The knee-jerk reaction of many Canadians, including Industry Minister Tony Clement, is to assume that high gas prices and inflated profit margins are likely to be explained by collusion among the big oil companies to fix prices at higher than acceptable levels. It may well be true that that there are price setting agreements reached among the major players in Canada, as Lorne Gunter suggests has happened before, but explicit collusion is not the only plausible explanation for high refining margins in Canada. The refinery sector should be under the lens of the Competition Bureau because the potential exists for the abuse of market power in this sector due to high concentration ratios, significant barriers to entry, and a product market with inelastic short run demand. Market power does not imply collusion or some grand conspiracy – it simply implies that the competitive forces in the market for refined products aren’t sufficient to drive prices down to marginal cost.
There is no question that oligopoly, or oil-igopoly if you will, exists in the Canadian refining sector. Canadian refinery capacity is a little under 1.85 million barrels per day (bpd), of which 85% is controlled by the 5 largest operators – what economists refer to as the 5-firm concentration ratio. The major players are Suncor (380,000 bpd), Imperial Oil (500,000 bpd), Irving (300,000 bpd) and Shell (172,000 bpd after closing its Montreal refinery). Generally speaking, a 4- or 5-firm concentration ratio above 50% would raise concerns about market power, while a 4- or 5-firm concentration ratio above 80% indicates a near-monopoly.
Since refineries have quasi-fixed capacity, and it would be clear if refiners were systematically rationing quantities to force higher prices, we should expect them to compete in the prices they set at the rack. This is where the high entry costs and time frames really matter. In the standard Bertrand model of price competition among firms in an oligopoly, the gains to any single firm from lowering their price relative to their competitors’ lies in taking over some or all of their market share. These potential gains to cutting prices serve to drive prices down to marginal cost even with a small number of firms in the market.
With a refinery, large shifts in market share aren’t possible. A refinery operator cannot decide to lower their prices tomorrow, and expect to be able to supply all 1.9 million bpd of refined products, since they do not have to capacity to do so, and could not create that capacity in the short term. So, in this case, a refinery which lowers their prices will not be able to capture a much greater market share, and they will simply earn a little less money per barrel and enable higher margins for their downstream clients at the retail level.
While the capacity constraints on each of the individual firms make it more likely that price exceeds marginal costs, there is a limit on the degree to which firms with market power can extract high margins – the limit comes from the twin threats of entry or regulation.
The refinery industry has significant fixed costs of entry – you can’t build a refinery quickly to take advantage of high margins. Rather, you must invest billions of dollars in capital on the belief that those margins will continue to exist. As many have suggested, increasing refinery capacity will likely lower margins, which in and of itself makes investing in a new refinery less attractive. In this type of an environment, we would expect to see limit pricing behavior in which existing refineries each benefit from keeping margins high, but not so high as to encourage entry. A second incentive, and perhaps where some of the value lies in the political posturing we have seen this week in Canada and the US, is the need to limit prices to avoid regulatory intervention in the market. In both of these cases, this could imply that the collusive outcome has lower prices than if there were no collusion at all.
So, is there collusion in gasoline markets? I have no idea. The potential certainly exists in the refinery sector for either explicit or tacit collusion. But, it’s just as likely that the collusion serves exactly the purpose to which Lorne Gunter alludes in his piece – to keep prices lower than they might otherwise be to avoid new entrants, government intervention, and/or long-term demand destruction – as it is that coordination exists to keep prices high. The refinery sector just isn’t set up so for competitive forces to push prices downward in the first place.
If you want to decrease refinery margins, the only guaranteed ways to do it are by increasing the elasticity of gasoline demand through more public transit, denser communities, more flexible work environments, or by deploying alternative energy sources for or means of transportation. If the impact of high gasoline prices were a sharp decrease in consumption, then you would start to see competitive forces erode margins much more quickly than a dressing down before a Parliamentary committee ever will.
Refining is an oligopoly because it is 99% of the time a low margin business with which the government interferes with regularly with constantly changing regulations.
Refiners don’t control the price of their major input cost (oil) nor their major output products (gasoline, diesel, heating oil), all of which are independently trading in transparent regulated commodities markets (mostly the Nymex).
i.e. Refining is a necessary but usually marginally profitable business for those who engage in it.
The reason for the current spike in the crack spreads is that gasoline is trading off the world price for oil (Brent) whereas the North American price of oil (WTI) is depressed because Cushing, Oklahoma is full to the brim with oil with insufficient takeaway capacity.
Refiners who have WTI oil as an input are currently making a killing. Refiners (like those in Montreal and points East and in the US Gulf Coast) are having a tough slog because their oil inputs trade off the world price.
The fact that 15% of the US refining capacity is currently under the threat of flooding is also impacting North American gas prices.
I don’t disagree with much of what you said in terms of the causality of recent price changes. I would argue though that causality does not exist between low margins and oligopoly. Refining is a natural oligopoly because of high fixed costs and increasing returns to scale, not because of low margins. If it were possible to quickly build and deploy small refineries, this would not be true. The development of small-scale gas turbines for power generation, which were relatively cheap and quick to build was the key change that dismantled the pure natural monopoly (not to be confused with regulatory monopoly) in electricity markets. Similar technologies simply haven’t emerged in refining. As such, it makes sense for there to be competition bureau oversight of the industry, and the industry players know this. The gains to exercising the significant market power that the industry does have (at least in the short term) would be mitigated by any regulatory intervention, hence Gunter’s hypothesis that refiners collude to keep the price low. I would also disagree with your contention that refiners don’t control the price of the end product. In a capacity-constrained oligopoly, that is not true. If a single refiner raises their rack prices, the others may not follow, but also can’t produce enough gasoline to serve the market. Retailers can still purchase at the higher price, but with tight margins and inelastic demand in retail, they would likely pass on that marginal cost to consumers.
So, I agree with your causality for the recent price run-up, but not necessarily with your views on industry dynamics.
Andrew
“Lorne Gunter eludes” (?) … do you possibly mean ‘alludes’?
Yes. Corrected.