David R. Henderson  

Failure to Arbitrage: Gasoline Markets

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Andrew P. Morriss and Donald J. Boudreaux have an excellent piece in today's Wall Street Journal, which, by the way, has several excellent pieces. (More on that in posts later today.) It's titled "A Coca-Cola Solution to High Gas Prices." Their basic argument is that the Environmental Protection Agency has balkanized gasoline markets, making gas prices in local markets more volatile than otherwise because gasoline companies can't legally arbitrage. An excerpt:

The role of regulators in fuel formulation has become increasingly complex. The American Petroleum Institute today counts 17 different kinds of gasoline mandated across the country. This mandated fragmentation means that if a pipeline break cuts supplies in Phoenix, fuel from Tucson cannot be used to relieve the supply disruption because the two adjacent cities must use different blends under EPA rules.

To shift fuel supplies between these neighboring cities requires the EPA to waive all the obstructing regulatory requirements. Gaining permission takes precious time and money. Not surprisingly, one result is increased price volatility.


I wrote about this in 1999 in "Perspectives on Gas Prices / State to Blame for Gas Price Rise / California isolated by its regulations on air quality," San Francisco Chronicle, July 23, 1999. Here's an excerpt:
According to the American Petroleum Institute in Washington, gasoline production [in California] was down from 953,000 barrels a day in March 1998 to 880,000 barrels a day in March 1999, a reduction of 7 percent. The main reason for this reduction is the recent fires at two California refineries, one at the Tosco refinery in Avon on February 23 and the other at Chevron's Richmond refinery on March 25. How could a 7 percent reduction lead to about a 25 percent increase in price? The answer is what economists call "inelastic demand." Translation: When the supply falls a little, the price has to rise to cause us to cut the amount we buy down to what's available.

Still, there's a puzzle left to explain. Ordinarily, when the price of a commodity rises in one region and that commodity is easy to ship from another region, people called arbitrageurs make money by buying where it's low and selling where its high. The arbitrageurs' increased shipments drive down the price in the high-price region. But that hasn't happened in California.

The reason is that because of regulation by the California Air Quality Board, gas sold here must meet stricter standards than gas sold in Nevada or Oregon, even though air quality outside of the Los Angeles basin is comparable to air quality in other states.

In short, arbitrageurs can't sell readily available gasoline from nearby states to California because such gasoline can't be legally sold here. Retooling costs for refiners in other states to produce California-legal gasoline are too high to make it worthwhile for the short time that we Californians must live with the price increase.


When I researched this op/ed, I interviewed an economist at the American Petroleum Institute who had a great line. He referred to the U.S. gasoline market as a "boutique market." Morriss and Boudreaux quote another great line from a refinery executive. It makes the same point: "Gasoline is not gasoline anymore. It is a specialty chemical."

In a follow-on post, Jonathan H. Adler makes a point I hadn't been aware of:
Worse, some of the content requirements are irrelevant for new cars due to modern pollution control equipment. Federally imposed boutique fuel requirements have outlived whatever usefulness they ever had.


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COMMENTS (10 to date)
Silas Barta writes:

I had to do a double-take when reading the '99 SFC piece because that Richmond (California) refinery just recently had another fire that halted production. I almost thought that the date was wrong.

Kinda funny how the article could be written today and be just as relevant, even down to the refinery fire and arbitrage impossibility.

IVV writes:

"...even though air quality outside of the Los Angeles basin is comparable to air quality in other states."

Methinks you haven't been to Bakersfield. Air quality through much of the San Joaquin Valley--especially the south end--has gotten far worse than the rest of the country.

David R. Henderson writes:

@IVV,
Good point. Notice the date I wrote this, though.

KLO writes:

"The reason is that because of regulation by the California Air Quality Board, gas sold here must meet stricter standards than gas sold in Nevada or Oregon, even though air quality outside of the Los Angeles basin is comparable to air quality in other states."

David, I don't understand the argument here. Are you saying that air quality would not degrade if lower quality fuels were permitted to be used in California? That is news to me. The primary reason certain parts of California have poor air quality as compared to many other places is their unique geography. You simply cannot compare large parts of California to other places and conclude that fuel formulation is irrelevant to air quality. This flaw in your argument was as true at the time you wrote the piece as it is today. When it comes to air pollution, California is dealing with a unique set of factors that you don't seem to understand very well.

MG writes:

KLO,

For whatever it is worth, I did not assume this was Prof. Henderson's argument. I don;t want to spek for him, but from my perspective the argument is that: Regulations cost money, sometimes the trade-offs are not worth it (but how could you know if you don't even know they cost you money), and sometimes they outlive their usefulness. There is a range of additional costs to seeking to achive desired air quality standards through boutique formulations, with significant outlier costs when disruptions occur. This is argument must be made again and again: as the article points out, and relived every year, the accepted conventional wisdom (and the policy making that thrives on it), is that any excess cost is always due to conspiracies by suppliers. Moreover, to the extent that the regulation may not aloow (I do not know if this is true or not) for temporary exceptions, the real trade-offs are economically worse than at steady-state. Finally, I for one want to hear more, not less, about the last argument: that there may no longer be much of a basis for these regulations.

Insight writes:

The way these regulations should be done is a surcharge. If you want to sell foreign gas in a region, you should pay an extra fee equal to or slightly higher than the imputed environmental value per gallon of the cleaner fuels.

KLO writes:

@MG

The problem is that David does not make any real effort to evaluate the benefits of the reformulation regulation before he concludes that the cost is "outrageous." His simplistic comparison of California's air quality to that of other states demonstrates that he does not understand that California possesses regions with unique geographical features that greatly increase air pollution. When someone points out to him that the air quality in one of these places, the San Joaquin Valley, has gotten significantly worse since he wrote his column, he acts as though this was somehow completely unpredictable.

guthrie writes:

KLO,

Would you call the current degrading of Bakersfield’s air quality a mark of success for the regulation (in place for at least 10 years)? If a regulation has a clear economic downside and not any clear upside, shouldn’t we re-evaluate that regulation?

KLO writes:

The air in Bakersfield would be worse were it not for the reformulation regulations. This is not disputed by anyone. The question is how large the benefit is relative to its costs.

There is a strong tendency among ideological people to claim that there preferred policy prescriptions have no costs. The gun lobby honestly wants us to believe that there are no safety benefits whatever to restricting private ownership of guns. Environmentalists want us to believe that stringent environmental regulations always improve the economy by reducing negative externalities. Free traders want us to believe that no one is harmed by free trade policies. It seems that no one wants to concede that life involves tradeoffs.

Mr. Econotarian writes:

Why can't we have one type of gasoline, and only in the few places in the country where it is required, have additives mixed in at the gasoline stations rather than shipped mixed to the gasoline stations?

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