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

Product exchanges²⁷ and terminal throughput agreements

Terminals, like refineries, have rack facilities for loading tanker trucks of the refiners or wholesale customers for deliveries to retail outlets, in the case of gasoline and diesel, and to homes and business establishments in the case of heating oil. As the name implies, terminals are usually connected to a principal transportation artery. For the most part, this is a pipeline and occasionally a train. In Atlantic Canada the primary means of moving product is via ship. According to Natural Resources Canada, there has been significant rationalization over the last 20 years, to the extent that in some locations there is a single terminal serving a number of suppliers.²⁸ There has also been widespread closure of terminals in the U.S., with the total falling from 2293 in 1982 to 1225 in 1997.²⁹ The closure of terminals in both countries has been made possible by agreements among refineries that allow for the sharing of facilities.

As indicated in the discussion of the reversal of the Trans-Northern Pipeline, by entering into product exchanges refiners are able to sell into a wide area without necessarily incurring the cost of transporting product from their refineries. However, to allow for the fact that locations differ in their proximity to a refinery, a location differential is often paid. For example, a location differential would have to be paid for product supplied in, say, Rimouski, relative to product supplied in Toronto. Exchange and terminal services agreements often allow suppliers to sell over a wider area than they would otherwise find it profitable to serve. In any event, the agreements certainly allow them to do so at lower cost. Furthermore, the agreements encourage the concentration of refinery capacity and thus contribute to the building of larger refineries.

Another set of agreements relate to terminal services. Contracts respecting terminal services can take several forms. Users may simply pay for the services, based on volume and length of storage. Frequently, however, the agreements provide for equal volumes of throughput over a specified period. Therefore there is no need for any payment by either party. Occasionally a terminal may be operated as a joint venture. The advantage of these various agreements that allow suppliers to share terminal facilities is that duplication is avoided. Where facilities already existed (which can be taken to be the general case in Canada and the U.S.) the principal savings from the viewpoint of terminal operation are in operating costs, including maintenance. Another important source of savings is derived from the fact that the higher rate of throughputs means that the refiners carry less inventory.³⁰

As an important aside, the price volatility in the U.S. has been attributed in part to the fact that the refiners have learned to operate with lower inventories. The smaller level of inventories is less successful in cushioning price against unanticipated increases in demand or decreases in supply. In my view, at least part of the reason for reduced inventories is associated with the closure of terminals as a result of terminal sharing agreements. If correct, this is a hidden cost of the agreements to share terminal facilities that does not appear to be recognized.³¹ This is not an important issue in Canada because of its smaller size; compared to the U.S. it is relatively easy to make up a shortfall in supplies through imports.

Since the terminals in a region are often owned by the refiner in closest proximity to them, in some cases they are a necessary adjunct to a product exchange agreement. Blending facilities at terminals allow each of the marketers using a terminal to include their additives, where they provide them, to the gasoline of the refiner supplying the terminal. Of course product exchange and terminal agreements do not necessarily meet all needs, as the discussion of Ultramar's Maitland terminal, which receives product by train, illustrates.

Although the agreements in question are generally cost reducing and competition increasing, the fact that competitors are getting together to discuss anything invites further consideration. If nothing else, the agreements do provide the opportunity for refiners and other suppliers to meet and discuss supply arrangements. It is therefore useful to explore whether the meetings are a likely source of illegal or otherwise anticompetitive arrangements. The conspiracy section of the Competition Act makes it an offence for a person to enter into an agreement or arrangement with another person to prevent or lessen, unduly, competition in the sale of or supply of a product through the fixing of prices or through market sharing arrangements. With respect to a possible agreement on prices, the supply and facilities agreements are entered into periodically, and at different times between agreeing parties, while prices at all levels move often and very quickly. Agreements on price levels through periodic meetings is virtually impossible. This argument, however, does not apply to possible agreements on price differentials. There is, however, a critical consideration negating the possibility of using meeting to negotiate product exchanges and facilities sharing agreements as an opportunity to agree on anything: the agreements are always entered into bilaterally. If the firms were going to risk an agreement that could result in fines or jail sentences it would be far easier to do it directly rather than through some complicated chain of bilateral meetings. Thus not only is there no evidence that the meetings on supply arrangements are used as an opportunity to fix prices, logic suggests that it would be a foolish way to proceed.

What about the content, per se, of the agreements? This depends on whether the agreements entail the mutual closure of terminals. Only in that case is there the possibility of a limitation of supply in a market. Assume, for example, two firms each have a terminal in two locations and that they each agrees to close one so that a single terminal remains in each location. If the terminals were so-called "public terminals", that is available for general use by market participants,³² then the closure would reduce the availability of terminal services on offer. Apart from terminals associated with pipelines, there are not, to my knowledge, public terminals; terminal services are generally acquired through the exchange of terminal services. This leaves for consideration the volume of product to flow through the terminals. If there are only the two firms the agreement on volumes could constitute an agreement to share the two markets, with the market shares determined by the amount of product that could flow through two terminals. However, this is a limiting and hypothetical case intended to demonstrate the conditions that require investigation. In fact, the number of suppliers using a terminal will depend on the number of marketers that do not themselves have terminal capacity in the area, and each will negotiate a volume of throughput that meets their supply needs. Thus agreements on the sharing of terminals is highly unlikely to have anticompetitive effects that offset reduced cost that encourages wider geographic coverage by firms and more competition.

²⁷ "Product exchange" is used here as a shorthand. For the most part the companies have entered into buy/sell agreements. But the effect is the same since there is a balancing of the amounts purchased and sold.

²⁸ Overview of the Canadian Downstream Petroleum Industry, February 2004

²⁹ U.S. Census Bureau, as cited in Federal Trade Commission, The Petroleum Industry: Mergers, Structural Change, and Antitrust Enforcement, an FTC Staff Study, August 2004, p.237.

³⁰ This is brought out in Shell's 2000 Annual Report (p.30) "The closure of two distribution terminals at Belledune, N.B., and Lewisporte, Nfld., reduced finished product inventory ?"]

³¹ The level of inventories is usually considered in terms of the range between the average high and low levels over the previous five years. But to observe the effects of the refinery closures one would have to trace the level of inventories relative to sales over a number of years. As a logical imperative, the inventory to sales ratio had to follow as terminals were closed, everything else being the same.

³² Federal Trade Commission, Structural Change etc, p.218.