California is famous for its car culture but that lifestyle has been expensive in recent months as the price of gas in the Golden State has climbed and climbed. California gas prices are almost always above the national average but in recent weeks the gap has grown more significant than usual.
So what gives? According to the Wall Street Journal, it’s all about supply chain issues (California’s Gas Price: Is There a Villain?, Oct 18).
What’s the lesson learned from California’s recent spike in gasoline prices, which is costing consumers millions of dollars and prompting calls for an investigation?
Probably nothing more villainous than this: In the world of tight supply-chain management, if you live by “just in time,” you on occasion will get hosed by “just in time.” And that’s the price Californians opted to pay, in part because they have goals beyond just access to cheap gas.
As the article goes onto explain, there are two issue here. The first has to do with the features of the market that have operational implications.
The state is an isolated market. Ships deliver oil to California’s refineries, which then make gasoline and pipe it throughout the state and to neighboring Nevada, Arizona and Oregon. There is no major pipeline or rail infrastructure that can quickly deliver large amounts of gasoline or oil from other locales in the U.S. to California—supplies that could mitigate shortages.
How isolated is California? While the rest of the U.S. is consuming less imported oil and more domestic shale oil from fields like the burgeoning Bakken in North Dakota and Eagle Ford in Texas, California is importing more oil from countries such as Ecuador and Iraq—now up to roughly half of what it consumes.
The state also mandates a special blend of cleaner gasoline—with the strictest specifications in the nation—especially in the extended summer months. The cleaner and pricier gasoline, in a driving market that’s larger than many countries, has been a plus for the state’s air quality, a goal Californians sought. But the trade-off is that during emergencies, California stands alone.
So the California gasoline market is its own little island. That has implications for how much capacity firms want to bring to the market. A refinery in Houston is geographically flexible in the sense that there are multiple US markets it can economically serve. A refinery in El Segundo (a city named after a refinery), however, has to live and die with the California market. That limited flexibility favors a smaller capacity.
Should California just build more refineries to increase supply?
The trend has been in the other direction, chiefly because many refineries weren’t sufficiently profitable. The U.S. has half as many refineries as it did a few decades ago, and California does too: 20 now, 14 of which make gasoline, down from 40 in 1982. Plant expansions and an increase in productivity resulted in a smaller percentage drop in capacity. But fewer, bigger plants can mean greater vulnerability, as recent months have demonstrated.
As that last sentence suggests, a big driver in the price spikes has been disruptions at some of California’s refineries. A fire here, an electrical glitch there and the next thing you know you have a price spike. Fewer, bigger plants means any small problem becomes a big problem as a large percentage of market capacity gets taken down. On the flip side, that should also mean relatively rapid drops in prices a capacity comes back on line (which the San Jose Mercury News has happened over the past week).
The second issue has to do with inventory — or the lack there of:
“The refining industry has gone to more of a just-in-time delivery system and has a more sophisticated understanding of where inventories stand,” says Gordon Schremp, senior fuels analyst at the California Energy Commission. The refiners calculate how often they’re likely to have an unplanned outage and compare that to the cost of expanding storage. “It doesn’t pencil out to squirrel away that fuel,” says Mr. Schremp. Chevron and Exxon declined to comment.
Mr. Schremp says the state considered building a strategic fuel reserve itself but, in part, decided to rely on a growing number of independent traders in the state who store components for gasoline during flush times and sell them into the market during shortages.
The interesting thing here to my mind is the implication that a just-in-time system is bad for consumers. That because no one is holding extra gas, consumer are more exposed to price shocks when there is any kind of disruption. What that ignores is that lower inventory during periods of normal operations should lower costs and (potentially) keep more firms in the market. That is, if operating a refinery meant carrying, say, three times as much inventory as is currently necessary, someone has to pay for that. If a significant chunk of that cost cannot be shifted onto consumers, then firms would exit the market. Thus as long as disruptions are fairly infrequent, consumer would win most of the time but have to bear the risk of high prices from disruption on occasion.
A final point. There is an interesting research question here that follows from that last paragraph. There is a direct link between inventory and time. The more inventory a firm carries, the longer it takes for production to flow to the market. Thus, what is produced today will be sold farther out in the future the more inventory the firm carries. Now suppose there is demand uncertainty. A firm with a short flow time (i.e., a lean one with low inventories) will be able to respond to market fluctuations more quickly — expanding output if the market is strong but contracting if the market is weak. A firm with a long flow time has to play it more conservatively — under-supplying a strong market but over-supplying a weak one.
So which is better for consumers? It seems pretty clear that the lean firm will be better off (even ignoring the inventory costs). But how much of that gain is coming from consumers? My intuition says that consumers have to benefit from the lean firm. Sure they may not get a windfall when the market is weak but they likely win big in a strong market. This would be particularly true when market conditions are sticky from period to period. A firm with a long flow time would be very slow to catch up to extended period of strong demand while a more flexible firm will catch up to the market quickly.