Gasoline Prices: Why So High Last Spring?

Ben Lieberman is senior policy analyst with the Competitive Enterprise Institute in Washington, D.C.

Gasoline prices rose an average of 31 cents per gallon between late March and May of this year, with consumers in some parts of California and the upper midwest paying more than two dollars well into June. As with other recent gas-price spikes, policymakers are debating why such increases occur and what can be done about them.

In Washington most of the attention has focused on allegations of illegal conduct by the oil industry. Consequently, there have been several federal investigations of alleged collusion and price gouging, and two Federal Trade Commission reports on previous gasoline price increases have recently been released. However, these reports point away from industry conduct as the cause of the price increases.

At the same time, evidence is emerging that the growing federal regulatory burden is having a substantial effect on gasoline prices and is a major factor in the volatility seen in recent years. In particular, the regulations promulgated under the Clean Air Act, which both dictate the composition of gasoline and place limits on the refining infrastructure, are a major contributor to the high prices today.

Fortunately, these laws and regulations were created by the federal government and can also be reformed by the federal government. Congress, working with the administration, can cut the red tape and reduce the price of gasoline, yet still provide the environmental protections the American people demand.

Before 1990 the composition of motor fuels was not extensively regulated by the federal government. Other than the phaseout of leaded gasoline and a few other measures, the 1970 Clean Air Act focused on reducing motor-vehicle emissions by regulating the vehicles themselves. As a result, even with substantial increases in vehicle miles traveled, overall motor-vehicle emissions have declined substantially, as have ambient pollution concentrations.¹ It should be noted, however, that these positive air-quality trends predate the passage of the Act, indicating that state and local controls were playing a role before they were pre-empted by the federal government.²

The emphasis changed somewhat with the 1990 amendments to the Clean Air Act, which contain extensive motor-fuel regulations. Specialized blends, namely reformulated gasoline and oxygenated gasoline, were mandated for certain areas of the country. The Act also set standards applicable to conventional gasoline, and granted the EPA administrator broad discretion to create additional fuel specifications.³ These provisions were aggressively implemented by EPA administrator Carol Browner during the Clinton administration. At the same time, California and other states and localities began to set fuel requirements of their own, often to obtain EPA approval of their State Implementation Plans (SIPs). A decade ago gasoline was a national commodity, but today there are many distinct types of motor fuels in use.

Perhaps most problematic of these provisions was the requirement for reformulated gasoline (RFG), designed to fight smog.⁴ RFG is mandated for the nine smoggiest areas of the country as well as any other area determined to be in severe non-attainment for ozone.⁵ In addition, several other areas of the country have opted into the program. In total, nearly one-third of the nation’s fuel supply is RFG.

The RFG program first took effect in 1995. RFG must meet several compositional requirements and performance standards designed to make it cleaner burning than conventional fuels. The EPA used its discretion to set standards for RFG that are more stringent than those set out in the Act.⁶ In addition, there are separate RFG formulations for northern states and southern states, and summer-specific requirements applicable between June 1 and September 15 of each year.

More stringent requirements for RFG took effect in 2000 (RFG II), with particularly tough summer requirements. In recent months, RFG has ranged from 14 to 22 cents per gallon more than conventional gas.⁷

For What Benefit?

Despite the higher cost, there are questions about the environmental benefits of using RFG. Although mandated primarily to help reduce ozone, the primary constituent of smog, it is unclear, despite more than five years of use, whether RFG has made a difference. A 1999 National Research Council report concluded that “although long-term trends in peak ozone in the United States appear to be downward, it is not certain that any part of these trends can be significantly attributed to the use of RFG.”⁸

In contrast to its questionable air-quality record, RFG has clearly caused concerns about water quality. The Clean Air Act requires that RFG contain 2 percent oxygen content by weight. This necessitates the addition of so-called oxygenates, usually methyl tertiary butyl ether (MTBE) or ethanol. Compared to ethanol, MTBE is cheaper and easier to incorporate into the fuel supply, and has become the oxygenate of choice in 85 percent of RFG. A few midwestern markets, including Chicago and Milwaukee, use ethanol as the oxygenate.

Over the past several years, MTBE in RFG has contaminated water supplies throughout the nation, leading to phaseouts in California, New York, and other states, and federal bills to reduce or eliminate the use of MTBE in motor fuels.⁹ In 1999 the EPA issued a report calling for reduction in MTBE use in fuels because of its effect on water supplies.¹⁰

Despite the impending state bans on MTBE, the Act still mandates oxygenates in RFG. The Bush administration recently denied a request from the state of California to waive the Act’s oxygen-content requirement.¹¹

If MTBE is phased out in these states (or nationwide), but Congress does not repeal the 2 percent oxygen-content requirement for RFG, the law would amount to a de facto ethanol mandate. This would almost certainly raise the average cost of RFG in the years ahead.

Beyond RFG, there are other requirements that dictate the composition of gasoline. There is an oxygenated fuels program, applicable in the winter months in areas not in attainment with the federal standard for carbon monoxide.¹² As with RFG, oxygenated fuels cost more than conventional gasoline.

In addition to specialized blends, conventional gasoline is also regulated. Like reformulated gasoline, there are regional and seasonal differences. For example, the EPA has promulgated state and month-specific requirements for Reid Vapor Pressure (RVP), a measure of how readily fuel evaporates.¹³

Balkanizing Effect

The price differential between RFG and conventional gasoline is substantial, but it represents only part of regulatory costs of gasolines. Conventional fuel is also subject to regulations that increase its price. However, the emerging problem is not so much the higher price of individual blends but the balkanizing effect of so many distinct gasoline recipes simultaneously in use. In 1999 the Energy Information Administration noted that “the proliferation of clean-fuel requirements over the last decade has complicated petroleum logistics,” and predicted that “additional clean fuels programs could make the system more vulnerable to local outages and price spikes.”¹⁴ In fact, one pipeline operator reports having to handle 38 different grades of gasoline.¹⁵ Many of these blends have to be refined, shipped, and stored separately from others.

At the same time that demand for motor fuels has grown and the challenge facing refiners to comply with gasoline requirements has never been greater, a number of regulatory constraints have impinged on refinery capacity. In fact, no new refinery has been built in the United States in the past 20 years, due in part to market forces but also to the Clean Air Act’s New Source Review (NSR) and New Source Performance Standards (NSPS) programs.¹⁶ Under these programs, both the construction of new refineries and major modifications to expand capacity at existing refineries are subject to strict procedural and substantive requirements.

The year 1997 represented a turning point of sorts for domestic-refining capacity. Over the past decade capacity increased modestly through expansion at existing facilities. But during the summer of 1997, refineries were operating full out, yet still could not keep up with demand.¹⁷ The United States has experienced occasional refining shortfalls since. Currently, refineries are operating at 96 percent utilization, essentially maximum, with little or no margin for error. With only slight capacity growth at existing facilities projected through 2002, the refinery capacity problem will not be quickly resolved.¹⁸

Unfortunately, in 1999 the EPA announced a new and more aggressive interpretation of NSR and NSPS as it applies to refineries and coal-fired electric power plants. Previously, routine maintenance at industrial facilities had been exempt from these requirements, while major modifications were not. By retroactively redefining as major modifications many facility projects—most of which were known to EPA when they were performed and treated as routine maintenance at the time—the agency now argues that many refineries were not operating in compliance with the law. This enforcement initiative will further complicate any attempts by the refining industry to meet future demand. The National Petroleum Council, an advisory committee to the secretary of energy, has warned that this “[r]einterpretation of NSR rules will significantly hinder the industry’s ability to continue its historical expansion rate.”¹⁹

Clearly, the many regulations already implemented under the 1990 amendments to the Clean Air Act are contributing to the volatility and high prices at the pumps. In addition, several more regulations are scheduled to take effect in the years ahead, which will further complicate petroleum logistics and increase the burden on the driving public.

Most significantly, EPA recently finalized new rules that will mandate substantial reductions in the sulfur content in gasoline and diesel fuel.²⁰ These rules are predicted to add to the cost of motor fuels.²¹ In addition, they are already having an effect on refinery operations. Despite current capacity shortages in the midwest, one Chicago refinery recently shut down, in part because of the prohibitive costs of the overhaul necessary to comply with these new sulfur rules.²² The National Petroleum Council “expects that individual refinery shutdowns will likely continue to occur in the future.”²³

Further complicating matters is the controversial new National Ambient Air Quality Standard (NAAQS) for ozone, which was promulgated in 1997 but held up by legal challenges.²⁴ If implemented, this standard will result in many counties in attainment with the current ozone standard going out of attainment, which would place even more severe operating burdens on refiners and may increase the number of areas using RFG or other specialized blends.

Recent Price Spikes and the FTC Report

The pattern of recent price increases is a reflection of this costly regulatory burden. Indeed, the when and where of the greatest gasoline price spikes match almost exactly with the when and where of the most burdensome regulations. The largest increases tend to occur in April through June. For example, this is the second year in a row that Chicago has experienced a late spring/early summer surge to two dollars per gallon. This is due, in substantial part, to the added complication of moving from winter-fuel specifications to summer specifications, at the time of year when demand is picking up.²⁵ This has been a particular challenge since the stringent new summer requirements for RFG II have been in effect.

The location of the sharpest price increases, California and the upper midwest, is also traceable to the regulatory burden. These two parts of the country face unique and challenging fuel standards.²⁶ In addition to the federal RFG program applicable in Los Angeles, Sacramento, and San Diego, California has instituted its own, more stringent RFG standard applicable in several other areas of the state.²⁷ Parts of the upper midwest have opted to use ethanol in RFG, which has posed problems since the new RFG II standards took effect last year.²⁸ Both areas also have tight local refining capacity, therefore only a relative handful of refineries make these specialized blends. Even a single incident resulting in downtime at one facility has caused supply shortfalls and price jumps in these areas. And once a price spike begins, these unique fuel requirements tend to prolong it, because excess supplies from neighboring areas cannot be brought in and sold.

The final report of the FTC investigation into the early summer 2000 midwest gasoline price spike further underscores the role of regulations.²⁹ Launched amidst allegations of illegal oil-industry conduct last summer, the report nonetheless “uncovered no evidence of collusion or any other anti-trust violation.”³⁰ While exonerating the industry of illegal conduct, the report listed refinery production problems, pipeline disruptions, and low inventories as the primary factors behind the price increase. These factors are directly or indirectly related to the regulatory burden, particularly the new RFG II requirements.

In addition, the FTC recently concluded an investigation of earlier gasoline price increases in California and other western states. It also found no evidence of illegal activity by refiners.³¹

The FTC’s findings were corroborated by the Energy Information Administration and Congressional Research Service, which both found that the new RFG II requirements and other rules were substantial contributors to the 2000 midwest gasoline price increases.³² The Congressional Research Service estimated that as much as 25 to 34 cents of the per-gallon cost were due to the new RFG II requirements.³³

What Needs to Be Done

The Bush Administration’s National Energy Policy contains several recommendations that, if properly implemented, will go a long way toward ensuring that future gasoline prices are as affordable as the market will allow. In particular, the plan directs EPA to study ways to reduce the proliferation of differing fuel requirements and increase the fungibility of the nation’s fuel supply.

President Bush has also recommended that EPA and the Department of Energy consider ways to streamline the regulations that are impeding refineries from expanding to meet demand. The President has also urged a reassessment of the EPA’s new interpretation of New Source Review.

Further, the federal government should also reconsider past efforts to micromanage the gasoline supply. Specifically, the requirement that RFG contain 2 percent oxygen content by weight is largely unnecessary to reduce smog, but complicates the logistics of supplying RFG and increases the price at the pumps. The federal government should not dictate the specific ingredients and recipes by which clean-air goals are met. Congress should amend the Clean Air Act by eliminating the 2 percent oxygen-content requirement.

In addition, EPA and Congress must reconsider some of the costly new fuel regulations scheduled to take effect in the years ahead, such as the strict gasoline and diesel sulfur standards. Otherwise, the already-bad situation facing the driving public will only get worse.

Notes

1. Joseph L. Bast and Jay Lehr, “The Increasing Sustainability of Cars, Trucks, and the Internal Combustion Engine,” Heartland Institute, June 22, 2000; Environmental Protection Agency, “Latest Findings on National Air Quality: 1999 Status and Trends,” August 2000.
2. Indur M. Goklany, Clearing the Air: The Real Story of the War on Air Pollution (Washington, D.C.: Cato Institute, 1999).
3. The Act states [42 USC §211(c)]: “The Administrator may, from time to time . . . control or prohibit . . . any fuel or fuel additive . . . if in the judgment of the Administrator any emission product of such fuel or fuel additive causes, or contributes, to air pollution which may reasonably be anticipated to endanger the public health or welfare.”
4. Clean Air Act, 42 USC §211(k).
5. This includes areas in and around Baltimore; Chicago-Gary-Lake County in Illinois, Indiana, and Wisconsin; Hartford, Conn.; Houston-Galveston-Brazoria, Tex.; Los Angeles-Anaheim-Riverside, Calif.; Milwaukee-Racine, Wis.; New York City, Philadelphia; Sacramento; and San Diego.
6. 59 Federal Register 7,716 (February 16, 1994).
7. Energy Information Administration, Retail Gasoline Prices, available at www.eia.doe.gov/oil.
8. National Research Council, “Ozone Forming Potential of Reformulated Gasoline,” 1999, p. 4.
9. Bureau of National Affairs Daily Environment Report, “Lawmakers Tackle MTBE Issue as EPA Reviews Rule to Ease Ethanol Use,” February 21, 2001, p. A–11.
10. Environmental Protection Agency, “Achieving Clean Air and Clean Water: The Report of the Blue Ribbon Panel on Oxygenates in Gasoline,” September 15, 1999.
11. Bureau of National Affairs Daily Environment Report, “EPA Expected to Deny California Request to Produce Non-Oxygenated Gasoline,” June 12, 2001, p. A–1.
12. Clean Air Act, 42 USC §211(m); Energy Information Administration, “Areas Participating in the Oxygented Gasoline Program,” July 1, 1999.
13. Clean Air Act 42 USC §211(h); Environmental Protection Agency, “Guide on Federal and State RVP Standards for Conventional Gasoline Only,” March 2000.
14. Tancred Lidderdale and Aileen Bohn, Energy Information Administration, “Demand and Price Outlook for Phase 2 Reformulated Gasoline, 2000,” April 7, 1999.
15. Ibid., p. 9.
16. 42 USC §§160–169, 170–178; 42 USC §111.
17. Statement of John Cook, petroleum division director, Energy Information Administration, before the Subcommittee on Energy and Air Quality, Committee on Energy and Commerce, U.S. House of Representatives, March 30, 2001.
18. Ibid.
19. National Petroleum Council, “U.S. Petroleum Refining: Assuring the Adequacy and Affordability of Cleaner Fuels” (National Petroleum Council Report), p. 4.
20. 64 Fed. Reg. 26,004 (May 13, 1999); 66 Fed. Reg. 5,002 (January 18, 2001).
21. National Petroleum Council Report, pp. 9–14; Energy Information Administration, “The Transition to Ultra-Low-Sulfur Diesel Fuel: Effects on Prices and Supply,” May 2001.
22. Peter A. McKay, Wall Street Journal, “New EPA Rules May Fuel Refiners’ Profits,” February 2, 2001.
23. National Petroleum Council Report, p. 8.
24. 62 Federal Register 38,856 (July 18, 1997).
25. Statement of John Cook, petroleum division director, Energy Information Administration, before the Subcommittee on Energy and Air Quality, Committee on Energy and Commerce, U.S. House of Representatives, May 15, 2001.
26. Energy Information Administration, “Summer 2001 Motor Gasoline Outlook,” April 2001.
27. Ibid., p. 5.
28. Ibid., p. 8.
29. Federal Trade Commission Final Report, “Midwest Gasoline Price Investigation,” March 29, 2001.
30. Ibid., p. 1.
31. Federal Trade Commission press release, “FTC Closes Western States Gasoline Investigation: Investigation Finds No Illegal Activity By Oil Refiners,” May 7, 2001.
32. Joanne Shore, Energy Information Administration, “Supply of Chicago/Milwaukee Gasoline Spring 2000,” undated; Lawrence Kumins, “Midwest Gasoline Prices: A Review of Recent Market Developments,” Congressional Research Service, June 28, 2000.
33. Ibid.