Reduced energy market concentration offsets refinement bottlenecks in supply chains – that significantly lowers oil prices

Much of the decline in numbers of refineries can be explained by reduced incentives to operate small, inefficient facilities and subsequent work-off of obsolete and high-cost capacity induced by the phase-out of crude oil price controls in the early 1980s. Environmental restrictions, boutique fuel requirements, and the MTBE ban have more recently contributed to tight refinery capacity. And while refiners have increased distillation capacity by 15 percent,62 refinery utilization rates have increased markedly since the early 1980s, peaking at around 95 percent in the late 1990s.63 Moreover, about 55 percent of U.S. operating distillation capacity in 2006 was in refining facilities with capacities greater than 200,000 barrels per day—a 36 percent increase over the last two decades.64 Currently, a relatively few, large facilities thus account for more than one-half of total U.S. refinery capacity.

The foregoing analysis raises concerns that refining in the United States is effectively a bottleneck in the production chain. In general, bottlenecks can have dramatic effects on prices, particularly when they are operated at the high utilization rates that have characterized the industry for several years. If consumption increases when capacity is tight, price increases reflect scarcity and appropriately ration demand. But if refiners deliberately shut down refining capacity (i.e., withhold), the supracompetitive price increase will directly harm consumers. Refining thus shares much in common in this regard with electricity: because capacity exists in discrete “chunks” that are utilized in increasing order of their marginal costs, one firm often owns more than one type of capacity, and demand fluctuates over time. Moreover a refiner or group of refiners need not hold a large share of capacity to profit from a withholding strategy. Even a small amount of capacity, if strategically withdrawn from the market, can produce a large price increase from which all firms with inframarginal capacity will benefit. The growth in size of refining facilities exacerbates such price effects because an outage at one large facility affects large volumes of refined products.

A second factor affecting the domestic industry landscape has been a fundamental shift in the role of the majors and independents over time. For example, a period of low profitability in the 1990s forced the majors to refocus their strategy on regional profit centers, resulting in spin-offs of refining capacity to the former independents. Refining capacity owned by the majors fell from 72 percent in 1990 to 54 percent in 1998.65 At the same time, the independents tripled their share of capacity from 8 percent to 23 percent, about two-thirds of which was based on assets acquired from the majors by firms such as Citgo/PDV America, Ultramar Diamond Shamrock, and Valero Energy. 66 Realignment of players in downstream markets contributes to harder-to-measure changes that merger analysis often dodges, such as the degree of vertical integration in upstream refining and downstream retail gasoline markets.67 Moreover, when coupled with ownership of a bottleneck segment such as refining, integration raises particular concerns about foreclosure and the leverage of market power to the retail gasoline outlet level.

A third important consideration is high and increasing concentration in refining and wholesale markets. Market structure is likely to be at the heart of most major competition policy questions involving petroleum markets. Where debates over market structure in other industries can turn on the ease of entry and the role of innovation in expanding the scope of markets, energy markets are still defined largely around constrained transportation networks and production cost differentials. Data from merger transactions over the last twenty years indicate refining market concentration ranging from 1,800 to as high as 6,700 HHI.68 Similarly, concentration in wholesale (e.g., terminalling or bulk supply) markets ranges from 1,565 to 4,600 HHI.69

Coupled with high concentration in specific markets, we also find increasing levels of market concentration in refining and wholesaling. Petroleum Administration for Defense Districts (PADDs) data for regional markets shown in Table 1 indicate double digit percentage increases in concentration from 1994 to 2002 in all the PADDs, with some areas moving from moderately to highly concentrated. These increases have likely been triggered by the gradual shutting down of refining capacity over time, the aggregate effect of mergers that do not exceed the Guidelines thresholds but nonetheless increase market concentration, and the effect of mergers that have not been adequately remedied. High concentration is problematic because it increases the probability of coordination among refiners.70 For example, refiners can tacitly or explicitly collude on output or on investment in new capacity by suppressing excess refining capacity and using swap agreements as a means of restraining capacity and preserving market discipline.71 Any discipline that new entry would bring to refining markets, however, is precluded by high sunk costs, environmental regulations, and the declining availability of domestic crude inputs.