MT: What’s interesting about the oil industry is that whether you own one truck or a large fleet, fuel pricing affects us all. And when you have an issue that is as important as fuel and something unsavory happens, such as high pricing, people tend to speculate as to why it’s happening and what’s behind it. One of the common beliefs is that the reason we have such high pricing right now is that oil companies are colluding to influence the price of fuel. As a long-time expert on the workings of the oil industry, what do you think of that? Is that belief valid?
Ervin: This is an industry that is rife with misperceptions by the public, media and government. Oftentimes there is legislation brought that can have the exact opposite effect of what the legislation intended. The whole perception of this gouging is certainly one that drives an awful lot of misunderstanding and frankly misdirection sometimes in terms of how governments behave. Gouging is a very valuated term, of course. It’s one that suggests that companies are getting together and manipulating the price upwards to basically line their own pockets. The fact is that when you look at what is happening behind fuel prices right now, one of the key drivers, and there are others, is crude oil pricing and the reasons behind that are complicated. That’s a commodity that does not have a made-in Canada price.
MT: When you mention crude oil and its impact on pricing, another common belief is that Canada has its own ability to control prices because of its reserves. So if we produced more and refined more ourselves we could have a made-in Canada price that would benefit Canadians. What do you think of that?
Ervin: Well that sounded pretty good to the government of the day about 20 years ago, which created a made-in Canada price. As a result investment in the Canadian upstream crude oil exploration development industry basically dried up and the government had to pretty quickly retract from that policy. What’s important to understand is that this is a global market. Western Canada is very self sufficient and in fact there is an export market for products such as crude oil and natural gas that goes principally to the United States. In Eastern Canada, however, we import a lot of energy from outside Canada from countries such as Venezuela to supply our refineries in that sector. And we wouldn’t necessarily benefit from building a lot of pipelines stretching from Edmonton to St. Johns, Newfoundland unless we brought back the National Energy Policy, which would be a mistake.
MT: So what you’re saying is that this is a multi-faceted issue with several factors that actually determine the end price. I want to see if we can’t break these factors down in a way that’s understandable to all. As in most industries, I assume fuel prices are driven by the laws of supply and demand. Let’s start off with supply of crude and take a bird’s eye view – what are the major factors at play?
Ervin: When you look at the dynamics of fuel oil prices you really have to look at the three different geographic perspectives. First and foremost starting at the beginning of that is the dynamics associated with crude oil itself, the raw material. Those dynamics really occur on a global scale. Crude oil is a global commodity and refiners around the globe, who are the buyers of crude oil, shop for the best prices. But crude has the ability to find its way to the market that will pay the highest price for that product from the seller’s point of view. That means that a refiner in Toronto basically ends up paying the same price for crude oil as a refiner in Amsterdam. This is a very, very volatile market where price can fluctuate on a daily and hourly basis.
If we go down further along the value chain and look at what refiners do to turn crude oil into the refined product then we are really talking about a more continental scale of competition. That means that a buyer in Buffalo, for instance, will certainly be interested in the wholesale price of diesel fuel in Toronto or perhaps even Montreal. So refineries within, for instance Eastern Canada and the Eastern Seaboard of the United States, often compete with each other in terms of selling their wholesale product to large institutional buyers.
And finally we get down to the end user such as a trucking company looking for the best price of diesel fuel for its trucks. Here we get down to the local competition and retailers are going to be competing with each other on a local level to attract that business but they will not be concerned about price wars going on in other regions because consumers won’t likely be driving to another region to take advantage of those price wars.
MT: When you look at pricing at the local level, how would it compare with other industries when it comes to the degree of competition that occurs? Many people would say there’s not enough competition going on.
Ervin: I actually characterize the fuel industry as being one of the most competitive industries that you will find anywhere. There is evidence of that in so many ways. There is evidence of that when you look at price comparisons without the tax for gasoline and diesel fuel in Canada versus the United States. There is certainly evidence of that when you look at refining back to retail margins or products like gasoline or fuel oil. With all the media and governmental attention being paid to this industry, there really have been no major findings anywhere over the course of the last 20 years to suggest that this industry somehow is not competitive.
MT: I assume you are referring to the multitude of government investigations on price fixing in the oil industry the last two decades which have not turned up anything?
Ervin: That’s right. In fact the volatility in the price itself is another one of those indicators of competition. It presents to me what I think is a paradox in the industry and that is that the markets that have the most volatile prices tend to be the markets that drive customers the most crazy and they tend to be the markets where customers are the most suspicious, even though consumers benefit from those volatile prices.
MT: To understand the factors behind pricing I want to dig a bit deeper and look at costs involved in determining prices.
Ervin: We just spoke about the local, regional and global levels of competition and those are just one set of dynamics driving fuel prices. It is important to realize that a refiner goes to the office in the morning, looks at where crude prices are, looks at what other refiners are charging and the rack price and basically then establishes what his refiner rack price will be on that day. The refiner is not simply able to say I am going to tack 15% on the crude price. That margin is a consequence of prices, it doesn’t set the prices. Similarly when you look at the difference between the rack price and the actual fuel cost (without tax) we come up with a measurement which we call the marketing margin, which is similarly derived. The price of fuel that is being set by competitors today is going to determine what that margin is. And finally taxes, which are by and large, fixed. If we look at the tax content for diesel, it is the second biggest element right now after crude costs, accounting for about 28% of the cost.
So we see through this value chain that it’s not just one dynamic but several dynamics that affect price. One of the most frequent questions asked is why is it that crude prices can go down today but the price of fuel goes up a day later. People can’t seem to get their heads around that but it’s because crude prices are not the only thing driving the industry. There are dynamics at various levels driving the price at the pump.
MT: Allow me to make a rather simplistic observation on a rather complicated issue. It se
ems to me that with taxes being such a large part of the price of fuel, the easy answer is to cut the tax. Or is that simply too big a tax grab for any government to willingly give up?
Ervin: Well the tax on gasoline and diesel fuel is huge revenue for governments not only at the federal level but provincially as well. When we talk about gasoline alone the annual tax revenue in Canada is well over 10 billion dollars a year and so if one was to actually reduce the taxes on gasoline and diesel fuel then governments would have to look for some other way to make up for that loss of revenue. The other problem is that a tax reduction would reduce the price but not the volatility of the product pricing. It is not the high price that’s the real issue, it’s the stability of the price that really creates an awful lot of concern.
This is an excerpt from the Let’s Talk about Volatile Fuel Prices series of cross-country seminars conducted recently by Transportation Media in partnership with Markel Insurance. Next issue, Michael Ervin comments on the pricing outlook for diesel and the short-term impacts of the move to LSF for the trucking industry.