity. The median is -.23 for the short term and -.43 for the long term. Kayser, Hilke A., “Gasoline Demand and Car Choice: Estimating Gasoline Demand Using Household Information,” Energy Economics, 22, 2000, estimated the short-term elasticity in the U.S. at .23. Puller, Steven L. and Lorna A. Greening, “Household Adjustment to Gasoline Price Change: An Analysis Using 9 Years of US Survey Data,” Energy Economics, 21, 1999, pp. 37-52, find a one-year price elasticity of .34, but model a more complex structure of responses within shorter periods. They find a larger elasticity of miles traveled in the first quarter after a price shock (-.69 to -.76), but that demand “snaps back.” The larger reduction in miles driven is still “inelastic.” Moreover, the reduction in miles driven is larger than the reduction 56

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in fuel consumed since it appears that households cut back on the most efficient driving miles (i.e. higher speed vacation miles). 74 Espy, Molly, “Explaining the Variation in Elasticity Estimates of Gasoline Demand in the United States: A Meta-analysis,” The Energy Journal, 17, 1996, Table 2, shows the average elasticity of demand for U.S. only studies at -.42. 75 See Bohi, Douglas R. Analyzing Demand Behavior: A Study of Energy Elasticities (Baltimore: Johns Hopkins University Press, 1981). 76 Friedman, David, et al., Drilling in Detroit: Tapping Automaker Ingenuity to Build Safe and Efficient Automobiles (Washington, D.C.: Union of Concerned Scientists, June 2001). Friedman, David, A New Road: The Technology and Potential of Hybrids (Washington, D.C.: Union of Concerned Scientists, January 2003), lays out a scenario in which conventional vehicles move to 40 MPG and hybrids move to 60 MPG. 77 EIA, Monthly Energy Review, Table 3.1a. 78 EIA, Monthly Energy Review, Table 4.4. 79 Elliot, R. Neal, Anna Monis Shipley, Steven Nadel and Elizabeth Brown, Natural Gas Price Effects of Energy Efficiency and Renewable Energy Practices and Policies (Washington: American Council for an Energy Efficient Economy, December 2003). 80 Federal Trade Commission, Midwest Gasoline Price Investigation (Washington, March 29, 2001), pp. i…4. 81 Consodine, Timothy J. and Eunnyeong Heo, “Price and Inventory Dynamics in Petroleum Product Markets,” Energy Economics, 22, 2000, p. 527, conclude “supply curves for the industry are inelastic and upward sloping.” See also “Separatiblity, Functional Form and Regulatory Policy in Models of Interfuel Substitution,” Energy Economics, 1989. 82 Consodine, Timothy J., “Inventories Under Joint Production: An Empirical Analysis of Petroleum Refining,” Review of Economics and Statistics, 1997, p. 527, “high inventory levels depress prices… In some cases, imports of product are more variable than production or inventories. 83 Pirrong, Stephen Craig, The Economics, Law and Public Policy of Market Power Manipulation (Boston: Kluwer, 1996), pp. 10… 24… 59. See also, Williams, Jeffrey and Brian Wright, Storage and Commodity Markets (Cambridge: Cambridge University Press, 1991); Deaton, Angus and Guy Laroque, “On the Behavior of Commodity Prices,” Review of Economics and Statistics, 1992. 84 Energy Information Administration, Petroleum 1996: Issues and Trends (Washington, September 1997), p. 27. The U.S. Department of Energy identified “lower than normal gasoline stocks” in a chapter entitled “Spring ’96 Gasoline Price Run-up.” Energy Information Administration, Assessment of Summer 1997, p. 5; “Statement of John Cook, Director, Petroleum Division, U.S. Department of Energy,” Subcommittee on Energy and Air Quality, Committee on Energy and Commerce, U.S. House of Representative, May 15, 2001, p. 1. 85 Energy Information Administration, Performance Profiles of Major Energy Producers: 2002 (Washington, February 2004), p. 20. 86 Energy Information Administration, Performance Profiles of Major Energy Producers: 2001 (Washington, January 2003), p. 78. 87 Federal Trade Commission, Midwest Gasoline, note 23, citing Organization for Economic Co-operation and Development and Department of Energy documents states, “Higher crude prices led producers to draw down inventories in anticipation of replacing them later at lower prices.” 88 National Energy Policy Development Group, National Energy Policy (Washington, May 2001), p. 7-13 (hereafter NEPDG). 89 GAO, p. 5. 90 GAO, p. 5. 91 Scherer and Ross, p. 526, formulate the issue as follows “To avoid these hazards, firms entering either of the markets in question might feel compelled to enter both, increasing the amount of capital investment required for entry.” 92 Shepherd, pp. 289-290, describes this issue as follows: When all production at a level of an industry is “in-house,” no market at all exists from which independent firms can buy inputs. If they face impediments or delays in setting up a new supplier, competition at their level will be reduced. The clearest form of this is the rise in capital a new entrant needs to set up at both levels. Ores, special locations, or other indispensable inputs may be held by the integrated firm and withheld from

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others. The integration prevents the inputs from being offered in a market, and so outsiders are excluded. A rational integrated firm might choose to sell them at a sufficiently high price. 93 Shepherd, p. 294, argues that integration by large firms creates this problem. Restrictions may be set on areas, prices or other dimensions … Only when they are done by small-share firms may competition be increased. When done by leading firms with market shares above 20 percent, the restrictions do reduce competition. 94 Perry, Martin K., “Vertical Integration: Determinants and Effects,” in Schmalensee and Willig (eds.), Handbook of Industrial Organization, p. 197. 95 Perry, p. 247. 96 Scherer and Ross, pp. 526-527; Shepherd, p. 290. 97 GAO, pp. 5 –9. 98 Borenstein, Severin, A. Colin Cameron and Richard Gilbert, “Do Gasoline Prices Respond Asymmetrically to Crude Oil Price Changes?” Quarterly Journal of Economics, 1997. 99 Scherer and Ross, pp. 526-527; Shepherd, p. 290. 100 GAO, p. 9. 101 GAO, p. 76. 102 GAO, p. 76. 103 GAO, p. 5. 104 GAO, p. 77. 105 GAO, p. 73. 106 Gilbert, Richard and Justine Hastings, “Vertical Integration in Gasoline Supply: An Empirical Test of Raising Rivals’ Costs” (Competition Policy Center, University of California, Berkeley, 2001), p. 27; see also Hastings, Justine, “Vertical Relationships and Competition in Retail Gasoline Markets: Empirical Evidence from Contract Changes in Southern California” (Competition Policy Center, University of California, Berkeley, 2000). 107 In 1990, 22 integrated companies covered an average of 28 states. In 1999, 17 companies covered an average of 26 states. 108 Even introductory economics texts now contain long discussions of strategic behavior and game theory [see, for example, Taylor, John B., Economics (Boston: Houghton Mifflin, 1998), Chapter 11] and it has become a routine part of applied policy analysis [Hastings, Justine, “Factors that Affect Prices of Refined Petroleum Products” (Washington, Federal Trade Commission Public Conference, August 2, 2001)]. 109 They certainly have value on the stock market (see Edwards, Kenneth, John D. Jackson and Henry L. Thompson, “A Note on Vertical Integration and Stock Ratings of Oil Companies in the U.S.,” The Energy Journal, 2000). 110 “Oil Data Show Industry Role in Shortages a Possibility,” The New York Times, June 15, 2001. 111 Peterson and Mahnovksi, p. xv. 112 NEPDG, p. 7-13. 113 Ye, Michael, John Zyren and Joanne Short, “Elasticity of Demand for Relative Petroleum Inventory in the Short Run,” International Atlantic Economic Journal, March 2003; Linn, Scott C. And Zhen Zhu, “Natural Gas Prices and The Gas Storage Report: Public News and Volatility in Energy Futures Markets,” Journal of Futures Markets, 24: 2004; Esnault, Benoit, “The Need for Regulation of Gas Storage: The Case of France,” Energy Policy, 31: 2003. 114 Peterson and Mahnovski, p. 16. 115 Peterson and Mahnovksi, p. 42. 116 Peterson and Mahnovski, p. 17. 117 Peterson and Mahnovksi, p. 17. 118 Peterson and Mahnovski, p. xvi. 119 U.S. Department of Energy, Energy Information Administration, Petroleum Supply Monthly (Washington, April 2000), p. 145, defines the lower operational inventory as follows: Lower operational Inventory (LOI): The lower operational inventory is the lower end of the demonstrated operational inventory range updated for known and definable changes in the petroleum delivery system. While not implying shortages, operational problems or price increases, the LOI is indicative of a situation where inventory-related supply flexibility could be constrained or non-existent. The significance of these constraints depends on local refinery capability to meet demand and the availability and deliverability of products from

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other regions or foreign sources. 120 The general literature on stock and storage behavior shows that stocks are typically kept to ensure operational flow (see Pyndick, Robert S., “Inventories and the Short-Run Dynamics of Commodity Prices,” RAND Journal of Economics, Spring 1994, “The Present Value Model of Rational Commodity Pricing,” The Economic Journal, May 1993). 121 Joanne Shore, Petroleum Division. The FTC reached a similar conclusion in its Midwest Gasoline Price Investigation, at note 23. 122 “Statement of John Cook, Director, Petroleum Division, U.S. Department of Energy, Subcommittee on Energy and Air Quality, Committee on Energy and Commerce, U.S. House of Representative, May 15, 2001, p. 1. 123 U.S. Energy Information Administration, Do Current High Petroleum Product Prices Reflect Price Gouging? (Washington, March 12, 2003), pp. 1-2. 124 U.S. Energy Information Administration, Summer 2003 Motor Gasoline Outlook (Washington, April 2003). 125 GAO, p. 93. 126 Calculated based on GAO, p. 139, note 50.. 127 Peterson and Mahnovksi, p. 43. 128 Balancing Natural Gas Policy: Fueling the Demands of a Growing Economy (Washington, September 2003). 129 Huntington, Hillard G. “Presentation to The Future of Natural Gas Markets: A Forum at RFF,” November 21, 2004, EMF 20: Natural Gas, Fuel Diversity and North American Energy Markets, November 2003, shows the NPC estimate as an extreme outlier in terms of price. 130 Energy Information Administration, The Majors’ Shift to Natural Gas (Washington, September 2001). 131 EIA, Performance Profiles: 2002, pp. 81-83. 132 EIA, Performance Profiles: 2002, pp. 71-72. 133 Beattie, Jeff, “U.S. Oil and Gas Producers Investing in Mergers, Not More Drilling – S&P,” Energy Daily, April 26, 2004. 134 Energy Information Administration, The Natural Gas Industry and Markets in 2002 (Washington, February 2004), p. 3. 135 EIA, The Natural Gas Industry, p. 2. 136 Four years after the initial signs of trouble and in spite of reforms instituted by the Federal Energy Regulatory Commission, things were still bad. “In numbers the FERC Chairman Pat Wood compared to a “cold shower,” staff of the Federal Energy Regulatory Commission said Wednesday that only 20 percent of companies are reporting all of their natural gas trades and about 10 percent are reporting power trades to public indices.” (Davis, Tina, “Gas Prices Reporting Better, But Still Lagging – FERC,” Energy Daily, May 6, 2004). 137 Moody, Dian, Natural Gas Price Indices: Price Manipulation Issues (Washington: American Public Power Association, January 2003). 138 Caruso, Guy, Outlook for Natural Gas & Petroleum, Energy Information Administration, May 19, 2003; Trapman, William, Natural Gas Storage, Energy Information Administration, October 29, 2002, show the low levels of storage in early 2001 and 2003. Policy Development and Energy Sections, Natural Gas Price Volatility, June 3, 2003, pp. 3-4, notes storage in 2003 at the start of the injection season was “50% lower than the previous year” and that “high prices of gas during the storage season make firms think twice about making purchases of gas for injection.” 139 Bradley, Malik and Ozfidan, p. 536. 140 Johnson, Jeff, “Chemical CEOs Protest Natural Gas Prices,” Chemical and Engineering News, Feb. 2, 2004. 141 Lobensz, George, “CFTC Probing Manipulation of Natural Gas Storage Data,” Energy Daily, May 5, 2004. 142 “Beattie, Judge Green Lights Lawsuit,” p. 3. The FERC has been hesitant to aggressively pursue market manipulation and only done so under pressure (see Davis, Tina, “Court Rips FERC, Opens Door For Bigger Calif. Refunds,” Energy Daily, September 10, 2004, p. 1; Davis Tina, “Snohomish: Documents Show Pervasive Market Manipulation by Enron,” Energy Daily, June 15, 2004, p. 1). 143 Landes and Posner, p. 947, stress the importance of adjusting scrutiny based on the market characteristics: Market Share Alone Is Misleading. -Although the formulation of the Lerner index… provides an economic rationale for inferring market power from market share, it also suggests pitfalls in mechanically using market share data to measure market power. Since market share is only one of three factors... that determine market power, inferences of power from share alone can be misleading. In fact, if market share alone is used to infer

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power, the market share measure… which is determined without regard to market demand or supply elasticity (separate factors in the equation), will be the wrong measure. The proper measure will attempt to capture the influence of market demand and supply elasticity on market power. 144 Landes and Posner, p. 954, also argued that the size of the market at issue should be considered, “if very high market shares are required to justify a finding of monopoly power in a small market, then a lower market share should suffice in a large market.” 145 Recent studies that document the importance of concentration and market power in various markets at a micro level include Sen Anindya, “Higher Prices at Canadian Gas Pumps: International Crude Oil Prices of Local Market Concentration,” Energy Economics, 2003; Delpachitra, Sarath B., “Price Rigidity in the Downstream Petroleum Industry in New Zealand: Where Does it Happen,” Energy Economics, 2002; Adrangi, Bahram, Arjun Chatrath, Kambiz Raffiee, and Ronald D. Ripple, “Alaska North Slope Crude Oil Price and the Behavior of Diesel Prices in California,” Energy Economics, 2001; Gilbert and Hastings; Borenstein, Cameron and Gilbert. 146 FTC Staff Study, pp. 230-231. 147 GAO, p. 61. 148 GAO, p. 128. 149 GAO, p. 139. 150 GAO, p. 81. 151 “Text of the Speech of President Bush,” in releasing the National Energy Task Force Report, The Washington Post, May 18, 2001. 152 Secretary of the Treasury Paul O’Neill recounts that the Vice President responded to the criticism of some of the administration policies with the blunt statement that, “We won the mid-terms [elections], this is our due.” The Washington Post, January 18, 2004, F-3. The quote is from Secretary of the Treasury O’Neill’s account of Vice President Cheney’s reaction to O’Neill’s complaint that the tax cuts would create a severe fiscal crisis. 153 “Supreme Court to Hear Cheney Task Force Case,” Energy Daily, December 16, 2003. 154 Frontline, June 6, 2001. 155 The California Attorney General reached a settlement with Dynegy for $280 million to settle complaints about price manipulation in about 6 months in 2000-2001. Included in the total was a settlement of $3 million that the Federal Energy Regulatory Commission had reached with Dynegy. In other words, the FERC has agreed to just about one penny on the dollar of the ultimate abuse (see Davis, Teena, “Dynegy Settle Power Fight with California,” Energy Daily, April 28, 2004). 156 Beattie, Jeff, “FERC Still Unsure About Reliability of Gas Price Reporting,” Energy Daily, November 5, 2003. 157 Kubo, Toru, Harvey Sachs, and Steven Nadel, Opportunities for New Appliance and Equipment Efficiency Standards: Energy and Economic Savings Beyond Current Standards Programs (Washington, D.C.: American Council for an Energy Efficient Economy, September 2001). Nadel, Steve and Howard Geller, Smart Energy Policies: Saving Money and Reducing Pollutant Emissions through Greater Energy Efficiency (Washington, D.C.: American Council for an Energy Efficient Economy, September 2001). 158 King, Llewellyn, “The Energy Pig-Out Has Been Delayed,” Energy Daily, December 2, 2003. 159 King identifies half a dozen columnists and newspapers who are usually strong supporters of President Bush who find the bill unacceptable. 160 Federal Trade Commission, Midwest Gasoline Price Investigation, March 29, 2001, pp. i…4. 161 Energy Information Administration, Horizontal Market Power in Restructured Electricity Markets (March 2000). 162 Cleveland, Cutler J. and Robert K. Kaufman, “Oil Supply and Oil Politics: Déjà vu All Over Again,” Energy Policy, 31, 2003, pp. 485-487, point out the obvious math of the situation. 163 Holly, Chris, “EWG: Generous Leasing Policies Fail to Ease U.S. Oil Dependence,” Energy Daily, p. 1, cites the conclusion that “of the 229 million acres offered for oil and gas development since the early 1980s, only 30 million acres – or 13 percent – have ever produced oil and gas…. This land has produced enough energy to satisfy only 53 days of U.S. oil consumption and 221 days of natural gas consumption.” 164 Cash flow includes both the increase in after tax income discussed earlier and depreciation expenses. 165 “Awash in a Gusher of Cash, Oil firms Are Reluctant Investors,” Wall Street Journal, August 26, 2004, p. A2. 166 Wall Street Journal, Awash, p. A-2. 167 Wall Street Journal, Awash, p. A-2. 168 Wall Street Journal, Awash, p. A-1. 90 169 Warren, Susan, “Oil Companies Curb Their Spending; Restraint Spurs Worries of Short Supplies in Future; Producers Stress Discipline,” Wall Street Journal, June 3, 2004. 170 Berenson, Alex, June 12, 2004.