California Gasoline:
The Return of Refiner Profits

Richard Gilbert
Professor of Economics
University of California at Berkeley

June 1, 2001

The average retail price of a gallon of branded regular gasoline sold in California surged from about $1.60 per gallon at the beginning of the year to almost $2.00 per gallon by the Memorial Day weekend. Since 1998, California gasoline prices have increased by more than fifteen percent per year. Consumers are outraged. What are the causes of these price increases? There is no shortage of culprits: the OPEC cartel; gas-guzzling SUVs; oil mega-mergers; and environmental restrictions are some of the usual suspects.

A better understanding of the causes of the spike in gasoline prices can be gained by considering each of the factors that contribute to the cost of gasoline at the pump. The price of a gallon of gasoline has four basic components:

(1) The cost of the crude oil feedstock--Crude oil prices are quoted in dollars per barrel. A barrel is equivalent to 42 gallons, and a common assumption is that is takes a gallon of crude oil to manufacture a gallon of gasoline.

(2) The margin earned by refiners--The refiner margin is the difference between the average wholesale price of gasoline sold to retailers and the price per gallon of crude oil feedstock.

(3) The margin earned by retailers--The retail (or dealer) margin is the difference between the average retail price of gasoline and the average wholesale price.

(4) Taxes--Taxes include state and local sales taxes, state excise tax, and federal excise tax.

Table 1 compares the average contribution to the price of a gallon of gasoline for each of these factors in January and May of 2001:

Table 1

Components of the Price of a Gallon of
Branded Regular Gasoline in California*
($ per gallon)

* Source: California Energy Commission
** May not sum due to rounding

The average price of branded regular gasoline increased by 35 cents per gallon from January to May of 2001, an increase of 22 percent. Higher crude oil acquisition costs for California refineries added seven cents to the price of gasoline per gallon. Taxes added another two cents. Clearly the most significant component in the rise of prices from January to May of this year was the refiner margin, which added 27 cents to the price. The increase in the refiner margin is typical of the trend over the past few years. The refiner margin in California increased from 32 cents per gallon in 1998 to 39 cents in 1999, 42 cents in 2000, and 58 cents in 2001. (See Figure 1.) The refining of gasoline has been an unusually profitable activity in the past year.

Figure 1. California Refinery Margins
Source: California Energy Commission

John D. Rockefeller created the Standard Oil trust in the late nineteenth century by controlling the key assets of petroleum refining and transportation. The rush for black gold periodically sent prices plunging and Rockefeller benefited as a net buyer of crude oil. The profit centers in the gasoline industry changed dramatically over the course of the twentieth century, moving to crude oil production as overcapacity in refining eroded profits in this sector. Times have changed. Whether oil companies are making profits that are excessive, or merely above depressed levels of the past, can be debated ad infinitum. California refiners have been able to earn much higher profits because California gasoline supply is tight relative to demand. The popularity of gas-guzzling behemoths no doubt has contributed to the supply-demand squeeze. Gasoline demand in California has increased from 13.8 billion gallons in 1997 to 14.8 billion gallons in 2000. No new refineries have been built in California to serve the growth in demand, several smaller refineries have closed, and additions to existing refinery capacity have not kept pace with the increase in gasoline demand.

Gasoline prices have increased across the nation, but are still well below the prices paid in California, adjusting for taxes. The main difference between California gasoline prices and the prices paid elsewhere in the nation can be traced to the margins earned by refiners. Over the period January 2000 to May 2001, the average refinery margin for gasoline sold in the Gulf Coast averaged 16.6 cents per gallon less than the refinery margin for gasoline sold in California. A portion of this price difference (perhaps 5 to 8 cents per gallon) can be attributed to stricter emissions requirements imposed on gasoline sold in California. Californians pay a price for the cleaner-burning specifications required by the California Air Resources Board. Environmental regulations impose obstacles for new refinery construction and raise the cost of retail facilities, which also adds to prices paid at the pump. But even after making generous allowances for the cost of California's cleaner gasoline and for other factors, such as higher taxes, there is still a substantial premium that Californians pay for gasoline relative to the rest of the nation. Why is this so?

With respect to gasoline, the California market is an island. California's tight specifications for reformulated gasoline sold in the state and limited pipeline interconnections across the state's borders isolate the California gasoline market from gasoline markets in the rest of the country. Competition among gasoline refiners is limited in California's island economy. There are six major refiners in California with a combined crude oil processing capacity of 1.7 million barrels per day. A handful of other, smaller, refiners contribute another 200 thousand barrels per day of capacity. The terminals that supply wholesale gasoline to California cities have an average of three refiners that sell gasoline at arms length to any dealer. As a comparison, gasoline terminals in the Gulf Coast states of Texas and Louisiana often have more than seven refiners that sell to any dealer. Research I have done with my colleague Justine Hastings suggests that the heightened competition that exists at these Gulf Coast terminals likely lowers refiner margins by three to five cents per gallon. Gulf Coast refiners also supply a large network of independent gasoline marketers. There is statistical evidence that competition from independent retailers also tends to lower wholesale prices and further squeezes the refiner margins. The larger network of independent retailers likely accounts for another one to three cents of the difference in the refinery margins between California and the Gulf Coast.

The number of independent refineries and the share of independent gasoline retailers in California dwindled over the past decade as the industry restructured through mergers, shut-downs, and exits. Some of the changes in the structure of the California refining industry have been responses to the cost of meeting the stringent specifications of California reformulated gasoline. The industry restructuring events that occurred over the past decade -- motivated in part by environmental constraints -- contributed significantly to the higher prices that Californians pay for gasoline. The phase-out of MTBE (an ingredient used to manufacture reformulated gasoline) will put additional economic pressures on California's refining industry.