The effects of recent volatility in international petroleum markets on Canadian wholesale and retail gasoline prices

Executive summary

This is a report written as part of an examination by the Competition Bureau into two sets of complaints. Consumers were concerned by high retail prices, and a number of operators of gasoline outlets were upset by the low margins that they could earn on gasoline sales in the Greater Toronto Area (GTA) and in Ottawa/Hull. The focus of this report has been to try to understand the reasons for these phenomena. In particular, could they be best understood as the result of the operation of normal market forces, or were there reasons to believe that they were the product of anti-competitive acts against which the Competition Bureau would have the authority to take action.

As part of its investigation the Competition Bureau made a number of information requests to all the principal petroleum companies and to a number of importers and major marketers of gasoline. The information was sought on a voluntary basis and the companies were assured that the material that they provided would be treated as confidential. There were several points in this report when it was necessary to draw on confidential information. As a result, two reports have been prepared, one that is confidential and intended solely for the eyes of the personnel of the Competition Bureau, and a second report that deletes the confidential material but draws on the conclusions derived from it.

For the most part the companies have been very cooperative. Detailed information on pricing in the GTA and in Ottawa/Hull was particularly helpful. Alternative public sources would not have provided the same detailed and accurate coverage. Where it was considered necessary, meetings were held with companies where the information provided by them was discussed.

There is much public information available on the petroleum industry. A number of companies provide it on a commercial basis. In addition it is a much-studied industry and there are a number of reports in Canada and the U.S. dealing with earlier spikes in prices. These have invariably found that the spikes in question were the result of factors that affected demand or, more often, supply, and were not the result of anti-competitive activities. These reports and more general studies of the industry have been consulted. Another important source of information drawn on is the reports of the companies to their shareholders and to regulatory agencies such as the Securities and Exchange Commission in the U.S. When read over several years they provide considerable information. Fortunately many of the important participants in the industry are public companies.

The report focuses on petroleum refining and the retailing of gasoline. Crude oil prices are not, and cannot be in issue since prices are determined internationally.

Crude oil is converted into petroleum products at refineries, which are highly automated chemical complexes. In the case of gasoline, it is either transported to a terminal for later local delivery, or it is picked up for local delivery by a tanker truck. The reach of refineries depends on the transportation arteries available to them. In the Atlantic Provinces the principal mode of transportation is by water. In other areas, it is pipeline, supplemented by rail transport. The difference between the cost of crude oil and what refiners receive for the product is the refiners' margin. It is required to cover the costs at the refinery, the transportation cost to terminals, and the storage cost at refineries and terminals.

Based on average refinery and retail margins in Ontario in 2003¹ and current values (October 2004) for crude oil and the Canadian dollar the current price of gasoline would be 85.3 cent/L, which is probably somewhat above the average price in Ottawa. Thus by now, after the industry has adjusted to the shocks of escalating prices for crude oil, the increase in price is all due to the increase in the cost of crude oil. Breaking down the retail price into its component parts based on the foregoing assumptions, the percentage division is: crude oil ? 49.9, taxes ? 35.5, refining margin ? 7.62 and retail margin ? 7.74. At prices below 85.3 cents/L at the time of this writing, either refining margin or retail margin would be lower. Obviously a different division would result at a lower price for crude oil. In 2003, the relative importance of taxes and crude oil were reversed; at $30 U.S. a barrel as opposed to the recent $53 U.S. per barrel, oil accounted for 38.3 percent and taxes for 42.6 percent.

The price spike in May 2004 was only partly the product of an increase in crude oil prices. A significant component of the increase was also due to a large increase in the refining margin in the U.S. With regard to any significant movement in wholesale prices, the Canadian and U.S. refining industries can be considered to be in the same regional markets. During a short time in May the U.S. refining margin reached a level that was about four times higher than the rather low margin at that time in 2003. Since May, margins in the U.S. have gradually come down and the Canadian dollar has increased in value, which explains why Canadian prices are similar to what could be expected at average margins in 2003. Thus the price spike that saw retail prices flirting with a dollar a litre was the product of increases in the price of crude oil and a large increase in wholesale refining margins on both sides of the U.S. border. The increase in Canadian refining margins was in keeping with the historical relationship with U.S. margins.

A number of factors were responsible for the increase in refining margins for gasoline. The most important from a long-range viewpoint is the balance of capacity to demand. At present levels of demand, refiners are operating close to capacity. Minor shocks, such as a shutdown of some refinery capacity for unscheduled maintenance, or unanticipated increases in demand, result in a temporary shortfall in supply leading to higher prices. For the present it appears that there are international supplies to meet shortfalls as long as there is adequate notice that the supplies will be required. Save for two refineries in Atlantic Canada primarily dedicated to exports to the U.S., there was as usual a minimal amount of exporting and importing by Canadian refineries. Exports were not a factor in the increase in retail prices.

The prospects for the building of new refineries in the U.S. or Canada are poor. Economic entry barriers into the industry are high, and there are additional impediments in the form of environmental regulations and uncertainty about the course of future demand. In the past, high crude oil prices have resulted in declines in demand as more energy efficient equipment and other energy saving steps were put into place.

As a general matter tighter refinery supplies are not a friendly environment for independent retailers. In some areas it is cost efficient for independent retailers to purchase supplies in the U.S. in truckload quantities, but this is not generally practical nor even a partial solution for large chains of outlets; they must have assured, contractual sources of supply and thus must rely on domestic refiners. The domestic supply situation will soon undergo some deterioration when Petro-Canada's Oakville refinery is closed at the end of the year. It appears to have been the victim of the high cost of meeting environmental regulations with regard to sulphur levels in gasoline and diesel. Only some of the supply lost will be made up through the expansion of Petro-Canada's Montreal refinery.

¹ Suncor's figures from its annual report are used for this purpose.