US Attorney General Eric Holder and Obama press secretary Jay Carney may think the process for how retail gasoline prices get established in the US is a big mystery. It isn't.
On Friday, two key Obama administration officials indicated that the federal government was going to investigate whether retail gasoline prices were coming down fast enough in the wake of last week's collapse in commodity prices. Attorney General Holder wrote a letter to the recently-established "oil and gas price fraud working group," saying that "fraud or manipulation must not be allowed to prevent price decreases from being passed on to consumers at the pump." Earlier in the day, in his daily press briefing, press secretary Carney said the administration had asked Holder to investigate the so-called "rockets and parachutes" phenomenon. It's a theory that retail gasoline prices rapidly rise when spot prices are ascending, but drift down slowly -- like a parachute -- when they are declining.
(Of course, all these events happened before prices soared on Monday, both on the NYMEX and in physical markets).
Let's review this mysterious sausage-making that caught Mr. Holder and Mr. Carney's eye the other day, and hope it will shine a light on a process that really isn't all that opaque.
All retail motor fuels pricing starts with two prices on the New York Mercantile Exchange: RBOB, the unfinished gasoline blendstock to which, for the most part, ethanol is added in a 90-10 blend to make finished gasoline; and the No. 2 heating oil contract, which serves as the basis for all distillate pricing, including diesel. It should be noted that the price of crude is not significant to the daily price-setting process.
There are five key spot markets in the US: the US Atlantic Coast; the US Gulf Coast; the Midwest's Group 3; Chicago; and the US West Coast. Virtually all spot trade is done as a differential to those two NYMEX benchmarks. Gulf Coast gasoline will usually sell at a discount to the RBOB contract; Chicago diesel will be priced against the No. 2 oil contract. And so on.
The most important thing to know at this point is that oil companies do not set the price on the street (except for the rapidly diminishing category of company-owned stores, a figure that is edging toward zero). The decision of what number to put up on the corner is completely up to the store owner. The joke in the industry is that the only thing the owner needs to figure out how to price gasoline is a pair of binoculars to see what the competition down the street is doing, and a stepladder to change the numbers.
The reality, according to consultant Gary Bevers, is that retail prices are often set by software, and the software in turn is keyed to those competitors' prices. Human decision-making isn't even involved.
The final pricing step taken by the oil companies then is at the wholesale distribution point, known in the industry as the rack. If you've ever seen a tanker truck rumbling toward a retail station to drop off a load, that truck filled up at the rack. (It's usually located in the industrial part of town.)
Every major company posts rack prices. These prices are significantly below retail prices, for obvious reasons: there are no taxes in the rack price e.g., sales taxes or federal gasoline taxes, and there is no retail markup. They are posted for cities big and small, they are set for diesel as well as gasoline, and are also posted for a few smaller products, like kerosene. There's an ExxonMobil price for Ultra Low Sulfur diesel in Amarillo; there's a Shell price for gasoline in Denver. There are thousands of them.
The primary factor determining rack prices is what happened in the spot market that supplies a particular region. For example, product coming into Atlanta on Colonial Pipeline originated in the US Gulf, so that Gulf Coast gasoline price we mentioned earlier is the starting point in producing a rack price. The price of Milwaukee diesel is going to be a function mostly of the price of that aforementioned Chicago diesel. (On Monday, as this is written, the Chicago market in particular is soaring, well above the levels of the NYMEX RBOB contract. Expect that to push rack prices in Chicago up at a rate greater than the rest of the country later Monday).
These prices get changed virtually every day. They often get changed twice a day. This is where the whole argument that "the oil companies are trying to keep their prices as high as they can for as long as they can" falls apart.
If a company doesn't post competitive numbers at the rack, it is going to lose sales in the all-important "unbranded" category. The unbranded gas stations are those that don't fly the flag of companies such as ExxonMobil or Chevron, but would be operated by independent operators like Sheetz, or Liberty, or any one of a few hundred familiar and less-familiar names. They buy gasoline from major suppliers, and that fuel is considered "unbranded." "Branded" gasoline gets sold by ExxonMobil, for example, to ExxonMobil-branded dealers, who must buy from ExxonMobil; they have no choice. That fuel will generally have some additives that the companies will claim make the branded fuel unique, and worth a bit more money.
These stations will have a percentage of supplies locked up through a contract. But for the balance of those needs, they will still be looking at who has the best deal, and they are studying that hour-by-hour. So if Valero's unbranded price at Greensboro, N.C. is kept too high, by even a half-cent, the discretionary buying to resupply a Racetrac station in High Point, N.C. that needs to get done one afternoon might be directed to the Shell Raleigh unbranded rack, because it's a half-cent cheaper. It's that competitive.
(The rack is competitive, but it may never get quite to the level of strife seen occasionally.)
So what if everybody just got together and slowed the pace of their rack price decline, coordinating their refusal to go along with the broader market? The problem with that conspiracy theory (besides the fact it's illegal) is that there is a great deal of rack business tied to the spot prices for any of those five regional spot markets. (Full disclosure: Platts assessments are generally the basis for those deals.)
Any company whose rack prices don't capture the reality of a plunging market--while the spot assessments are reflecting all of that decline -- is going to find itself on the outside looking in on the discretionary business that's getting done against those spot numbers. So it isn't just rack-to-rack competition; it is also rack-to-spot.
To give you an example of how rapid those changes are, here's the history of what Valero did with its Atlanta unbranded regular gasoline rack price late last week, courtesy of data provided by DTN: On May 4, Valero's price stood at $3.7085, effective 6 p.m. At 11:30 am on Thursday, the day of the price plunge, it was cut to $3.5525. Then just 6.5 hours later, it was cut again, to $3.4020. The next day, when prices started moving up (before a late plunge pulled them back down), Valero's prices went up to $3.482 and then up to $3.508. But from top to bottom, Valero cut its prices 30 cts/gal in 24 hours.
Marathon's Detroit rack wasn't quite as volatile. Its price effective 6 pm on May 4 was $3.472/gal, and it was cut to $3.253 24 hours later, after that day's slide. One day later, it inches up to $3.2555. In Houston, Shell dropped its price from $3.6468/gal effective May 4 to $3.4304 a day later. The early price rise of Friday led Shell to increase that rack price to $3.5404.
And so on. Each price is the function not just of broad market trends but also local conditions.
The point here is that these oil company decisions undercut the idea that major transportation fuels suppliers are engaged in "rockets and parachutes" price-setting. That pretty much takes the oil companies out of the blame of why prices at the pump don't fall as fast as the spot numbers; they are in charge only of their rack prices, and those prices move, and they move a lot.
Then why isn't the street price coming down rapidly? We'll go back to our guy with the binoculars.
It isn't a conspiracy that a seller of a good will try to keep a price as high as possible for as long as possible; that's Econ 101. If he's posting $4.25/gal gasoline and just got a cheaper load from the rack, and he then finds that his blood enemy two blocks south of him hasn't changed his price, he'll probably keep it at $4.25 as long as he can. But if he turns to his right and see that his other blood enemy, two blocks to the north, got a cheaper load and cut his price, well, up the stepladder we go, and the $4.25 is getting reduced. This isn't a deep dark conspiracy.
The data that the Justice Department will study is going to show that oil company rack prices are responsive to the market. The companies have no choice if they want to stay competitive.
So that leaves retail prices. Does the Department of Justice really want to get in the business of telling retailers how fast they must move their prices in response to rack movements? Doesn't it have better things to do?
Given Platts readership, this is preaching to the choir. The investigation, like so many before it, will likely produce no evidence of oil company collusion. It's political posturing, but so is the claim that producing more domestic crude will make the US energy "independent," or effect current prices (or even have much of an impact on future prices, for that matter). Like it or not, it's how the game is played and our job as reporters (my former job, actually), is to try to get to the reality behind the fiction - as you have attempted to do here.
However, given the occasionally significant retail price differences I see in the DC area among close-by stations, I'm not sure every dealer has a pair of working binoculars or even cares, at least in the short-term, whether his competitor has a lower price.
While it may be true that the decision of how much to charge is completely up to the owner, the does not mean the oil company plays no part.
The oil company does set the price it charges the retailer, and that price varies by location; not just by locality, but often by neighborhood or even intersection. While two Exxon-branded dealers a mile apart may set their own prices, the fact that one is charging 10 cents more than the other may not have been totally his decision. He may be being charged 8-12 cents more per gallon. It's not unusual to see a cluster of stations in one area competitively priced against each other, but much higher or lower than another cluster a couple miles away - even though they are in the same governmental areas wrt taxes. The oil companies are charging the stations in the different areas different amounts, based on what they believe the market will bear, while keeping prices competitive with other companies in the same small area.
This is not to say that there is any collusion, price-fixing or other anti-competitive practice at work. Just that the competition is occurring at both retail and wholesale levels, and that the oil companies do have a role in determining differences in pump prices at stations, in how they set their wholesale prices at a micro level.
I find that even where there are significant retail price differences in the same area, there's usually some justification for it. More often than not, it's ease of access. In fact, I can think of one place here in Los Angeles where the prices of two gas stations across the street from each other regularly reverse twice a day with the commuting pattern. The guy on the more heavily-trafficked side of the street always has the higher price. It seems to switch around noon, then switch back sometime overnight. On weekends when the traffic is relatively light and there's little penalty in time or convenience for going around the block to get to the opposite station, the prices tend to be uniform.
There are other things too. One brand is always a few pennies cheaper, but they're the one whose stations don't take credit cards and charge a small fee for ATM card purchases that more than makes up for the difference on a typical refill.
Quite frankly, although I understand and approve of the intent of this article, it's basic argument is flawed from the beginning.
"All retail motor fuels pricing starts with two prices on the New York Mercantile Exchange: RBOB, the unfinished gasoline blendstock to which, for the most part, ethanol is added in a 90-10 blend to make finished gasoline; and the No. 2 heating oil contract, which serves as the basis for all distillate pricing, including diesel. It should be noted that the price of crude is not significant to the daily price-setting process. "
I take particular issue with this statement: "It should be noted that the price of crude is not significant to the daily price-setting process. "
This statement is wholly in error and misleading to the readers. The price of crude DIRECTLY affects the prices of both RBOB and heating oil. You can clearly visualize this by charting the pricing of the three over the last 6 months or, any period of your choosing that provides an appropriate number of data points.
Moreover, you can see this direct correlation in the span of a trading day. You can also see the price of crude affected by the price of silver, the price of gold, the valuation of the dollar, the political stability of world markets, etc. All of these and many more factors affect the daily price of crude which, directly impacts the price of gasoline at the pump via RBOB and heating oil.
To a lesser degree, the price of gas at the pump can be traced to fluctuations in the corn market and it's effect on Ethanol pricing.
In a nutshell, gas prices at the pump skyrocket because the price is dependent on myriad factors and the many companies that profit from it keep a close eye on these factors and adjust accordingly in order to maintain profit margin. The prices parachute down because higher margins can be achieved by a slower, more cautious reaction to market factors fluctuating downward.
The point is that when an oil company sits down to calculate rack prices, it is the price of the benchmark on the NYMEX, plus the differences in the local "referring" market like the US Gulf Coast that matter. Obviously, the price of crude affects the price of RBOB or No. 2 oil, and as you note, crude is affected by many factors. But if crude jumped 75 cts one day while the products were flat, for whatever reason, the decision-making for the rack price would look at the movement in the products, and the crude would not be relevant. That's the point I was making. As far as rack prices parachuting down, I have yet to see an analysis -- and I will concede, I haven't done a thorough one myself -- that rack prices are moved down at a slower rate than they are moved up, even though the idea that retail prices "parachute" down certainly makes sense. That's a localized decision. My unscientific observation of rack prices is that they are highly sensitive to movements in the spot price, up or down, and any difference in the rate of movement would be minimal. If not, as I said, they would immediately become uncompetitive with spot-based rack pricing.