On Petrol Prices; the Power of Producers; and Policy Prescriptions
The debate on FuelWatch and its possible efficacy in reducing petrol prices appears to have either ignored or under-estimated the consequences of some key features of the industry, namely, structure of the industry; conduct of the players; information asymmetry; and consumer behaviour.
Opponents champion the ‘market system’ and decry regulatory intervention. ‘The market’ for petroleum products, however, is far from perfect – no market is, but well-functioning markets do not exhibit the significant inefficiencies that the petroleum industry does, which adversely affect consumers.
First, the structure of the refining segment of the industry is highly concentrated. The link between concentration and high profitability has been drawn by Joe Bain and Leonard Weiss, among others. A consumer base that is dispersed over a large geographical area can limit economies of scale, and therefore large numbers of competitors would be economically unfeasible in the petroleum refining sector. The retailing sector, through alliances such as Caltex-Woolworths; Shell-Coles; and the diminishing number of independents, is also tending to become more concentrated.
Whatever the limitations on options for decreasing the level of industry concentration, the conduct of oil industry participants, however, is a different story. Anthony Sampson, in the first edition of his book, The Seven Sisters, describes the complex web of inter-relationships between the oil majors and their influence on ‘the market’ at that time (the 50’s), including their success in lobbying for special treatment. He describes the oil companies’ conduct in obtaining a ‘Business Review Letter’ from the US Anti-trust authorities, exempting them from legal action for joint price negotiations with petroleum resource host countries and concludes that the latter learnt well, ultimately forming OPEC, the producers’ cartel.
In Australia, we do know that the refiners supply each other’s outlets. They also, communicate with each other frequently and with each other’s outlets and have a common interest in minimising ‘cut-throat’ competition to maximise profits.
In addition to ‘upstream’ collaboration for supply of refined product, the oil companies have their own outlets (through which they have a ‘window’ on retailing) and supply independent retail competitors, who are, in effect, dependent on them for regular supply, with obvious implications for commonality of interest – could we really expect small independent petrol-retailing businesses to vigorously compete with their suppliers on whom they depend for their continued supply and, therefore, existence?
The oil companies do not need to collude; the circumstances for tacit co-ordination that lead to anti-competitive outcomes are present. In the natural gas segment of the petroleum industry, Western Australian industrial users of natural gas are concerned about delays in developing gas resources which are necessary for their industries. Joint venture developers of natural gas may have mutually beneficial objectives that differ from those of users. Users have argued that only two entities supply the domestic (Western Australian) market and the joint marketing arrangements of the N-W Shelf joint venture significantly reduces competition. Industrial users have called for strengthening of the commercial test for retention leases which allow reserves to be held dormant (Andrew Burrell, Australian Financial Review 11th July 2007). Many of the key players in the natural gas sector are also key players in oil production, with ownership and other links to the refiners.
Tony Abbott says that if there were any anti-competitive conduct, the Australian Competition and Consumer Commission would have dealt with it. This ignores attempts by the ACCC and its predecessor, the Trade Practices Commission, to attack such co-ordinated conduct by the oil companies in the courts. Even if collusion is going on, the odds on proving it to the evidentiary satisfaction of a court are extraordinarily long.
Turning to consumer behaviour, it is accepted by all sides that demand is relatively inelastic. The option of reducing demand in response to a significant price increase (as would be likely to occur in more elastic markets) is, therefore, not available to consumers.
Because of the linkages between the oil companies; between them and independent retailers; the common profit-maximising objectives of all industry players; and the information asymmetry between suppliers and consumers, the circumstances are favourable to consumer exploitation through frequent price changes, generally biased upwards rather than downwards (the notorious ‘stickiness’ of downward movement of prices following world oil price declines, in contrast to immediate upward movements following world price rises, is well known).
Importers have tried to enter the market but, after sporadic efforts, have exited. The lack of storage terminals and long-term links with a critical mass of retailers, among other reasons, have limited their effectiveness in constraining the market power of the incumbents.
This is where FuelWatch comes in – attempting to ‘slightly tilt the playing field back’ in favour of consumers from its current steep slant in favour of suppliers by (a) forcing effective disclosure (i.e. by informing consumers at large, rather than only those pulling up at the pump); and (b) tying the supplier to its price offer for a specific time (obviating the problem of price changes while consumers are driving to the outlet or, indeed, while about to fill up).
What is really at issue is the right of retailers to change offer prices at will. Ordinarily, where the market is operating efficiently and competitively, there is no problem with that – pricing to reflect changing costs and/or to meet competition is at the heart of the free market. Efficient markets are predicated upon the free flow of key information, particularly prices. For the reasons of industry structure and conduct, outlined above, however, this market fails that test and, for that reason, public policy demands intervention.
In posting prices, retailers will, obviously, consider their costs and the likely prices of competitors and price at a level that secures an acceptable level of sales volume. Too high, and competitors will increase their sales at the expense of the higher-priced retailers. Too low, and retail margins will be reduced, although this would be offset to some extent by increased sales volume. Not being able to change prices for 24 hours, the oil companies and retailers would no longer be able to opportunistically manipulate prices to their unfair advantage.
Brendan Nelson has asked whether grocery prices are also to be regulated in the way FuelWatch is to regulate petrol prices nationally. Grocery retailers seem to have no difficulty maintaining their prices for grocery products for more than a day and, indeed, tying themselves to ‘advertised specials’ for a number of days or ‘until sold out’. Admittedly, wholesale grocery price changes are less frequent than for petrol, but, there is no evidence that petrol wholesale price movements are as volatile as retail petrol prices. Hence, multiple retail price changes for petrol in a single day, cannot be justified on costs, when wholesale product is supplied and priced less often. Retailers can only sell what they have bought, or contracted to buy. It is either in their tanks or en route, at an agreed price.
Some attempts have been made in the past to regulate control of petroleum retail outlets under legislation relating to petrol franchising. Public assessments of the efficacy of those approaches, however, do not appear to be available.
Clearly, some other approach is necessary. FuelWatch is one. Regulation should be proportionate to the problem; cost efficient; and provide certainty. There is no suggestion that FuelWatch offends any of those criteria. $20 million in a multi-billion industry could not be said to be unduly costly and the level of intrusion is not disproportionate in the circumstances where consumers would otherwise continue to be significantly disempowered. While regulatory costs would vary between the large and small petrol retailers, the need for frequent (and more costly) physical checking of competitors’ prices would be obviated – everyone would have access to the ‘posted’ retail prices.
Business is vociferous in its demands for predictability, consistence and certainty in areas such as tax, industry policy, competition policy, investment policy etc. Should not consumers be entitled to some predictability and certainty for 24 hours?
The degree of intrusion appears to be quite moderate when compared to a number of states in the US, where, some decades ago, producers were barred from owning petroleum retailing outlets (this stricture also applied to cinema exhibition and bulk beer retailing). Such intervention is understandable when the difficulties of preventing anti-competitive conduct in concentrated vertically integrated industries are taken into account. In telecommunications throughout the world, fixed-line network owners have been able to thwart competitors (and regulators) for decades. By contrast, FuelWatch is minimally intrusive.
The effectiveness of FuelWatch, based on the Western Australian experience, is in question. Some departmental advisers have suggested that it could even lead to a small increase in prices. The evidence for that case has not been made public. Has the case for the likelihood of FuelWatch leading to price decreases been explored?
The comments of Mr Fitzpatrick, of the MTAA of WA are curious. He says the WA system has not led to a reduction of prices, only to consumers ‘shopping around’. Mr Fitzpatrick does not appear to understand that it is the ‘shopping around’ that exerts downward pressure on prices. What makes ‘shopping around’ for groceries effective in getting the best bargain is the knowledge that prices are highly unlikely to be changed while the consumer is en route or in the grocery store. Retail petrol price fluctuations within the day are clearly intended to neutralise the effectiveness of ‘shopping around’.
Assessing the counterfactual is always fraught with difficulty and uncertainty. It is axiomatic, however, that reducing information asymmetry helps effective bargaining. It is this principle that grounds the auction system and modern technically sophisticated variations thereof – screen trading for financial products which show in real time, at the decision-making point, the available offers and bids. Why deny petrol consumers some benefits of transparency and certainty? Lest the screen-trading price change option analogy be cited as an argument to amend FuelWatch to a six-hourly notification system (as canvassed recently), it is important to note that retail buy/sell decisions on securities can be made while the trader is ‘on screen’ in distinction to the retail purchase of petrol. Frequent checking of prices for petrol in a multiple-price-change-per-day scenario would considerably lessen the effectiveness of FuelWatch – consumers have enough to do in the day without multiple checks of petrol prices before purchasing.
Peter Martin (Canberra Times 31st May) has criticised the ACCC ‘averaging’ calculation, on the basis that a substantial proportion of petrol sales are made on ‘discount’ days, or at lower prices, which skews the average downwards. First, prices on offer are prices nevertheless – whether taken up by few or many. Second, they are the prices paid by those who purchase on that day from the relevant outlet. Finally, the evidence he cites shows that two thirds of WA consumers and one third of NSW consumers pay the higher prices. The more purchases are made on ‘discount’ days, or from lower-price outlets, the better; through FuelWatch, the ‘word’ will be propagated more widely than by ‘word of mouth’.
The progressive weighting of sales at lower prices would pressure retailers to adjust their prices over the rest of the week downwards to smooth sales and those who price higher than others, whether on the same day or, on average, as between days, would be forced to ‘meet the market’ or lose business.
The environment card has also been played i.e. is one in favour of lower prices and, therefore, anti-environment; or for higher prices and pro-environment. This is a red herring. The environment issue is quite different to the allocative efficiency issue of petrol pricing. The latter is a question of appropriation of profits by petrol companies based on the level of prices charged to consumers and the efficiency consequences thereof, in circumstances where market structure and conduct favour the former. Given the relative inelasticity of demand, price changes are unlikely to alter consumption sufficiently significantly to have beneficial environmental consequences in the short to medium term. Gouging consumers and businesses which use petroleum-based fuels, on the other hand, seriously affects living standards and economic efficiency.
Consumption of water and fossil fuel for electricity generation could be argued to be as important as petrol in terms of environmental impact. Should we allow suppliers to raise charges to increase their profits so that consumption is reduced for the benefit of the environment? Consumers may be able to reduce their total carbon footprint in a lower-cost way, or in a way that affects their utility less, than by being forced to reduce their tailpipe emissions through higher-than-necessary petrol prices.
Clearly, a whole range of environmental approaches e.g. emission cap and trade systems, low-wattage light bulbs; more fuel-efficient cars etc are part of the mix of environmental strategies, rather than impoverishing consumers through unnecessarily high petrol prices and, thereby, add to suppliers’ profits.
Indeed, we can expect a staunch defence of the profits of the petrol industry in the introduction of the emissions trading mechanism. It is already asking for exemption on the basis that it is a key input to the economy. Passing strange that this concern is not reflected in the need for efficient, information-based retail pricing which affects both industry and consumers. Malcolm Turnbull has said that he is in favour of ‘technological’ solutions to the environmental problem such as hybrid cars rather than including petrol in the ETS. Sounds like the Coalition has already decided its position on that issue.
Some analogy/contrast has already been drawn between petrol and grocery retailing. There is also a direct linkage with serious implications.
The introduction and gradual expansion of the discount petrol voucher system could well change the structure of the petrol retailing market for the worse. Its effectiveness can be gauged from the extension of 4c vouchers for grocery purchases to additional discounts for non-petrol purchases of a certain value at the petrol station. While the ACCC has shown that even with the voucher discount, nett prices for Coles Express petrol have exceeded the average, by ‘leading’ prices up, if consumers believe that they can get such discounts off the market price, there is real risk that the grocery majors could extend their combined dominance of the grocery retailing market to petrol retailing by use of such vouchers to progressively capture market share and, eventually, with the oil majors (who supply the grocery-retailer-operated-petrol outlets), eliminate independent petrol retailers. A corollary is that competing grocery retailers would be adversely affected by consumers’ preference for shopping at Coles and Woolworths to obtain petrol vouchers. Thus, both petrol retailing and grocery retailing markets would tend to greater concentration from their already high levels at present. This outcome needs to be prevented.
FuelWatch is a worthwhile first step, but if it is modified to operate in 6-hour intervals, its effectiveness will be seriously compromised. The effectiveness of FuelWatch as presently designed needs to be assessed and, if not sufficiently effective, a policy prescription which addresses the serious deficiencies in the operation of this market will need to be fashioned.
