What Determines the Profitability of a Retail Gasoline Outlet?

A Study for the Competition Bureau of Canada

7. Conclusions

The objective of this research is to address a significant gap in the literature by using empirical analysis to understand significant determinants of individual outlet profitability with respect to retail gasoline. In doing so, we are implicitly assuming that the relevant product market is gasoline. There are also some important caveats to acknowledge. First, caution must be exercised in generalizing the conclusions of this study as our dataset only consists of five stations from the Greater Toronto Area and adjoining areas. Second, our sample of independents consists of retailers whose primary revenues are not from gasoline. Third, our profitability analysis is incomplete as we were unable to obtain all information on expenses and ancillary revenues of site operators.

Nevertheless, the benefits of using economics as well as accounting style profitability analyses are obvious. Both methodologies yield some very complementary findings with respect to the profitability of a retail gasoline outlet. Employing individual data between 2002 and 2004 from five stations (outlets A and B owned by two different independent retailers, and C, D, and E – each owned by a different vertically-integrated firm), we specifically arrive at the following conclusions.

1. Simple graph as well as more sophisticated econometric analysis suggests that movements in both retail and wholesale prices are largely dictated by corresponding fluctuations in crude oil prices. In other words, we find that an increase in wholesale and crude oil prices results in a similar increase in retail and wholesale prices, respectively, for all outlets. These results are striking because they imply that outlets react quite similarly to crude oil price shocks irrespective of whether the firm is vertically-integrated or an independent retailer. Further, they demonstrate the benefits of possessing individual station data, which permits us to conduct the analysis. Specifically, a 1 cent/litre increase in wholesale prices is significantly correlated with 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 is associated with a 0.73 and 0.71-0.91 cent/litre increase in (regular grade) wholesale prices experienced by independents and refiners, respectively.
2. The above and the fact that outlet C’s internal transfer prices are almost identical to wholesale prices incurred by outlets B and A cast serious doubt on the possibility of strategic behaviour by vertically-integrated refiners. This result offers contrary evidence against the likelihood of predation by vertically-integrated firms, specifically in the form of higher wholesale prices charged to independents.
3. The economic analysis demonstrates the positive profit margins enjoyed by all outlets with respect to gasoline sales, calculated simply as the difference between retail and wholesale prices multiplied by sales volumes. When profits are calculated in this limited and imprecise fashion, trends in it seem to be driven mainly by throughput as is evident in the differences between outlets B and C (the vertically-integrated firms) in this respect.
4. However, pricing also contributes to profitability. This becomes quite apparent when one takes into the account the relatively small gap in sales volumes but much wider spread between average retail prices charged by outlet C (vertically integrated firm) and outlet A (independent).
5. Due to the limited sample size we are unable to determine the reason why outlet C is able to charge higher prices. Possible factors include consumer preferences due to branding and to the availability of a wide array of ancillary products, and differences in the degree of local competition.
6. In this respect, there seems to be some qualified support for the idea that local competition impacts prices charged by outlets. This is especially relevant when one compares the higher prices charged by outlet C compared to outlet D and the fact that outlet D has to compete with more outlets within a 1 km radius.
7. Although all the stations do make positive margins on gasoline sales (taking into account only wholesale prices), the profitability analysis clearly demonstrates that these figures are erroneous without factoring in station specific costs. Once avoidable and unavoidable costs have been included, both outlets A and B incur losses with respect to gasoline sales. These findings clearly demonstrate the pitfalls of relying on simple differences between retail and wholesale prices in evaluating outlet and ultimately, industry profitability. Further, the results underscore the point that high gasoline prices do not necessarily translate into enhanced and sustainable profits.
8. The losses incurred by A and B may be interpreted as evidence of predation. However, given the similarity in wholesale prices between themselves and vertically-integrated firms, and common patterns in retail prices, this is extremely improbable.   
9. From an overall perspective, outlet C is the only profitable outlet on an annual basis. Although, outlet C’s prices are higher, its profitability seems to be driven mainly by the fact that its throughput is considerably higher than the other outlets.
10. However, this is of course assuming a strictly retail gasoline product market. In all likelihood, outlet A and outlet B make significant profits from the retail stores the gasoline outlet is co-located with.
11. Unsurprisingly, most gasoline revenues are generated from the sale of regular grade gasoline. But the vertically-integrated firms (outlets C and E) do earn a larger proportion of revenue from the sale of premium grade fuels relative to outlets A and B.
12. All stations make profits from the sale of in-store products as well as car wash services. But relatively, the vertically-integrated firms (outlets C and E) make considerably higher profits on ancillary sales (car wash and convenience store) compared to the independents, both in absolute as well as proportional terms. 
13. Hence, is it possible that vertically-integrated firms might be able to sustain low retail prices by relying on sales of ancillary products? First, the price elasticity of demand for gasoline from an individual station is probably quite high, implying that a drop in retail prices will probably result in significantly increased revenue. However, even if retail prices do drop below wholesale prices, it is unlikely that stations can exclusively rely on revenues from ancillary services.
14. We are limited in what we can say about station efficiency given some missing data on ancillary revenues and specific costs incurred by actual site operators.
15. The critical factor driving profitability is throughput, which not only impacts revenue but also average total costs and hence profitability. Throughput is obviously related to factors such as population density, local traffic, and the degree of local competition. In this respect, the Bureau should be careful in its investigation of alleged anti-competitive actions by vertically-integrated firms. Losses incurred by specific outlets could be a function of a variety of factors that are simply a result of poor business strategy, circumstances, or choice, rather than a consequence of predation or squeezing. 
     

8. References

Eckert, Andrew, and Douglas S, West (2004) “Retail Gasoline Price Cycles across Spatially Dispersed Gasoline Stations”, Journal of Law and Economics, 47(1), pp. 245-73.

Eckert, Andrew (2003) “Retail Price Cycles and the Presence of Small Firms”, International Journal of Industrial Organization, 21(2), pp. 151-70.

Kardasz, Stanley W., and Anindya Sen (2005) “An Empirical Test of Raising the Rivals’ Costs”, Working Paper, University of Waterloo.

Sen, Anindya (2005) “Does Increasing the Market Share of Smaller Firms Result in Lower Prices?”, forthcoming, Review of Industrial Organization.

Sen, Anindya (2003) “Higher Prices at the Gas Pump: International Crude Oil Price Fluctuations or Local Market Concentration? An Empirical Investigation”, Energy Economics, 25(3), pp. 269-88.

9. Appendices

Appendix A.  Information Request Sent to Participating Retailers

Competition Bureau (Confidential once completed)

Information Request

1. What is the corporate name of your company and the trade name or banner(s) under which it conducts business?
2. What is the address and postal code of the gas station?
3. For the past three years, supply the gasoline station’s monthly profit and loss operating statements, in electronic format and in sufficient detail to:

i)   provide separate financial results for fuel retailing operations, car wash operations, food/merchandise retailing operations or other operations.  These operating statements should separately disclose revenues and cost of sales and operating costs to the extent that they can be allocated to specific operations;

ii)  disclose details of costs by major category, including labour, repairs and maintenance, utilities, equipment leasing/depreciation, insurance, supervision, overhead including allocations of costs from head office, if any.

iii) provide information on physical volumes of fuel sold;

iv) provide information on hours of labour worked by all wage earners and salaried employees.

4. For the past three years, provide the gasoline station’s monthly balance sheets, in electronic format and in sufficient detail to indicate separate information on assets and liabilities associated with fuel retailing operations, car wash operations, food and merchandise retailing operations or other operations. 
5. For the past three years, supply the gasoline station’s information on:

i)  the size of the site; the number of fuel dispensing pumps and the size of any merchandising outlet or other operations;

ii) any labour, supervisory or other costs that were in respect of services provided by owners or other financially unrelated parties and the basis of those costs.

For the past three years, supply the gasoline station’s information on:

i) whether any fuel or merchandise was purchased for the gasoline station from financially unrelated parties and the cost of those purchases.

ii) the names of suppliers of wholesale gasoline. Also, please provide a breakdown in terms of the amounts obtained each supplier (in percentages).
 
iii) whether this breakdown has remained relatively fixed over the past three years. If not, please give a history of changes that have occurred with respect to wholesale arrangements over the past three years.

iv) wholesale prices paid by you for each grade of gasoline on a monthly basis for the past three years.

v) the number of grades of gasoline offered by your station. Further, please confirm whether the station has been offering the same grades over the past three years.

vi) retail prices charged for each grade of gasoline on a daily basis for the past three years.

vii) the amount of gasoline sold (in litres) for each grade of gasoline on a monthly basis for the past three years. 

viii) the distribution of profits with regard to each grade of gasoline. For example, after taxes, is the distribution of profits from regular/premium 80%/ 20%?

1. For the past three years, supply the gasoline station’s information on

   ---

   i) how many other competing stations are in a close vicinity.

    ii) which companies are these stations affiliated with.

   iii) what do you imply by "close  vicinity" (define in terms of radii).
    iv) whether these stations been in existence for the past three years. If not, please document the entry/exit of new/existing stations over the past three years.

2. Can you articulate your business strategy? For example is your strategy to keep a certain margin between retail prices and wholesale prices? If so, what is the average margin you need to maintain? Has this remained constant over the past three years?

3. How much discretion do you have in setting prices? Do you have complete discretion or do you only set prices that are communicated to you by head office? Or is it somewhere in between? If so, please describe the price setting process in detail.

4. On average, how many times do you change prices within a day?

Send confirm your willing to participate and meet our deadline by calling Dennis Lu at (819) 956- 2907. Responses in electronic format may be submitted on a diskette or CD. Send all written responses by fax at (819) 953-8546 or by mailing them along with any diskette or CD to the address below: 

Civil Matters Branch, Competition Bureau
Attention: Dennis Lu
15th Floor
50 Victoria Street,
Gatineau, Québec
K1A 0C9
 
Appendix B. Curriculum Vitae of Authors

Anindya Sen
Department of Economics
University of Waterloo
200 University Avenue
Waterloo, Ontario
Canada N2L 3G1
Phone: (519) 888 4567 ext. 2123
Fax: (519) 725 0530
Email: asen@watarts.uwaterloo.ca

EMPLOYMENT

July 2005 to present: Associate Professor of Economics, University of Waterloo

Sept. 2002 to present: Affiliated Research Scientist, Center for Behavioral Research and Program Evaluation, Faculty of Health Sciences, University of Waterloo

Sept. 1999 – June 2005: Assistant Professor of Economics, University of Waterloo

June 1998 - Aug. 1999: Economist, Competition Bureau, Federal Government of Canada

EDUCATION

1998 Ph.D., Economics, University of Toronto.
1992 M.A., Economics, Concordia University
1990 B.A. (Hons.), Economics, University of Delhi

AWARDS

GRANTS

External

• Co-investigator, “Improving Access to Canadian Smoking Data”, Canadian Tobacco Research Initiative, ($1,500,000). 08/04-08/09
• Co-Investigator, “Improving the Population Impact of Telephone Counselling for the Treatment of Smoking”, Heart and Stroke Foundation, ($1,209,618) 08/01-06/06.

Internal

• CBRPE Faculty Award ($20,000), 2001-03      
• New Faculty Research Award ($5,000), University of Waterloo, 2000     

PUBLICATIONS

Work Published in Refereed, Scholarly Journals

Public & Health Economics

1. Sen, Anindya “Do Stricter Penalties or Media Publicity Reduce Alcohol Consumption By Drivers?”, Canadian Public Policy 31(4), December 2005.
2. Sen, Anindya “Is Health Care a Luxury? New Evidence from OECD data”, International Journal of Health Care Finance and Economics 5(2), June 2005, pp. 147-164.
3. Sen, Anindya, Jonathan Gruber, and Mark Stabile, “Estimating Price Elasticities When there is Smuggling: The Sensitivity of Smoking to Price in Canada.” Journal of Health Economics 22(5), September 2003, pp. 821-42
4. Sen, Anindya, “An Empirical Test of the Offset Hypothesis”, Journal of Law and Economics 44(2), October 2001, pp.481-510.
5. Sen, Anindya, “Do Stricter Penalties Deter Drinking and Driving? An Empirical Investigation of Canadian Impaired Driving Laws”, Canadian Journal of Economics 34(1), February 2001, pp. 149-164.
6. Sen, Anindya, “Will Stricter Penalties Deter Drunk Driving?”, Policy Options 20(7) 1999, pp. 54-57.

Industrial Organization

7. Sen, Anindya, “Does Increasing the Market Share of Smaller Firms Result in Lower Prices?”, Review of Industrial Organization, 26(4), 2005, pp. 371-389.
8. Sen, Anindya, “Higher Prices at the Gas Pump: International Crude Oil Price Fluctuations or Local Market Concentration? An Empirical Investigation.”, Energy Economics, vol. 25, no. 3, May 2003, pp. 269-88.
9. Sen, Anindya and Ted Mallett, “Does Local Competition Impact Interest Rates Charged on Small Business Loans? Empirical Evidence from Canada”, Review of Industrial Organization, 19(4), December 2001, pp.435- 450.
10. Sen, Anindya, Ted Mallett, and Ruma Sondhi, “Jury Still Out on Internet Benefits: More Branches Keep Bank's Loan Rates Low”, Canadian Business Economics 8(3), February 2001, pp.21-29.

Work Published in Conference Proceedings

11. Sen, Anindya, “Traffic Fatalities and Seatbelt Laws”, Canadian Transport Research Forum Meetings,

Consulting Reports

“Estimating the Economic Benefits of the Marine Transport Industry in Canada”, (with Peter Dungan and LECG LLC), report for Transport Canada (http://www.cmc-ccm.co m/acrobat/MIBS-FinalReport.pdf), 2004.

“A Cost Benefit Analysis of the Multi Jurisdictional Disclosure System”, (with Poonam Puri and LECG LLC), report for the Ontario Securities Commission (http://www.osc.gov.on.ca/Regulation/Confidence/pic_20030627_cba-dis closure-system.pdf), 2003.

“Estimating the Impact of Mergers among Bread Manufacturers in Canada”, report for the Competition Bureau, Industry Canada, 2001.

“Competition and Gasoline Prices in Eastern Canada”, report for the Competition Bureau, Industry Canada, 2000.

PRESENTATION OF RESEARCH

At Conferences

Canadian Economics Association Meetings, 2005, 2004, 2003, 2002; Interdisciplinary Conference Sponsored by the National Cancer Institute of Canada, University of Waterloo, 2001; Canadian Law and Economics Association Meeting, 2000, 1999; International Business and Economics Society Meetings, 1999; Canadian Transport Research Forum Meetings, 1999.

Invited Presentations at Universities

2004  University of Guelph, McMaster University.
2001  Ryerson University, York University, University of Toronto, University of Western   Ontario.
2000  McMaster University, Faculty of Health Studies, University of Waterloo.

Other

• “Evaluating the Economic Impact of the Marine Transport Industry”, presented to Transport Canada, 2004.
• “Inferring the Presence of Market Power from Tax Hikes”, presented to the Competition Bureau, Industry Canada, 2003.
• “Estimating the Impact of Mergers among Bread Manufacturers”, presented to the Competition Bureau, Industry Canada, 2001.
• “Competition and Gasoline Prices in Eastern Canada”, presented to the Competition Bureau, Industry Canada, 2000.
• Expert Testimony on the Causes of Rising Gas Prices, House of Commons Industry Committee, 1999.

TEACHING

Courses Taught

• Undergraduate: ECON 361 (Cost Benefit Analysis), ECON 341 (Public Expenditure), ECON 321 (Econometrics), ECON 201 (Microeconomics)
• Graduate: Public Finance, Health Economics

SERVICE

Department Level
Director, Seminar Series, 2000-01, 2003-04
Member, Graduate Committee, 1999-2005

Refereeing
Journal of Political Economy, Canadian Journal of Economics, Journal of Health Economics, Journal of Public Economics, Social Science and Medicine, Journal of Policy Analysis and Management, Contemporary Economic Policy, Southern Economic Journal.

Robert H. Boulton, Principal, LECG

55 University Avenue, Suite 1000
Toronto, Ontario, Canada, M5J 2H7
direct: 416.682.7183
main:  416.364.6400
fax: 416.364.6900
email:  bboulton@lecg.com

BIO/SUMMARY

Robert H. Boulton 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.  Bob has 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.

EDUCATION

Chartered Business Valuator, 1999
Chartered Accountant, 1979
Bachelor of Commerce, University of Toronto, 1977

PRESENT POSITION
LECG, Principal, 2004 - Present

OTHER POSITIONS HELD
Low Rosen Taylor Soriano, Principal, 2000 - 2004
Cole & Partners, Associate, 1995 - 2000
Boulton & Associates, Principal, 1990 - 1995
Helix Investments Limited, CFO, 1986 - 1990
Ernst & Young, Chartered Accountants, Senior Manager, 1977 - 1986

PROFESSIONAL MEMBERSHIPS & ASSOCIATIONS
Canadian Institute of Chartered Accountants
Canadian Institute of Chartered Business Valuators
Institute of Chartered Accountants of Ontario

PUBLICATIONS
Journal Articles and Seminars

1. ‘Valuation Assumptions Must Be Substantiated and Reasonable’ (with Prem Lobo), The Lawyers Weekly, September 19, 2003.
2. ‘Getting In On The Ground Floor’ (with Stephen Cole), CA Magazine – Business Valuation Section, May 1998.
3. ‘Beating the Odds’ (with Stephen Cole), CA Magazine – Business Valuation Section, June/July 1996.
4. Lecturer at various professional development programs concerning business valuations.
5. Due Diligence Skills & Best Practices Conference, Federated Press, April 2004, Toronto.