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

Price volatility in the U.S. and its relevance to the present investigation

In order to appreciate wholesale price movements in Canada it is useful, but not strictly necessary, to understand the forces that are operating in the U.S. One could simply take the prices in the U.S. as given and focus on whether the increase in Canadian prices was the result of an increase in the spread between Canadian and U.S. prices. Assuming that there was no such increase, one could conclude that the increase in Canadian prices was the result of a continuation of a long-standing relationship that has not been found to be objectionable in the past. In the event that the increase in Canadian prices was partly the result of an increase in the spread, the focus would be on the reasons for the increase and whether they were associated with anti-competitive acts by Canadian refiners. But given that the Canadian refining industry is heavily dependent on the course of the industry in the U.S., it is useful to explore the forces driving prices in the U.S. If nothing else, it may provide indications of whether price spikes in the future are likely.

Two components of price were responsible for the spike in U.S. wholesale prices: increases in crude oil prices and increases in the spread between the price of crude oil and the wholesale price of gasoline. The causes of the increase in crude oil prices are much commented on and there is little point in adding to this discussion even though this was the major explanatory factor. The reasons for the increase in refinery margins are worth identifying, however.

Chart 1: Gasoline Crack Spead New York

A study of the price spike starting to develop in April 2004 (the third in a little more than a year) listed the following factors relating to refinery issues as contributing causes:³³

• "A shortage of refinery capacity ? resulting from a lack of new construction ? such that the nation needs to import about 1 mbd of blending components and finished gasoline from foreign refineries. Increasingly challenging fuel specifications ? including the MTBE ban in several states [California, New York and Connecticut] and the 2004 standards for reduced sulfur content ? add to the complexities of refining and distribution.
• Steadily growing gasoline demand, which has increased by 500,000 barrels per day since 1999 ? .This has accounted for virtually all the nation's increase in oil consumption.
• Gasoline inventories were low; as of early April, there was less than two days of available supply in the system.
• Crude oil stocks are below normal seasonal levels, having just rebounded from below minimum operational levels. There is little refining capacity to make more gasoline, and crude might not be available [due to low inventories held at refineries] even for that small increment."

It is evident that no single factor was solely responsible for what turned out to be a sustained increase in crack spreads. However, some ranking is possible. The most important and long-lasting factor is the level of capacity. Refineries were reported to be operating at about 95 percent capacity, which left little room for adjustments to unanticipated increases in demand or reductions in supply. This situation is unlikely to change in the foreseeable future.

As discussed earlier, the ordinarily high entry barriers into refining, stringent pollution control conditions governing the construction of new facilities, along with uncertainty about future demand, make it highly unlikely that there will be any major additions to refinery capacity in the near future. As has been true through part of the 1990's and continuing, additions to capacity are most likely to take the form of modifications of existing refineries. Therefore, the U.S., and particularly PADD 1 (predominantly the eastern seaboard), will remain dependent on imports to balance insufficient supplies. I have not seen any studies that measure excess capacity to produce gasoline in the Atlantic Basin. While it is generally known that there is a steady shift away from gasoline towards diesel, the full extent of export capacity in Europe is not generally available. Thus it is not known how much cushion imports can provide against continuing upward pressure on prices if demand continues to increase. In any event, only adequate resiliency in the domestic system can prevent occasional spikes in price.

Low inventories of gasoline³⁴ and crude oil prevented adjustments to growing demand without a run-up in prices. There is a view that the principal reason that stocks for both gasoline and crude oil were low was that there was backwardation in the futures market, namely that prices for future delivery were lower than those in the near present. This implied that there was a general expectation that prices would not be sustained. The effect would be to limit the refiners' ability to hedge against a fall in prices. Thus available capacity was not being used to add to gasoline stocks and refiners were reluctant to hold more than minimal amounts of crude oil. Whatever the merits of this explanation for the low inventory levels, it is one that can only operate temporarily; eventually expectations adjust. However, significant fluctuations in crude oil prices could recreate the conditions whereby this explanation for low crude and product stocks could again apply.³⁵

The fact that there are 18 different formulations of gasoline (excluding differences due to octane ratings), is pointed to as another factor that limits supply flexibility since the general result is greater geographic segmentation. In spite of frequent news stories regarding concern by lawmakers about this situation, it does not appear that action to limit the number of formulations is at hand.

The conditions that resulted in the run-up in refinery margins are thus likely to be continuing ones and it can be expected that there will be periods of surging prices of gasoline and other refined products. However, if crude oil prices stay high, corrections to the problem of limited refinery capacity may come from the demand side as energy use declines in response to higher prices.

³³ Lawrence Kumins and Robert Bamberger, Gasoline Price Surge Revisited: Crude Oil and Refinery Issues, Congressional Research Service, April 8, 2004, pp. 11-12.

³⁴ Inventories as measured against the high and low levels held in recent years. The fact that terminals were closed in previous years is a structural condition that is built into these inventory levels.

³⁵ Most refiners engage in extensive hedging since small movements in prices can devastate the bottom line.