Business: Oil Industry Merger

Washington Post business columnist Steven Pearlstein was online to discuss a column about oil prices and a merger of refiners. He writes that a merger approved last week is good for business, but not consumers.

A transcript follows.

About Pearlstein: Steven Pearlstein writes about business and the economy for The Washington Post. His journalism career includes editing roles at The Post and Inc. magazine. He was founding publisher and editor of The Boston Observer, a monthly journal of liberal opinion. He got his start in journalism reporting for two New Hampshire newspapers -- the Concord Monitor and the Foster's Daily Democrat. Pearlstein has also worked as a television news reporter and a congressional staffer.

His column archive is online here .

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Akron, Ohio: Are the oil companies involved in anti-trust activities -- price fixing and/or monopoloies?

Steven Pearlstein: The oil companies are well advised legally and do a good job of avoiding any clear antitrust violations. The problem is that they collaborate with members of cartel that fixes prices by limiting output. And over the years, they have figured out how to piggyback on OPEC in a way that allows them to enjoy the benefit of oligopoly profits without having to actually be a member of OPEC, which is what I refer to when I say "free riding" on the price fixing cartel. In the late 90s, when oil prices were depressed at some times, the major oil companies used to say they were restructuring themselves so that they made the same amount of money whether crude prices were high or low. But I'd say in recent years they've learned how to become much more profitable when prices are high. They are no longer indifferent to crude prices. And one reason is that have pulled back from really competing aggressively in the refining area, selling off much of their capacity to the Valeros of the world.

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Louisville, KY: I've heard a lot of people on both sides of the aisle complain that the price of oil is the fault of the situation in the Mid-East and with OPEC. I've been dying to note to those people, and others, that three of the top five producers of oil used in the United States are members of NAFTA (Canada-#1, US-#2, & Mexico-#5). Saudi Arabia is #3 and Venezuela is #4. Although both of those are OPEC nations, NAFTA still "wins." The primary users of Mid-East oil are Europe and Japan.

Steven Pearlstein: I don't think it is particularly useful to talk about where a particular country imports its oil from. There is a global market for oil that sets the benchmark prices, and oil is swapped around all the time so that the transportation costs can be kept as low as possible. But it doesn't make much of a difference if we import oil from Venezuela or Saudi Arabia-- if it wasn't one, it would be the other. Its a commodity, its fungible. It turns out we are most dependent on Canadian oil and gas, in some cases as a result of easy transportation through pipelines, in other cases through long term contracts and ownership by U.S. based multinationals. But again, other than issues concerning certainty of supply in times of war, the soruce of the oil is somewhat irrelevant in an economic sense.

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Arlington, Va.: What lessons can we draw from the hurricane? Do mergers like these lead to consolidation of processing facilities that would be more susceptible to a disaster?

Steven Pearlstein: I don't think so. No lesson I can draw, really.

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Washington, D.C.: Were you honestly surprised by the FTC's decision? When was the last time a large merger was blocked?

Steven Pearlstein: Actually, the FTC did force Valero to alter a previous acquisition, based on their traditional analyses of some regional markets. But no, I was not surprised, given the staff's long history of concluding that the oil industry is full competitive. Outraged, yes, but not surprised.

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Sterling, VA: I was wondering why we are accepting oil from other nations, while we already have a reserve of 700 Million barrels of oil. If we used some of this, wouldn't that help to reduce the price of gas?

Steven Pearlstein: The problem with the recent gas price spike is not with crude supply, but refining capacity. The Bush administration tried to help relieve that bottleneck by waiving environmental rules that prevent import of certain types of refined gasoline, which is helping quite a bit.

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Austin, Texas: Katrina's victims asked for help from their fellow citizens. What did the oil companies do, but to take advantage of the situation? In fact, it is ironic that when 9/11 occurred, the stock market went down and yet with this catastrophe, stock prices have increased. Is this because the World Trade Center represented $$$ and Katrina represented the poor?

Steven Pearlstein: No, I don't think that is it. And I think we should be careful of saying the oil companies took advantage of the situation, although they will enjoy a windfall profit for a while. Look, in any market, when supply is interrupted and demand exceeds supply, the price rises. And the effect of the higher price is to ration the scarce commodity to those who need it most, while depressing demand -- both of which are a good thing, under the circumstances. If oil companies were to keep prices artificially low, out of some sense of obligation, all that would happen is that gas stations would run out sooner, with other bad consequences. The right policy response to this isn't to limit prices -- it is to consider some form of windfall profits tax. But you really wouldn't want to get into that unless these exhorbitant prices persist for a long time. Those kind of taxes are notoriously tricky to devise and administer.

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Arlington, VA: Why does gasoline cost so much less than almost any other liquid we buy - like bottled water ? I mean, oil is relatively hard to find, you have to drill a really deep well, then pump the semi-viscous fluid to the surface, put it into pipelines, load it on a ship for sometimes a very long journey, refine it, and distribute it. Not to mention all the environmental clean-up costs and security apparatus cost in basing Americans to guard the Saudi and other monarchies etc. Many bottled waters are just straight from some spring. Aren't we getting gouged by the water industry ?

Steven Pearlstein: I suspect the profit margins are very good on bottled water, which is why Coke and others have gone into it in such a big way. But remember, water has much higher bottling, transportation, storage costs than fuels, which are handled in much larger volumes, enjoying lots of scale efficiencies. So I'm not sure these kinds of comparisons are so useful.

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Fairfax, Va.: You write that Valero has a track record of making refineries more efficient. How can it be a bad idea to give it more opportunities to improve production through the Premcor deal?

Steven Pearlstein: Let's take your argument to its illogical conclusion, which is to ask why, if Valero is so good, we don't let them buy up every refinery in America? And the answer to that is that they would impose monopoly pricing, since they wouldn't be constrained by price competition. So the answer to your question is that consumers are best served when a market is truely competitive, which means having half a dozen very good companies competing for market share by offering good products and services at prices below the other guy. That doesn't fully describe the oil market,for all sorts of reasons we could go into, one of which is that it is virtually impossible for someone to enter this industry. Very high barriers to entry. Which means that when you have an underperforming company like Premcor available, what you hope is that it falls into the hands of another, independent, separate competitor, to maximize the number of really aggressive companies in this segment of the industry. Another Valero, in other words. There aren't many such potential competitors available, so allowing combinations of potential competitors, when there are so few to begin with, is bad competition policy. And that is what the FTC keeps missing.

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Washington DC: Mr. Pearlstein: Good column today, and indeed, what else could you expect when representatives of the oil industry are running the country? It seems obvious to me that they also are creating an atmosphere that doesn't discourage price gouging, and I'm convinced that we (the consumers) are being gouged, although I don't think it's our local gas stations that are gouging us. I'd like to see you spell out here who is gouging us, and why they are getting away with it (or is it perfectly legal?). Also, please tell us if there's even any theoretical redress.

Steven Pearlstein: You know, as much as I'd like to blame this on the oil guys in the White House, I don't think that's what's going on here. The problem is with the lawyers and economists who work at the FTC through various administrations, who have a particular way in which they analyze mergers and markets. In many instances, this analysis proves very useful. In this industry, it no longer does. And they are basically too timid or unimaginative to begin to lay the legal and economic groundwork for a different kind of analysis -- one that gives due weigh to the role of the OPEC price-fixing cartel that controls the supply of basic feedstock for the industry, and one that acknowleges the high barriers to entry and the oligopolistic behavior of the major oil companies. The way I'd frame the question about a refinery merger is this: We know that we get higher prices and price spikes because there is a capacity shortgage. How does this merger increase or decrease the chance that capacity will be increased in a way that enhances price competition -- not in reference to the status quo, but in reference to who else might reasonably buy these assets? And framed that way, you might conclude that Premcor should be preserved as an independent companies with enough scale to break from the pack and try to compete on the basis of price.

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Washington, DC: Hi Steven,

Clearly, mergers in the oil industry have a negative impact on consumers. And that's not just consumer groups like Public Citizen reaching that conclusion - it's the U.S. Government Accountability Office, the research arm of Congress. In May 2004, GAO released a report

www.gao.gov/new.items/d0496.pdf

showing that recent mergers have directly led to higher gasoline prices (and keep in mind, the price analysis ends in 2000, long before the mergers of ChevronTexaco and ConocoPhillips, so the price impact is much bigger).

And refining profit margins are hitting record highs. According to the US Department of Energy

www.eia.doe.gov/emeu/aer/pdf/pages/sec5_53.pdf

the US refining industry had profits of 22.8 cents per gallon in 1999. By 2004, that profit margin jumped 79% to 40.8 cents per gallon.

Environmental regulations over refineries aren't the problem. After all, a small company, Arizona Clean Fuels, is successfully obtaining all the necessary air quality and other environmental permits to build a brand new refinery outside Phoenix Arizona. If a small company can do it, why can't the world's most profitable corporation, ExxonMobil?

Public Citizen has tons of info on oil company price gouging:

www.citizen.org/cmep/energy_enviro_nuclear/electricity/Oil_and_Gas/

Steven Pearlstein: Public Citizen has been a lonely voice on this for many years. I would take some issue with what you say, however. I'd note that the Arizona Fuels folks have been at this a long time, which does speak to the difficulty in siting. I'd like to see a federal law that expedites siting. And I'd lay off the gouging vocabulary.

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ChinRub Retreat: I keep reading about economic devastation from terrorism, floods, acts of God... I've never understood this. Money doesn't disappear -- it will either be saved or spent elsewhere. Reconstruction will generate all kinds of (new) jobs, resource use, etc. A short term dip will be a 'make-up' spike in months to come, no? thanks

Steven Pearlstein: I'll be writing about this issue Friday, I expect. But let's not be too cavalier in thinking of this only in terms of economic output. Destruction of capital stock and undepreciated assets is costly. If it weren't, we would be rooting for everything to be destroyed every year, so we could have a high GDP to reconstruct it. Obviously, you have to look at both output and capital stock together to make judgments about economic welfare.

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Fairfax, VA: It seems to me that a shortage of investment might have more to do with the low prices of a few years ago, rather than monopoly power (I remember gas at less than $0.80). They have to pay off the investment over a long time, and the prices of the past couple of years are not likely to be stable. Any comment?

Steven Pearlstein: Yes, there were years of low profitability. Yes, oil refineries are very long term investments. But so are auto plants, power plants, chip fab plants, shipping vessels. And in all those industries, there are large price swings. Somehow, however, those industries manage to invest and add capacity in a way that avoids the kind of shortages and price spikes that have become endemic in the oil industry. Smart people figure out what the price cycle is, average things out, and come up with reasonable hurdle rates and longterm pricing strategies that let companies make money in the long run while continuing to invest in capacity. And they do that in competitive industries because they know if they don't, someone else will, and come along and take their market share. In the oil industry, smart people have figured out that if they don't invest to keep supply up with demand, they all do better.

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Riverdale, Ga.: I was paying about $15 to fill my gas tank under the Clinton administration. I am now spending $45 to fill my gas tank under the Bush administration. What is Bush not doing that Clinton did? Please explain why prices have tripled under this administration.

Steven Pearlstein: Political dating in this instance is really not appropriate. Sorry.

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Washington, DC: A sober examination of the fundamentals reveals that a sustainable market price for crude is anywhere between $45 and $49 per barrel. The current price is largely due to what market experts call an "instability premium." That being the belief that there will be a major disruption in supply between now and December (since the current $69 price is for December delivery).

Are the geniuses on Wall Street banking on the President stepping on his crank by invading Iran or Venezuela like he did in Iraq? Or are they simply pumping up the price on their own in hopes of capitalizing on shorts in the future?

Steven Pearlstein: I'm sure there are all sorts of speculative and instability premiums built into today's crude price, which is in the mid-60s when I last looked. These could go away. But let's remember that only a year or two ago, the oil industry was happy with prices in the mid 30s. So I'm not sure where you get the equilibrium price at $45. I've heard it is closer to $25.

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Sterling, VA: Bottled water costs less than $7 for 24 1/2 liter bottles at Staples. That's about $2.20/gallon. Costco has it cheaper, so gas is now more expensive that bottled water.

Steven Pearlstein: Thanks for doing the math.

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Washington, DC: Why don't you mention the March 2001 FTC investigation into price gouging (www.ftc.gov/os/2001/03/mwgasrpt.htm) that concluded, in part, that oil companies were choosing not to sell excess gasoline supply because that "would have pushed down prices and thereby reduced the profitability" of existing sales. The FTC report continued: "An executive of -one] company made clear that he would rather sell less gasoline and earn a higher margin on each gallon sold than sell more gasoline and earn a lower margin." The FTC didn't find any violations of antitrust laws because there was no collusion. But, it concluded: "In each instance, the firms chose strategies they thought would maximize their profits."

Steven Pearlstein: Strategic withholding. Excactly. That was the story in the California energy crisis (although that involved outright collusion). But it can also be done without making phone calls in an industry with a handful of large, experienced players. And that is exactly what we are dealing with here.

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Savage, MD: Do you think that the gas prices are going to fall sometime soon?

Steven Pearlstein: Yes, but not back to $1.50.

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Falls Church, VA: Mr Pearlstein,

Is the price of oil rising because production has peaked?

Steven Pearlstein: No. I don't believe that, though there is a whole school of energy analysts out there who do.

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Southern Maryland: I understand that the much of America's oil refining capacity is located in and near the areas devastated by Hurricane Katrina. Is it strategically and economically wise to have this capacity so centralized?

Steven Pearlstein: I think you go where the oil is. And it is certainly reasonable to expect that this will generate geographic concentration. It is also useful to have geographic clusters of suppliers, in oil or any other industry.

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Detroit, Michigan: I have not read or heard a good (i.e., nonpartisan) explanation of why this country has not built more oil refineries in recent years. Can you explain this?

Steven Pearlstein: The companies already in the business don't want to, because its hard, risky, because the returns are better when they expand existing refineries rather than build completely new ones. And because they don't want supply to get to the point where it actually meets demand. They want to keep things tight. They make more money that way.

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Laurel, MD: Isn't it obvious that with the record-setting net profits that the big oil companies earned in 2004 that the outrageously high price of gasoline has been artificially inflated so that Exxon/Mobil, Shell, BP, et al. can "make hay while the sun shines"? If President Bush was an oilman himself, would we see the big oil companies getting away with this? They are, after all, profiting at the expense of American consumers.

Steven Pearlstein: You might say companies always profit at the expense of consumers. But over time we have concluded that if an industry is truly competitive, the amount of profits is reasonable and most of the gains from efficiency and producitivity go to consumers. The problem here is that the industry is insufficiently competitive.

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Vienna, VA: Our national reserve was, in May of 2002, 550 million barrel of oil, and that was all-time high. In the middle of August, our reserve was 770 million barrel. Don't you think that the buying frenzy of this government attributed to this crisis in the first place? Also, when the price hit $70.00 barrel is so convenient for this administration so they will not ask for any more money for Iraq reconstruction(140 million dollars a day income).

Steven Pearlstein: I doubt things are so conspiratorial.

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Washington DC: It seems that this week is the first time the president asked folks to conserve energy and reduce gas usage. I just can't figure out why folks think they have a right to cheap gas, considering its a nonrenewable resource that's quickly being depleted and taking into account the much-higher cost of gas in other countries, including Canada. Would it be political suicide for the president to urge gas conservation, or it simply a matter of his not wanting to offend his oil industry buddies and donors?

Steven Pearlstein: Conservation has never been a high priority of the industry or this administration, that is a fact.

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Danvers, MA: Steve, charges of gouging to the contrary, refiners' margins are up big time even as the cost of their input (crude) has risen. Is there any other rational explanation?

Steven Pearlstein: Yes, demand exceeds supply. And in an industry where demand is inelastic, small changes in this gap can result in very large changes in price. That's a rational explanation,although that doesn't make the consequences any less painful.

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Falls Church, VA: How come gas price go up so much quicker then they go down? Also how come they never go down to where they were before price run ups? Both of these hold true even when the cost is escalated and de-escalated at the same cost and speed.

Steven Pearlstein: One suspects that is true, but the FTC staff failed to find evidence of this on a widespread basis. Not sure what else to say.

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Silver Spring, MD: Dear Sir,

I realize that it would be very difficult for the government to prove a case of price-fixing among the oil conglomerates as the burden of proof would rest on the government and, as you say, these companies are very well advised by counsel to at least avid the appearance of price fixing/gouging. I seem to dimly remember during the Carter administration, there was a supposed oil shortage, yet tankers were sitting off port unable to off-load because the oil tanks were topped off.

It seems to me the government is willing to "talk the talk but not walk the walk'' Would you agree? If yes, s it because it would be prohibitively expensive to explore the possibility of protracted litigation should it come to that?

Steven Pearlstein: The government as a whole has to come up with a policy to address regulation of an industry based on an internatinoal price fixing cartel. Right now, OPEC is beyond the reach of U.S. law. Maybe its time to explore changing that.

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Arlington, VA: Hi Steven: I'm amused by the number of people who complain about high gas prices, but will gladly hand over $4.00 a day for a latte. My question is are we not competing now with China and India for the world's oil? Isn't China's success as a global player a double edged sword for the United States as they are a big consumer of our exports, however, they will need oil to advance their economy?

Steven Pearlstein: Hey, they'll need lattes too!

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Germantown, Maryland: So, it sounds like Valero is a good long term investment for one's stock portfolio, no?

Steven Pearlstein: It surely would have been last year at this time. But past is not prologue when it comes to investing. Be wary of buying stocks at their peak.

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Washington, DC: What are these high barriers to entry? Are they natural to the industry, or entirely regulatory? Is there anything a government can do to inject competition into a non-competitive industry?

Steven Pearlstein: High barriers to entry are natural to this industry, no doubt about it. Big scale efficiencies. Big upfront investments needed. Not sure there's anything government can or should do about that, other than use a different antitrust analysis in industries that have it.

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Wichita, KS: I thought there was once "conventional wisdom" that when gas prices got to approximately $2.00 a gallon that demand was reduced to such an extent that this in itself was incentive enough to have a better match between supply and demand. Was this "story" a fairy tale?

Steven Pearlstein: Not sure about the exact numbers, but it is true only over the long run. Over the short run, gas consumption is relatively inelastic -- that is, people have no choice but to consume as much as they did when prices were lower until they have a chance to buy a more efficient car, or change their mode of commuting to work or move to a house closer to work. In the short run, things are pretty sticky.

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Arlington, TX: Is the FTC members selected anything like the drug committees of the FDA? Are they truly independent?

Steven Pearlstein: Appointed by the president and confirmed by the Senate, with at least two being of the minority party. In this case, both Dems and Republican members signed off on the staff recommendation.

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San Jose, CA: Since American oil companies appear to be unwilling to build additional refineries into the US, why don't other companies build additional refineries in foreign countries, and import refined producs into this country? Is it more difficult to import gasoline and heating oil than regular crude?

Steven Pearlstein: I've been asking the same question myself, and getting not very good answers from the industry. Obviously, transportation costs are higher when you import. But you might well save on production costs if you did it in Aruba. So I don't know why investment in offshore refineries that are designed and built to produce gas for the American market haven't been a good alternative. Again, my suspicion is that they don't want to invest in too much capacity.

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Washington, D.C.: How does degree of operating leverage play a role in all this? Don't refiners have very high fixed costs and low variable costs, so that they must sell huge volumes to cover their overhead and then everything above that goes virtually to the bottom line? That would explain why new competitors don't enter the market even though short term profits are very high.

Steven Pearlstein: Yes, it does. But this is not the only industry that has such characteristics. And yet others manage to be more competitive when it comes to investing in new capacity.

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Steven Pearlstein: That's it for today folks. Thanks for a lively discussion.

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