What Determines the Profitability of a Retail Gasoline Outlet?

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This study has been conducted by Anindya Sen, Associate Professor of Economics at the University of Waterloo, and Robert Boulton, Principal, LECG Canada. Professor Sen is an empirical economist with expertise in Canadian competition policy and has published several peer-reviewed papers on the impact of competition in retail gasoline and financial services. Robert Boulton is a Chartered Accountant and Chartered Business Valuator and has worked or practiced exclusively in the areas of business valuation, damages quantification and corporate finance since 1986. His experience includes venture capital investing with one of the pre-eminent venture capital firms in Canada and being the CFO of a public multi-national computer component manufacturer. He has also consulted on matters concerning shareholder disputes, minority oppression actions, intellectual property infringement and professional negligence and has extensive experience with Competition Act matters relating to mergers and acquisitions.
 
LECG wishes to acknowledge the efforts of Anthony Clemente and Julius Koo, Senior Consultants, which have been seminal. Of course, any mistakes or errors remain the responsibility of Professor Sen and LECG Canada.

Executive Summary

In conjunction with LECG Canada, Professor Anindya Sen has been asked to conduct an independent study aimed at understanding the significant determinants of outlet profitability in the retail gasoline industry using data collected by the Competition Bureau.

There have been frequent allegations of anti-competitive behavior on the part of vertically-integrated gasoline firms including: predatory pricing; collusion; retail price-fixing; and the “squeezing” of smaller independents through higher wholesale prices in an effort to force their exit from the industry.

Evaluating the validity of such complaints is hampered by a lack of understanding of the factors behind the profitability of a typical gasoline retail outlet. This is largely due to the difficulties of procuring appropriate data; obtaining the relevant information from individual outlets is quite difficult. This could also be the reason behind the paucity of related academic research.

This study seeks to bridge these gaps by employing pricing and other financial data from 2002 to 2004 obtained from representative retail outlets owned by vertically-integrated firms as well as independent retailers in the Greater Toronto Area and adjoining areas. The variation in location and firm structure allows us to evaluate (in a qualified manner) the impact of local competition as well as the presence of “squeezing” by vertically-integrated firms. Also, this research is truly unique in terms of methodology as it consists of a blend of economic as well as accounting techniques.

Simple graph and qualitative analysis suggests that movements in both retail and wholesale prices are largely dictated by corresponding fluctuations in crude oil prices; however, local competition does seem to impact retail pricing. Importantly, they lend little support to the existence of predatory pricing.

These results are further substantiated by the econometric results, which suggest that an increase in wholesale and crude oil prices results in a similar increase in retail and wholesale prices, irrespective of whether an outlet is owned by an independent or a vertically integrated refiner. Specifically, a 1 cent/litre increase in wholesale prices results in a 0.87 and 0.81-0.89 cent/litre increase in retail prices for regular grade gasoline charged by independents and vertically integrated firms, respectively. On the other hand, a 1 cent/litre increase in crude oil prices results in a 0.73 and 0.71-0.91 cent/litre increase in (regular grade) wholesale prices experienced by independents and refiners, respectively.   

Our analyses reveals that while differences in retail prices are not extremely large, wholesale prices are almost identical across stations, offering evidence contrary to the existence of squeezing or predatory behavior by vertically-integrated firms. On the other hand, there are considerable differences in sales volumes. These facts suggest that controlling for size, the profitability of an outlet is principally dependent on throughput.

In terms of division across specific grades, the independents obtain roughly 80% of their total revenue from the sale of regular grade gasoline. On the other hand, the vertically-integrated firms earn roughly 70% of their revenue from regular grade sales demonstrating a greater relative reliance on premium grades. 

From a policy perspective, key findings stem from the profitability analyses, which offer clearer insight on the true income of retail outlets. Specifically, while net revenue figures based on the difference between retail and wholesale prices suggest profits for all outlets, the profitability analysis demonstrates that very few outlets consistently earn profits once station specific costs are factored in. For example, net revenue figures imply that independents obtained a per litre profit of between 2.57-3.14 cents from the sale of regular grade gasoline while vertically-integrated firms earned from 2.5-3.5 cents/litre. In comparison, the profitability analyses indicate that independents consistently made losses on an annual basis. Even integrated refiners sometimes incurred losses. This is insightful given the common belief that high gasoline prices inevitably results in enhanced profits.   

These results point to the pitfalls of exclusively relying on the difference between retail and wholesale prices in evaluating outlet and ultimately, industry profitability. The other important insight is that while ancillary revenues from convenience store sales and car wash facilities may be small relative to total gasoline revenues, once they have been adjusted for relevant costs, they contribute substantially to overall profitability. However, one must be very cautious in drawing strong inferences from the profitability analysis due to the lack of data on outlet operator revenues and expenses.

While profitability analysis is typically not conducted by the Competition Bureau, the findings of this study point to the benefits and importance of such research in determining the state of competition within or across industries.

Introduction

While there has been an abundance of research aimed at attempting to explain movements in Canadian gasoline prices, there is limited empirical literature on the determinants of individual outlet profitability. This is unfortunate, as a better understanding of this issue has some rather profound implications for public policy.

An examination of recent trends suggests that the Competition Bureau is frequently asked to investigate allegations of predatory behavior on the part of vertically-integrated gasoline firms. A common complaint is that vertically-integrated firms often drop retail prices to levels that are unsustainable for smaller independents, resulting in their exit from the market. Vertically-integrated firms have an incentive to engage in such behavior, as fewer competitors will enable them to recoup present financial losses through higher future prices. Further, vertically-integrated firms are able to sustain predatory or low prices as they earn a significant amount of profits from ancillary product offerings.

Another example of predatory behavior is when vertically-integrated firms increase input or wholesale prices charged to smaller independents in an effort to drive up their costs and eventually force their departure from the market. Again, this implies obvious benefits for vertically-integrated firms in terms of enhanced market share and revenue, but possible harm to consumers from higher retail prices. Economists have labeled such increases in wholesale prices as “raising the rivals’ costs”.

However, it is important to understand that the exit of smaller firms might even result in lower retail prices. This would specifically occur if the smaller independents happen to be inefficient with higher marginal costs relative to larger vertically-integrated firms.

Hence, in the absence of certain information, it is very difficult to evaluate the existence and/or extent of predatory behavior. As a consequence any public policy measures might have confounded impacts that adversely impact societal welfare. In this specific context, answers to the following questions would be of obvious value;

1. Typically, how closely do prices charged by both vertically-integrated firms and smaller independents follow each other?
2. What are the important determinants of outlet profitability?
3. Do vertically-integrated refiners charge wholesale prices to their affiliates differently from wholesale prices charged by refiners to independents?
4. How can one distinguish an efficient station from an inefficient one?
5. What is typical profitability enjoyed by vertically-integrated and independent retailers?
6. How much revenue do vertically-integrated firms enjoy from the sale of ancillary services and products?

This study attempts to answer these questions using outlet specific data provided by both independent as well vertically-integrated firms. In order to preserve confidentiality, the outlets owned by the independent retailers are labeled as “A” and “B” while different vertically-integrated firms own “C”, “D”, and “E”.  Each of these firms has provided month specific data on a variety of financial indices from one specific outlet each located in the Greater Toronto Area or the adjoining municipalities of Oshawa, Pickering, Burlington, Hamilton, Cambridge, and Kitchener-Waterloo. 

Providing answers to the above questions has obvious implications from the perspective of Canadian public policy. A better understanding of the business details faced by an “average” gasoline retail outlet in one of Canada’s most competitive markets will assist the Bureau in forming benchmarks to evaluate the validity of complaints related to retail gasoline, in an efficient and effective manner. From an academic viewpoint, access to such detailed information is rare and could possibly assist in addressing some interesting questions in the field of industrial organization.

However, it is important to acknowledge that a significant number of the above questions cannot be addressed through economic or econometric techniques. Profitability analysis is critically required to understand the efficiency of each station. In this respect, this report is truly a unique contribution to the literature as it consists of detailed analyses performed by economists as well as accountants. 

The remainder of the report is structured as follows. The next section clearly delineates the objectives and limitations of this report. Section 3 contains a cursory summary of relevant literature. Section 4 consists of a description of the data while Section 5 discusses the economic and econometric research. Relevant profitability analysis is contained in Section 6. Section 7 concludes with a summary of the principal findings.

1. Objectives and Limitations

Using station specific data from five retail outlets, this study attempts to understand the determinants of outlet profitability by;

1. Evaluating and comparing trends in retail prices charged across different grades of gasoline by these stations and comparing them to corresponding movements in city specific retail prices.
2. Evaluating and comparing trends in overall profitability of these stations on a “stand alone basis” as well as by category (vertically-integrated versus independents).
3. Decomposing and comparing trends in station profitability into gas and non-gas revenue.
4. Econometrically estimating the impact of fluctuations in wholesale prices on retail prices and comparing differences across stations.
5. Comparing wholesale prices experienced by these different stations to city specific averages.
6. Empirically evaluating the impact of local competition on retail prices.
7. Understanding the impact of cost structure on profitability.

8. The data, though unique and containing more information on an individual station level than other comparable databases, consists of details on only five stations. Hence, caution must be exerted in extending the conclusions of this study to other settings.
9. One must also be cautious in extrapolating the conclusions of this study to independent retailers. Our sample of independents consists of two retailers (outlets A and B) with operations that are not focused on gasoline sales and with no direct refining capabilities.
10. With respect to outlets owned by vertically-integrated firms (C, D, and E), this study does not attempt to evaluate the division between upstream and wholesale profits. This is beyond the scope of this study.
11. Due to missing information, data on stations A, B, C, and D are used for the economic analysis while corresponding data on stations A, B, C, and E are employed for the profitability analysis.

2. Definitions

For the purpose of this study we specifically employ the following definitions, which are in most cases, consistent with the Conference Board of Canada (2001);

2.1 Efficiencies

Are assumed to accrue from initiatives that impact per unit avoidable costs. Avoidable costs are costs that can be foregone by ceasing operation of the outlet.  Avoidable costs, of course, include those costs that vary with sales levels or are independent of the sales level. 

2.2 EBITDA

This is a profitability measure defined in terms of earnings before interest, taxes, depreciation and amortization (EBITDA).

2.3 Ancillary Services

Ancillary services include car wash service, convenience store sales, automotive services, and full service restaurant sales.

2.4 Independents

A firm with no refining capacity is assumed to be an independent.

3. Literature Review

There has been a significant amount of research on Canadian retail and wholesale gasoline prices over the past decade. One of the motivating factors is the popular perception that retail gasoline prices are “unreasonably high”, especially during the summer time, resulting in frequent public hearings and investigations by the Competition Bureau. The underlying belief is that vertically-integrated firms collude in order to set and maintain high gasoline prices. This review discusses the main findings of some recent and relevant econometric studies.
 
The Conference Board of Canada (1999) conducted a comprehensive study on determinants of both average monthly retail and wholesale prices across 11 Canadian cities from 1993 to 1999. Using a simple empirical specification, the study finds a positive and significant correlation between retail and wholesale prices. Further, a one-cent increase in wholesale prices is associated with a one-cent increase in retail prices within a one-month period. On the other hand, variation in wholesale prices is primarily influenced by movements in U.S. wholesale prices. The key conclusion is that both retail and wholesale markets are competitive with variation in retail prices and wholesale prices being ultimately determined by international crude oil prices rather than the degree of local competition.

Sen (2001) finds comparable results using a similar dataset but with a slightly different empirical specification. Specifically, he employs an econometric model where the effects of market concentration and wholesale prices (along with other factors) are estimated on retail prices. Similar to the Conference Board (2001) he finds that a greater amount of the variation in retail prices is explained by wholesale prices rather than local market concentration. Local market competition also plays a much smaller role in determining movements in wholesale prices relative to the impacts of crude oil price shocks. Hence, his conclusions are remarkably similar to the Conference Board (1999) findings; specifically that, although competition does play a role in determining retail and wholesale prices, the relative impacts are much smaller in magnitude than the effects of crude oil prices. Given these findings, the allegation of price fixing and collusion by vertically-integrated firms is difficult to sustain.  

Another strand of literature focuses on the role of smaller independents on retail competition. Employing pooled cross-city time series data on wholesale prices and market firm shares from 1991 to 1998, Sen (2005) finds that an increase in the market share of independents has no statistically significant direct impact on retail prices. On the other hand, Eckert (2003) finds that the presence of independents can be correlated with retail price cycles.

Finally, Sen (2005) evaluates the impact of vertical integration on wholesale prices in an effort to evaluate the existence of “raising the rivals’ costs”; in other words, the incentive of vertically-integrated firms to increase input or wholesale prices to smaller independents in order to eventually force their exit and thus enhance revenues and market shares from the retail markets. However, his results indicate a negative and statistically significant correlation between the aggregate retail market share of vertically-integrated firms and wholesale prices, suggesting that vertical integration is more likely to be associated with efficiencies rather than strategic behavior. The important point is that as in most other previous studies, there seems to be little evidence of anti-competitive behavior on the part of larger firms.

The above review raises several interesting observations. First, while most studies focus on average prices within and across cities, very few have actually managed to use station specific data. As pointed out by Eckert and West (2004) station specific data are definitely more desirable in trying to understand firm behavior and allows for richer analysis. Indeed, most of the questions raised in section 2 can only be answered through station specific data. Second, there has been little research in trying to understand the determinants of station specific pricing as well as profitability obviously because of a lack of relevant financial data. This study attempts to bridge this gap using outlet specific data from five stations in the Greater Toronto Area and adjoining areas as well as a combination of economic and profitability analyses.