The effects of recent volatility in international petroleum markets on Canadian wholesale and retail gasoline prices

Introduction

This is a report written as part of an assignment that I undertook with the Competition Bureau starting in early June to participate in its examination of the source of high retail prices and, seemingly paradoxically, low retail margins. This examination was commenced May 4 and announced on the Bureau web site. It was undertaken in response to a large number of complaints by consumers and independent retailers regarding retail gasoline prices. The consumers were concerned by the large run-up in prices and the retailers, particularly those in the Greater Toronto Area (GTA) and the National Capital Region (NCR), by the compression in their margins. The focus of my efforts was to understand the sources of these concerns; more particularly, to investigate whether the changes taking place were the result of normal market forces or illegal or otherwise anti-competitive actions taken within the Canadian industry to take advantage of the volatility in international crude oil and wholesale gasoline markets. Where appropriate, the possibility of illegal conspiracies or Abuse-of-Dominant-Position are also addressed in other contexts. I was also specifically charged with providing sufficient background on the structure, conduct and performance of the industry in order to make intelligible any conclusions that I might draw.

The petroleum industry is much studied and is almost constantly under review in the U.S. at one level or another. There is a ready market for information on the industry and a number of companies specialize in the collection of information on prices (and volumes) for all types of crude oil, quoted wholesale prices at locations throughout the world, and for retail prices and market shares in local markets. The demand for this information emanates primarily from participants in the industry. They need the information for their operations and planning. Government departments with the responsibility for monitoring and understanding events in the industry are other consumers of some of this information. Although quoted wholesale prices are different than transaction prices because of discounts, the general level of discounts is known to industry participants and is fairly readily available to government departments when the need arises. In other words, this is a highly transparent industry. There is never any problem about knowing what is happening in the industry at all levels. What is less apparent is why certain changes are occurring. This is similar to other industries, with the exception that it is rare to be able to closely trace the relationship between the price of a raw material and that of consumer products as is the case with crude oil and gasoline, diesel and heating oil.

Although a considerable amount of data is available, the voluntary cooperation of all the principal refining and marketing companies was elicited to obtain additional information related to the specific complaints under investigation. There was a high degree of cooperation. In addition to asking the major oil companies for their explanation of the sharp increase in retail prices, they were asked to provide specific information on: wholesale and retail prices in the GTA and the NCR; all agreements relating to the purchase, sale or exchange of products or services; and the matters discussed at association and like meetings. In addition, importers and wholesalers were asked about their activities and their reading of the import situation in the context of a high degree of capacity utilization in North America and Europe. A number of large retailers were also approached, in particular those retailers who were important marketers in other areas, such as Walmart, Loblaws, Costco and Canadian Tire. All, save for the latter, were recent entrants and are perceived as a new and dynamic force in retail gasoline markets. The retail price information obtained from some market participants was an important addition to that collected by the firms specialized in information gathering. In volatile markets retail prices tend to change often, sometimes upwards of 25 times a week and sampling by commercial firms may miss important changes.¹ The discount structure for wholesale prices, provided by some companies, was also important where it was necessary to have an appreciation of transaction prices. In all cases public sources of information, principally annual and quarterly reports and information on wholesale prices were consulted and were helpful in providing background, in formulating questions, and initiating dialogue in the interviews that were conducted with the firms asked to provide information.

As mentioned earlier, this is a much-studied industry. In Canada the most recent effort was the Report of the Standing Committee on Industry, Science and Technology, Gasoline Prices in Canada, (House of Commons, Canada, November 2003) The Committee was investigating "the causes of the recent increase in the price of gasoline" and the negative effects said increase was having on the economy. After examining price information at all levels of the industry, the structure, performance and profitability of the downstream sector the Committee found that normal market forces were at work and explained the price increase. It did, however, recommend that a Petroleum Monitoring Agency, with a three year mandate, be set up that would report to Parliament. The Canadian Alliance Members of the Committee dissented. Currently, the principal source of information that is provided in an organized way² is a bi-weekly report, Fuel Facts, provided by MJ Ervin and Associates and Purvin & Gertz Inc. that is presented to the public by the Canadian Petroleum Producers Institute.

The Committee and the Competition Bureau were able to draw on a report by the Conference Board of Canada, The Final Fifteen Feet of Hose: The Canadian Gasoline Industry in the Year 2000. This is an ambitious effort that dealt with the industry from crude to retail. As well as providing considerable descriptive material, the report conducted a number of statistical tests. Its principal conclusions from the viewpoint of present concerns are that: Canadians enjoy some of the lowest gasoline prices in the world and the increase in retail prices occurring at the time were the result of increases in crude oil prices. Partly because of different mandates, but also because of my professional concerns over several decades, the material in this report differs considerably from that in Fifteen Feet of Hose. There is a greater emphasis on wholesale prices and a more detailed investigation of likely manifestations of market power in the present report.

There are numerous studies and commentaries by the U.S. Energy Information Administration and committees of the U.S. Congress on the causes of changes of retail prices. Of course crude prices are always traced as an important element, although usually with some lag. What has been different about recent increases in retail prices has been the role that larger refinery margins have played. As a general matter, over the years Canadian refiners have shared in the ups and downs of the U.S. industry since it has been demonstrated repeatedly that wholesale prices in the larger Canadian centres such as Montreal, Toronto and Vancouver do not differ markedly from wholesale prices in relevant comparison points in the U.S. and closely track changes in prices at those U.S. locations. One of the simpler, albeit critical, elements of this report has been to investigate whether the wholesale price differences between key U.S. and Canadian centres widened during the period of concern. A widening would not necessarily demonstrate a departure from normal market forces, but it would indicate that conditions in the Canadian industry made consumers highly vulnerable to shocks to the international system and would invite further investigation of the structure and conduct of the industry.

This report is divided into several sections. The first deals with the structure and economics of petroleum refining. Although public attention tends quite naturally to concentrate on pricing at the retail level, to the extent that competition issues exist, they are usually embedded in the refining sector where the number of suppliers are fewer and entry conditions are much more difficult. Included in this section is a discussion of the various agreements among refiners and other suppliers relating to reciprocal supply agreements and the sharing or purchase of terminal services. The second section deals with pricing at the wholesale level, beginning with the run-up in prices in the U.S. and with the reasons that have been put forward to explain the increase in refinery margins. Although the by now traditional interest in comparing quoted prices in several cities with relevant points in the U.S. is pursued, considerable attention is devoted to price comparisons of points within Canada. To this end, there are separate sub-sections devoted to pricing in Eastern and Central Canada, and Western Canada.

It is unnecessary to have a separate section on crude oil since the principal facts regarding crude oil are well known and non controversial. Apart from the brief discussion below, further discussion of crude oil is deferred until the section on refining. For present purposes it is sufficient to acknowledge the following: crude oil is an internationally traded commodity over which domestic suppliers and buyers have no control; Canada is a net importer in the east and is a major exporter in the west;³ its price is at least partially under the control of OPEC, but it is subject to shocks precipitated by political events. Finally, the use of the singular when referring to crude oil is only a convenience; there is a great variety of oils with varying properties.

Wherever possible the descriptive material in this report relies on public sources. Annual and quarterly reports by companies and industry publications provide a fairly well rounded picture of the industry. Although not all companies are publicly traded entities, fortunately this is not the case for the three national companies: Imperial, Petro-Canada and Shell. The reports of Suncor and Canadian Tire also proved very valuable.

¹ In the U.S. Oil Price Information Service avoids the sampling problem by purchasing data from a fleet card provider to obtain both retail and wholesale prices.

² As mentioned earlier in the text, data can be purchased from firms such as Bloomberg or Reuters, but the information that they provide is in raw form.

³ The National Energy Board monitors energy markets, including those for crude oil, to ensure that domestic buyers have access to supplies on similar terms and conditions as export buyers. (Annual Report 2003, p. 45)