INST Committee Report

Crude Oil Price Increases

Petroleum company executives offered five reasons for rising crude oil prices in the past year: (1) speculation in oil due to a looming war in Iraq; (2) labour unrest in Venezuela; (3) the political crisis in Nigeria; (4) unusually cold weather in northeast North America; and (5) low inventory levels in North America. An industry analyst (MJ Ervin) corroborated these five causal factors and, to a limited extent, quantified their impact. From the supply side, he claimed that the Venezuelan and Nigerian crises led global crude oil production to decline 6% in the first quarter of 2003, the equivalent of 5 million barrels per day. He also commented on two demand-side factors at work. First, speculation over a potential war between the United States and Iraq resulted in an estimated war premium on crude oil of between US$6.00 and US$8.00 per barrel. Second, an unusually cold winter throughout most of northeast North America increased the demand for crude oil on an already strained production system, driving U.S. inventory levels to their lowest in recent history.

The Commissioner of Competition confirmed these claims, explaining that the Competition Bureau’s research indicates that the most recent increases in the prices of crude oil and gasoline occurred because of the following:

In early February, gasoline prices started to increase across North America and peaked during the second week of March 2003. Since that time prices have retreated to their December 2002 level. All information available to date confirms that these increases in the price of gasoline were the direct result of the increase [in price] of crude oil caused by four factors: (1) a political crisis in Venezuela, which affects that country’s oil production; (2) it was a time of impending war in Iraq; (3) unusually cold weather in the north-east of North America; and (4) low inventory levels in North America. [Konrad von Finkenstein, Commissioner of Competition, Competition Bureau, Industry Canada; 40:15:30]

Witnesses appearing before the Committee who alleged collusion and price-fixing in the downstream sector did not dispute these five causes as a source of recent price increases. Those witnesses recognized that crude oil prices are determined in global markets that are, more than anything else, influenced by OPEC (Organization of the Petroleum Exporting Countries) production decisions. They also recognized that speculators will move tanker loads of crude oil across the world to arbitrage geographical price differences that are greater than the cost of transportation, thereby frustrating localized price-fixing attempts in the upstream sector. However, they maintained that these recent supply disruptions provide a convenient backdrop for decisions by Canada’s highly concentrated and vertically integrated oil producers to raise rack and pump prices above competitive levels. The Committee now turns to this issue.

Rack Price Increases and Supplier Margins

The Committee heard conflicting testimony on rack prices and refiner and/or marketing margins. Industry officials claim that rack prices are competitively set and comparable to those of the United States. Furthermore, supplier margins in Canada are smaller than those in the United States and have been so throughout most of the past decade. On the other hand, representatives from the Association québecoise des indépendants du pétrole (AQUIP) maintain that the petroleum industry is too concentrated and that this allows the large vertically integrated companies to increasingly control both rack and pump prices without resorting to price-fixing per se. Representatives from the Coalition pour la défense des consommateurs de carburant du Saguenay-Lac-St-Jean and from Essence à juste prix went further, claiming that the majors do fix prices to boost their profit margins. In either case, according to these representatives, excessive refining and marketing margins explain the recent run-up in gasoline prices made possible behind the veil of recent supply disruptions.

The two organizations alleging a conspiracy could not offer any formal evidence in support of their position, but the Committee also recognizes that their opinion is widely shared amongst the public. However, the Commissioner of Competition, who is armed with sufficient search and seizure powers to investigate such allegations and has done so many times in the past, believes otherwise. The Commissioner stated that:

Since 1990 the Bureau has conducted four major investigations related to the gasoline industry and found no evidence to suggest that periodic price increases resulted from a national or regional conspiracy to limit competition of the gasoline supply or from abusive behaviour by the dominant firms in the market. Indeed, it should be noted that following each period in which prices had increased market forces caused prices to return to historic levels. This is consistent with the result of numerous investigations conducted by our counterparts throughout the world who have generally arrived at the same conclusion. [Konrad von Finkenstein, Commissioner of Competition, Competition Bureau, Industry Canada; 40:15:30]

AQUIP, for its part, offered the corporate concentration data presented in the previous chapter as evidence of its claim. The Committee, however, believes that these data alone are insufficient evidence of high and supra-competitive supplier margins. Since the late 1990s, product specification regulations have been harmonized between Canada and some northern border states of the United States, thereby removing these barriers to trade. Gasoline imports by many large independents have been, and continue to be, a major source of competition that keeps Canadian rack prices in some locations in check with those at selected U.S. border locations. For example, the Committee was advised to consider the competitiveness of the Toronto marketplace:

In the Toronto market, for example, they have options to buy from one of five local domestic refiners and marketers. They also have the option to import product either by marine when the seaway is open, or by truck from Buffalo and Detroit. In many respects, on the wholesale price for gasoline in Toronto, we are a price taker. If our prices are not competitive versus Buffalo or Detroit, or the marine option up the St. Lawrence, trucks and ships will move. As a result, we need to ensure that we’re competitive against that very large international market. [Simon Smith, Vice President, Fuels Marketing, Imperial Oil Limited; 43:15:35]

[I]f I look at data published by the Government of Ontario that tracks Buffalo rack versus Toronto rack, they move fairly closely in tandem. If you don’t believe Buffalo is a liquid market, our experience has been that when prices in Toronto are out of sync with Buffalo, product moves in both directions. There are refiners and marketers in Buffalo that can make Canadian-spec gasoline quite easily, meet the benzene, meet all the sulphur specs. There are other markets like Detroit, which is a very large market and also will be an important factor in southern Ontario. [Simon Smith, Vice President, Fuels Marketing, Imperial Oil Limited; 43:16:20]

The Committee notes that Figure 1 of this report showed that Toronto and Buffalo rack prices did track each other very closely in the past year — a fact that tends to corroborate the claim of competitive rack prices.

The Committee was also told that U.S. refineries have about a 30% to 40% advantage in terms of economies of scale over Canadian refineries. Despite this fact, the total margins (refiner and marketing) in Canada were lower than in the United States, suggesting a more competitive and efficient market in Canada. The Committee was provided with data stretching back more than a decade that support this claim. The data on which Figure 2 of this report is based, however, point to somewhat higher refiner margins in Canada than in the United States, but to lower marketing margins in Canada. There is, therefore, some discrepancy in the data depending on the period under study. The Committee would have preferred that the refineries justified their margins. In any event, if AQUIP’s contention that corporate concentration has led to higher supplier margins in Canada is true, it must be true for the United States as well. The high concentration of ownership within the gasoline industry must be a continental, and not solely a Canadian, problem.

Figure 2 data point to slightly higher refiner margins and lower marketing margins in Canada than in the United States. Once again, this finding brings up the possibility of cross-subsidization amongst downstream activities. In this regard, the Committee reviewed the Conference Board of Canada’s report that found some indirect evidence of cross-subsidization but that it was statistically insignificant. In support of that conclusion, one industry official stated that:

[T]here is a great degree of autonomy within the marketing and the refining divisions [at Shell Canada]. Both … have the opportunity and exercise it to establish our respective prices based on market forces. From the standpoint of the way we operate the retail or the commercial brand businesses, we too are looking at the market forces establishing the ultimate selling price to consumers, and there is no attempt to cross-subsidize or subsidize by virtue of integration one business versus another. They are intended to stand alone. Our decisions on how we operate the business and what kind of investment it can generate for the future are determined on the standpoint of individual businesses. So in that context our retail business looks very similar in terms of a model to what an independent could do. [Terry Blaney, Vice-President of Marketing, Shell Canada Limited; 42:17:10]

The smaller marketing margin in Canada may, therefore, be the result of more aggressive shopping on behalf of Canadian consumers in response to higher prices (due to higher taxes) than in the United States. However, without cost data — specifically, avoidable cost data — the allegation of cross-subsidization cannot be proven or refuted. For this reason, the Committee believes that more investigation and study of this issue are warranted.

The Committee was also aware that seasonal aspects of demand affect not only the slate of products produced by the petroleum companies, but also rack prices and the amount of inventory carried. Winter months require the production of more heating fuel and less gasoline. Summer months require the opposite. According to one industry official, this contrast became more striking in the summer 2002–winter 2003 period:

We had cold weather … and all of a sudden demand was strong and everyone was struggling to find products to bring to the market. … [A]s the price went up, we decided to buy a bit less crude, maintain a bit less inventory because at some point it’s very expensive if you carry a lot of inventory in this business and you end up with $3 million or $4 million capital tied up … So you want to maintain inventory at a slightly lower level as price goes up if you think it’s going to be a short-term situation, especially if it’s unexpected disruption … [François Trudelle, Directeur principal, Approvisionnement en produits et Optimisation de l’exploitation, Ultramar Limited; 42:16:35]

These strategic decisions have an impact on the refiner’s margin:

These higher margins were a reflection of extremely low gasoline inventories in the United States. For the most part, gasoline inventories in the U.S. during the latter part of 2002 and the first three months of 2003 were at their lowest levels of the past several years. … [R]efiners also tend to minimize inventories when prices are high in an attempt to protect their exposure to a sudden drop in price. The low inventory position put further upward pressure on wholesale prices, which in turn influenced refining margins. [Michael Ervin, MJ Ervin and Associates; 43:16:00]

These explanations suggest that low inventory levels of crude oil were in fact a strategic response by refiners to keep inventory and production costs down, which is consistent with pro-competitive conduct.

Finally, there is the issue of rural versus urban marketing margins. Higher transportation costs to northern rural communities are obviously one factor, but they are not the only factor. Rural retail gas stations are, in general, much smaller than their urban counterparts, which can exploit significant economies of scale and scope that are not available to rural gasoline stations. One industry official explained:

[T]he entire difference [in retail prices between rural and urban centres] is not explained by transportation. If you take a large retail facility in Montreal, Toronto, Vancouver, they could well sell 12 million litres of gasoline a year. They also would typically have a 1,500- or 2,000-square-foot store behind that facility; they might have a car wash behind that facility, all of which provides revenue to the retailer. … The revenue available off that particular facility helps determine what the price is.

In many of the urban centres … the retail facilities are much smaller. They may sell 1 million litres, or 1.5 million litres, or 2 million litres a year. … So for those people to make a living, … they ask for a higher profit margin on the gasoline, because they need a larger margin on 1.5 million litres than the operation does in the major city who is selling 12 million litres, or 20 million litres, for that matter, which there are facilities in Toronto that do that. [Ford Ralph, Vice-President, Wholesale and Retail, Petro-Canada Limited; 42:16:05]

The Committee understands this to be the case with most retail goods, not just gasoline, and refers the reader to the Conference Board of Canada’s study, which deals with the issue in more detail.

Gas Pump Price Increases and Pricing Uniformity and Volatility

The trend in gasoline prices in Canada since the mid-1980s has been modestly upwards if taxes are included. If taxes are excluded, the trend is significantly downward. An industry official quantified these price trends as follows:

It’s the tax impact that has made a material change in the value and prices of gasoline to Canadian consumers. … [From 1983 to 2002, Canadian consumers have seen] an increase of roughly … 40%. … Since 1983 … the real price of gasoline to Canadian consumers has declined … it’s a decline of roughly 30% ex-tax. [Simon Smith, Vice-President, Fuels Marketing, Imperial Oil Limited; 43:15:35]

The data suggest that relief from high and increasing gasoline prices would best be achieved by lowering government taxes. Cutting the price margins at the different stages of supply would likely be injurious to suppliers’ financial performance and would threaten the economic viability of the less efficient suppliers. Furthermore, the downward trend in gasoline prices ex-tax since the mid-1980s — a period in which corporate concentration increased significantly — tends to contradict the claim that increased industry concentration has led to higher retail prices (ex-tax).

Price uniformity and volatility are also a concern. The public often notices and complains about retail gas stations in the same local market — those within a couple of street blocks of each other — charging prices that are identical, or only a fraction of a cent different. When one of these retail outlets changes its price — whether raising or lowering it — competitors in the immediate vicinity follow in lockstep within minutes. The public has always been suspicious of this price uniformity and volatility, which appears too systematic to be anything other than price-fixing. Indeed, the Committee heard complaints from two witnesses who alleged that only a conspiracy to fix prices could explain these pricing patterns. They could offer no evidence, however, in support of their allegation.

Industry officials beg to differ. They explain price uniformity within a local market as the consequence of the unique way in which retail gasoline prices are posted — on large signs outside each retail outlet that can be read by motorists travelling as fast as 60 kilometres an hour. Consumers have proven to be very price-conscious, travelling great distances to save a fraction of a cent per litre, even though this may amount to a saving of only 10¢ or 20¢ on an average fill-up. Retailers are aware of this extreme shopping behaviour by motorists, and must therefore keep an eye on their immediate rivals’ prices for fear of losing sales. In their own words:

So let’s take a corner, here’s a Petro-Canada facility and here’s another service station right across the corner, whatever brand. That facility decides to drop its price one-half cent per litre. Let’s just take 70¢, 69.5¢ per litre. Somebody is driving down the street at the speed limit in the city. They can see right away the price difference. Many people, many, many people will change their purchasing behaviour for half a cent a litre, interesting, because a fill is about 40 litres, that’s about 20¢. People will drive a mile for a half a cent a litre.

So what happens? If our station does not react to that station’s half a cent a litre below by dropping our price a half a cent a litre, we can lose a third of our business in a flash. People and our operators look across the road. If they see the price drop — we have a pricing centre — they phone us and we can authorize them in a matter of minutes to drop their price, because if we don’t, we’re going to lose business to them, just like that. That is why you see the same prices. [Ford Ralph, Vice President, Wholesale and Retail, Petro-Canada Limited; 42:16:05]

Competitive pricing under these conditions leads to price volatility, which was both quantified and explained to the Committee in this way:

On every street corner where we have sites, last year we had more than 200,000 price changes at our retail sites, up from 70,000 just three years ago. Why? Because of intense competition in our retail markets. We are continually seeing new and aggressive competitors coming into this market, including grocers and mass merchants. The irony is that gasoline pricing is probably the best example of competitive markets at work. [Ford Ralph, Vice President, Wholesale and Retail, Petro-Canada Limited; 42:15:30]

It is clear that industry participants believe both the uniformity and volatility of retail gasoline prices are the direct result of very fierce competition, particularly from the newest entrants. However, the Committee is less confident that this is the case.

Long Weekend Gas Pricing

The issue of long weekend or vacation pricing was raised by a couple of witnesses. These industry watchers claim that retail gas stations raise their prices in concert — suggesting a conspiracy to raise prices — just before a long weekend. Apparently, the same is true of the price of heating fuel in unusually cold winters:

The price of gasoline has regularly shot up in the last five years. Curiously enough, prices at the pump always go up right before the long summer vacation or before Christmas and you never see the price of heating oil go up in the summer but only during the coldest months of winter. [Claude Girard, Coalition pour la défense des consommateurs de carburant du Saguenay-Lac-St-Jean; 43:15:45]

Industry representatives did not dispute these price increases. They simply offered an efficiency or pro-competitive explanation for them.

In terms of winter pricing of heating fuel, the demand for heating fuels may (as noted above) outstrip supply when the weather is colder than expected. To avoid potential shortages or stock-outs, prices rise to stimulate both increased conservation by consumers and increased production by suppliers. The same applies to gasoline pricing before a long weekend. The Commissioner of Competition rationalized this pricing behaviour as competitive by way of a well-understood example:

[T]his is a question of demand and supply. Roses go up on Valentine’s Day, automatically, every florist in the city will raise the price of roses just before Valentine’s Day. Does that mean there’s a conspiracy? Not necessarily … at that time of the year, you raise the price of roses. The same way with gasoline; people go on long weekends, on drives, etc. so taking advantage of it does not necessarily amount to conspiracy. [Konrad von Finkenstein, Commissioner of Competition, Competition Bureau, Industry Canada; 40:16:30]

The Committee also notes that further investigation of the issue reveals that there is somewhat more to it than meets the eye. The statistical findings of the Conference Board of Canada are informative:

While it is true that prices do sometimes shoot up before long weekends, they are just as likely to increase prior to any other weekend throughout the year. The fact is that dealers attempt to increase prices, normally in the middle of the week, in order to restore margins that have been reduced because of street level competition. If they do not succeed, prices tend to drift down on Friday and on the weekend. Increases before long weekends may more likely be accepted by competitors in anticipation of the higher holiday demand, but this cannot be proven statistically.¹¹

This conclusion suggests that gasoline prices rise just prior to long weekends, but also just before a number of other regular weekends throughout the year — a situation that to some extent validates opposing claims. Such pricing behaviour may not be the result of collusion, but could be the consequence of individual retailers simultaneously and independently recognizing a situation of increased demand; they have plenty of history to prepare them for such opportunities. It would seem, then, that consumers are more aware of price increases before a long weekend than before other weekends.