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“A Coca-Cola Solution to High Gas Prices”

Related to this post from a few minutes ago on the state-induced fragmentation of petroleum refining in the United States, and the resulting higher retail prices of gasoline, is this August 22, 2012, op-ed in the Wall Street Journal by Andy Morriss and me. You can read our WSJ essay beneath the fold.

A Coca-Cola Solution to High Gas Prices

When you fill your car with gasoline, you probably think you’re buying a commodity. Just as a Coke bought in Los Angeles is the same as one bought in Boston, a gallon of gasoline purchased one place is the same as one bought elsewhere—right? Wrong. As one refinery executive noted in 2003, “Gasoline is not gasoline anymore. It is a specialty chemical.

For most of the 20th century, the United States was a single market for gasoline. Today we have a series of fragmentary, regional markets thanks to dozens of regulatory requirements imposed by the federal Environmental Protection Agency (EPA) and state regulators. That’s a problem because each separate market is much more vulnerable than a national market to refinery outages, pipeline problems and other disruptions.

Today’s fragmentation is a throwback to the early 20th century, when fuel markets were fragmented because of high transportation costs. Early retail outlets sold gasoline and kerosene that varied dramatically in quality from place to place. John D. Rockefeller named his company “Standard Oil” precisely to advertise the consistent quality of its products. But as transportation costs fell with the proliferation of pipelines, markets expanded and competition intensified.

By the 1920s and early 1930s, oil companies were engaged in a vigorous “octane war” to improve quality and reduce price. This competition helped transform 100-octane fuel from a chemical that sold for $25 per gallon in the early 1930s to a mass-produced commodity selling for about 25 cents per gallon a decade later. That improvement helped win the Battle of Britain by giving the Royal Air Force a performance edge over the Luftwaffe. By 1944, Standard of Indiana alone could refine 1.15 million gallons of 100-octane aviation gasoline per day, a production rate surpassing that of the entire industry before the war.

After the war, prices continued to fall as competition drove producers to improve their fuels and expand their pipeline networks. With the gasoline market becoming national, refiners gained the scale to innovate in ways that further boosted quality and cut prices.

Not everyone was happy about the expansion of the market for fuels. Refiners located near higher-cost oil supplies complained that their competitors on the coasts had access to cheaper foreign oil, and domestic oil producers resented foreign competitors’ lower costs. These complaints started American energy policy on the path to our current fragmented markets.

Instead of allowing market forces to determine the efficient size of refineries, the federal Mandatory Oil Import Program in 1959 began granting special favors to small refiners, inland refineries, and anyone with a smart enough lawyer. These favors fragmented the market for domestic fuels by replacing decisions based on market conditions and technology with ones based on politics.

Similar bureaucratic meddling continued under the price and allocation controls that took over after the Arab oil embargo in the early 1970s. The result was a proliferation of small “tea kettle” refineries built to gain bureaucratic privileges rather than to meet market demand.

In 1989, the EPA implemented regulations to reduce gasoline evaporation. The following year, amendments to the Clean Air Act substantially expanded the EPA’s authority over fuel composition.

Unfortunately, little was known about fuel composition’s impacts on emissions, so the first steps were largely guesswork. One particularly bad guess was the mandate to add oxygenates to gasoline in order to reduce carbon-monoxide emissions. That led to the use of the chemical MTBE, which turned out to cause serious environmental damage. When regulators dropped it (stranding refiners with the investments they’d made to blend MTBE into gasoline), only corn-based ethanol was left to satisfy the mandate, itself an environmental and economic disaster.

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.

Another result: Since competition is a key source of falling gas prices, restricting competition by fragmenting markets reduces the market’s ability to lower prices.

From the 1920s to the 1950s, competitive markets successfully drove improvements in transportation fuels while reducing prices. We need to unleash those forces again. A good place to start is by undoing the anticompetitive regulations that keep our fuel markets small and fragmented—and making the sale of gasoline once more like selling Coca-Cola.

Mr. Morriss is a professor of law at the University of Alabama. Mr. Boudreaux is a professor of economics at George Mason University.