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Bureaucrats and Gasoline: Why Gas Prices Are So High in the Midwest

Editorial

July 2000

by Mackubin T. Owens

Despite assurances earlier this year by Energy Secretary Bill Richardson that prices had peaked in the spring, the cost of gasoline has continued to escalate, especially in such Midwestern cities as Chicago and Milwaukee. When the price of a critically important commodity like oil rises rapidly over a short period of time, there is an understandable desire to hold producers responsible. For instance, Vice President Al Gore and some of his supporters have blamed the recent spike in gasoline prices on “Big Oil” and “price gouging.” Profits, they note, are up substantially. But oil companies, big or small, are not the problem. Instead, the distortions that affect the US energy market have been caused primarily by many of the same individuals who are pointing the finger at oil companies: politicians and bureaucrats.

Of course, oil companies are a favorite target of energy demagogues. Indeed, the charges leveled by the vice president conjure up images of the 1970s—déjà vu all over again. But logic points away from the oil companies as the cause of higher prices. Because if oil companies can raise prices at will, why did they wait so long to do so? Why did they let energy prices remain low for so long; indeed why did they permit them clearly benefit to fall to record lows last year? And why did they choose to “price gouge” primarily in Chicago and Milwaukee? The fact is that three decades of investigations have never produced a shred of evidence to support the contention that oil companies have colluded to raise prices.

It is clear that oil companies gain from higher prices, but the producer of any commodity is better off when the price of that commodity increases. And it shouldn’t come as a surprise that oil company profits are higher now that crude oil is selling for over thirty dollars a barrel than they were when oil was selling for ten dollars a barrel last year. The question remains, of course, what has caused the price of oil to rise?

The answer has two parts: first, market dynamics and second, the unintended consequences of environmental regulations. The market dynamics are straightforward—demand has increased while supplies have declined. On the one hand, US demand for gasoline, already strong due to a robust economy, has surged as Americans take to the highways during the summer vacation season. American demand for gasoline appears to be inelastic—a substantial increase in price produces only a small decline in the quantity demanded. The reasons for this include the fact that demand is usually inelastic in the short run (consumers don’t seek substitutes); and even with recent price increases, Americans spend a smaller proportion of their total wealth and income on energy than they used to.

So even if oil supply were unchanged, the increase in demand would tend to lead to higher prices for petroleum products. But supply has been curtailed as well. Oil producing countries, led by members of the Organization of Petroleum Exporting Countries (OPEC), cut back production last year after crude oil prices collapsed to record lows. Recently, OPEC approved a small increase in oil production—708,000 barrels per day (BPD)—bringing OPEC’s daily production to 25.4 million BPD.

But much of this new production is high-sulphur crude oil from the Middle East that does not meet the clean-air standards set by the Environmental Protection Agency (EPA). And even if it met EPA standards, it would not be enough of an increase to offset the increase in demand created by summer travel in the United States.

But reply the skeptics, why does gasoline cost so much more in the Midwest than elsewhere in the United States? Part of the answer has to do with unique regional problems of supply and refining capacity. But the more significant part of the answer has less to do with economics per se and more with politics—the politics of environmentalism.

First, there have been problems with the pipelines supplying the Midwest. One was shut down for two weeks due to a fire in March. It is now operating at only 80 percent capacity for safety reasons. Meanwhile, refining capacity is tight because several important Midwest refiners were temporarily off line. Finally inventories were unusually low going into summer because a cold winter had increased demand for heating oil, which producers continued to refine instead of gasoline, and the rising price of crude discouraged restocking by refineries.

These factors were sufficient in and of themselves to cause problems. But they were further exacerbated by bureaucratic regulations and micro-management. On June 1, just in time for the summer driving season, the EPA implemented stringent new clean air regulations mandating the use of “reformulated gasoline” (RFG) in certain areas of the country, including Chicago and Milwaukee, where gasoline prices have sky-rocketed. Wisconsin and Illinois are required by law to produce RFG with ethanol, something that has proven more difficult than anticipated. As a result, RFG stocks are particularly tight, so prices are higher in the Midwest than in other parts of the country.

So far, the EPA has refused to waive the requirement that gas stations sell only RFG in these parts of the Midwest. As a result, motorists in Chicago often drive to the suburbs only a few miles away where they can buy conventional gasoline for 40 cents less than the two dollars per gallon that it would cost them to buy the RFG mandated by the EPA in the city.

Of course, clean air is an economic good, and it might be worth the higher cost of RFG—if it actually worked. But a 1999 study by the National Academy of Sciences concludes that RFG is only moderately effective in reducing smog. It cuts some emissions at the expense of others. Meanwhile, a recent Congressional Research Service (CRS) report concludes that EPA regulations have increased gasoline prices in the Midwest by 50 cents a gallon. The cost of RFG seems high given the limited benefits.

If the EPA has its way, we can expect much more of the same in the near future. The agency is in the process of preparing new regulations that will further distort the gasoline market, e.g. new standards for sulphur content in gasoline and diesel fuel. In promulgating these new standards, they are ignoring the warnings of refiners that they will raise the cost of refining and create supply problems. Pending EPA regulations create more permanent and systemic problems as well. Because producers face the constant threat of additional regulations, incentives are distorted and investment in refining is reduced.

The Nobel laureate Friedrich von Hayek once defined economics as “the study of the unintended consequences of human action.” The bureaucrat-generated distortions of the US gasoline market are a clear example of exactly what he had in mind.

Mackubin Thomas Owens is professor of strategy and force planning at the Naval War College in Newport, RI, and an adjunct fellow of the Ashbrook Center. The views expressed here are his own and do not reflect the position of the War College, Navy Department, or Department of Defense.

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