[Senate Hearing 107-509] [From the U.S. Government Printing Office] S. Hrg. 107-509 GAS PRICES: HOW ARE THEY REALLY SET? ======================================================================= HEARINGS before the PERMANENT SUBCOMMITTEE OF INVESTIGATIONS of the COMMITTEE ON GOVERNMENTAL AFFAIRS UNITED STATES SENATE ONE HUNDRED SEVENTH CONGRESS SECOND SESSION __________ APRIL 30 AND MAY 2, 2002 __________ Printed for the use of the Committee on Governmental Affairs U.S. GOVERNMENT PRINTING OFFICE 80-298 WASHINGTON : 2002 _____________________________________________________________________________ For Sale by the Superintendent of Documents, U.S. Government Printing Office Internet: bookstore.gpo.gov Phone: toll free (866) 512-1800; (202) 512-1800 Fax: (202) 512-2250 Mail: Stop SSOP, Washington, DC 20402-0001 COMMITTEE ON GOVERNMENTAL AFFAIRS JOSEPH I. LIEBERMAN, Connecticut, Chairman CARL LEVIN, Michigan FRED THOMPSON, Tennessee DANIEL K. AKAKA, Hawaii TED STEVENS, Alaska RICHARD J. DURBIN, Illinois SUSAN M. COLLINS, Maine ROBERT G. TORRICELLI, New Jersey GEORGE V. VOINOVICH, Ohio MAX CLELAND, Georgia THAD COCHRAN, Mississippi THOMAS R. CARPER, Delaware ROBERT F. BENNETT, Utah JEAN CARNAHAN, Missouri JIM BUNNING, Kentucky MARK DAYTON, Minnesota PETER G. FITZGERALD, Illinois Joyce A. Rechtschaffen, Staff Director and Counsel Richard A. Hertling, Minority Staff Director Darla D. Cassell, Chief Clerk ------ PERMANENT SUBCOMMITTEE ON INVESTIGATIONS CARL LEVIN, Michigan, Chairman DANIEL K. AKAKA, Hawaii, SUSAN M. COLLINS, Maine RICHARD J. DURBIN, Illinois TED STEVENS, Alaska ROBERT G. TORRICELLI, New Jersey GEORGE V. VOINOVICH, Ohio MAX CLELAND, Georgia THAD COCHRAN, Mississippi THOMAS R. CARPER, Delaware ROBERT F. BENNETT, Utah JEAN CARNAHAN, Missouri JIM BUNNING, Kentucky MARK DAYTON, Minnesota PETER G. FITZGERALD, Illinois Elise J. Bean, Acting Staff Director and Chief Counsel Dan M. Berkovitz, Counsel Laura E. Stuber, Counsel Kim Corthell, Minority Staff Director Mary D. Robertson, Chief Clerk C O N T E N T S ------ Opening statements: Page Senator Levin................................................ 1, 79 Senator Collins..............................................10, 81 Senator Akaka................................................ 12 Senator Lieberman............................................13, 82 Senator Carnahan............................................. 15 Senator Voinovich............................................ 16 Senator Bunning.............................................. 18 Prepared statement for May 2, 2002: Senator Bunning.............................................. 129 WITNESSES Tuesday, April 30, 2002 James S. Carter, Regional Director, U.S., ExxonMobil Fuels Marketing Company, Fairfax, Virginia........................... 20 Gary Heminger, President, Marathon Ashland Petroleum, Findlay, Ohio........................................................... 21 Ross J. Pillari, Group Vice President, U.S. Marketing, BP, Warrenville, Illinois.......................................... 24 David C. Reeves, President, North America Products, ChevronTexaco Corporation, San Ramon, California............................. 26 Rob Routs, President and Chief Executive Officer, Shell Oil Products U.S., Houston, Texas.................................. 29 Thursday, May 2, 2002 Hon. Ron Wyden, a U.S. Senator from the State of Oregon.......... 85 Richard Blumenthal, Attorney General, State of Connecticut, Hartford, Connecticut.......................................... 89 Jennifer M. Granholm, Attorney General, State of Michigan, Lansing, Michigan.............................................. 91 Tom Greene, Senior Assistant Attorney General for Antitrust, California Department of Justice, Sacramento, California....... 95 Peter Ashton, President, Innovation and Information Consultants, Inc., Concord, Massachusetts................................... 108 Justine S. Hastings, Assistant Professor of Economics, Dartmouth College, Hanover, New Hampshire................................ 112 R. Preston McAfee, Murray S. Johnson Professor of Economics, University of Texas, Austin, Texas............................. 115 Philip K. Verleger, Jr., President, PK Verleger, LLC, Newport Beach, California.............................................. 118 Alphabetical List of Witnesses Ashton, Peter K.: Testimony.................................................... 108 Prepared statement with attachments.......................... 204 Blumenthal, Richard: Testimony.................................................... 89 Prepared statement........................................... 179 Carter, James S.: Testimony.................................................... 20 Prepared statement with an attachment........................ 130 Granholm, Jennifer M.: Testimony.................................................... 91 Prepared statement........................................... 187 Greene, Tom: Testimony.................................................... 95 Prepared statement........................................... 198 Hastings, Justine S.: Testimony.................................................... 112 Prepared statement with attachments.......................... 215 Heminger, Gary: Testimony.................................................... 21 Prepared statement........................................... 146 McAfee, R. Preston: Testimony.................................................... 115 Prepared statement........................................... 227 Pillari, Ross J.: Testimony.................................................... 24 Prepared statement........................................... 157 Reeves, David C.: Testimony.................................................... 26 Prepared statement........................................... 161 Routs, Rob: Testimony.................................................... 29 Prepared statement........................................... 170 Verleger, Philip K., Jr.: Testimony.................................................... 118 Prepared statement........................................... 239 Wyden, Hon. Ron: Testimony.................................................... 85 Prepared statement, May 2, 2002.............................. 175 Exhibits 1. GChart: Average Midwestern Retail Gasoline Prices, January 1999-April 2002................................................ 250 2. GChart: Michigan Retail and Rack Prices, January-August 2001. 251 3. GChart: Average United States Retail Gasoline Prices, January 1995-April 2002................................................ 252 4. GRecent Mergers.............................................. 253 5. GChart: HHI Index for United States Gasoline Wholesale Market in 1994........................................................ 254 6. GChart: HHI Index for United States Gasoline Wholesale Market in 2000........................................................ 255 7. GChart: Market Share of Top 4 Firms in the Gasoline Wholesale Market in 1994................................................. 256 8. GChart: Market Share of Top 4 Firms in the Gasoline Wholesale Market in 2000................................................. 257 9. GChart: Illinois Retail Prices (Net Taxes), June 2001........ 258 10. GChart: Maine Retail Prices (Net Taxes) by Brand, January- August 2001.................................................... 259 11. GChart: Michigan Retail, Rack, and Spot Market Prices, January-August 2001............................................ 260 12. GChart: Michigan Retail Prices (Net Taxes) by Brand, April 2001........................................................... 261 13. GBP Amoco Midwest/Mid Continent Strategy..................... 262 14. GBP Amoco CEO Statements..................................... 266 15. GPowerine Memo............................................... 267 16. GARCO West Coast Market Fundamentals......................... 268 17. GARCO Memo on Role In Market................................. 269 18. G1992 Texaco Memo............................................ 271 19. G1993 Chevron Memo........................................... 272 20. G1996 Texaco Memo............................................ 273 21. G1997 Pricing Strategy Emails................................ 274 22. GChart: Wolverine Pipeline System Overview................... 276 23. GChart: Pipeline Transportation Charges in 1999.............. 277 24. GChart: Michigan Daily Retail Price Changes (Net Taxes) by Brand, April 9-14, 2001........................................ 278 25. GChart: Petroleum Administration for Defense Districts (PADD) 279 26. GMarathon Oil Company, Summary: Short-Term Price Outlook..... 280 27. GLetter from Gary R. Heminger, President, Marathon Ashland Petroleum, dated May 13, 2002, to the Permanent Subcommittee on Investigations, clarifying April 30th testimony................ 281 28. GLetter from James S. Carter, Regional Director, U.S., ExxonMobil Fuels Marketing Company, dated May 17, 2002, to the Permanent Subcommittee on Investigations, clarifying April 30th testimony...................................................... 282 29. GLetter from Ross J. Pillari, President, BP America Inc., dated May 16, 2002, to the Permanent Subcommittee on Investigations, clarifying April 30th testimony................ 285 30. GLetter from ChevronTexaco, dated May 14, 2002, to the Permanent Subcommittee on Investigations, clarifying April 30th testimony of David C. Reeves................................... 287 31. GMemorandum from James S. Carter, Regional Director U.S., ExxonMobil Fuels Marketing Company, dated May 2, 2002, to the Permanent Subcommittee on Investigations, clarifying the record on zone pricing................................................ 288 32. GSupplemental questions and answers for the record of Ross J. Pillari, BP America, Inc....................................... 289 33. GSupplemental questions and answers for the record of Gary R. Heminger, Marathon Ashland Petroleum........................... 294 34. GSupplemental questions and answers for the record of Rob J. Routs, Shell Oil Products...................................... 299 35. GSupplemental questions and answers for the record of David C. Reeves, ChevronTexaco Corporation........................... 302 36. GSupplemental questions and answers for the record of James S. Carter, ExxonMobil Fuels Marketing Company.................. 311 37. GChevronTexaco's comments on the Permanent Subcommittee on Investigations' Majority Staff Report entitled Gas Prices: How Are They Really Set?........................................... 314 38. GAttachments to prepared statement of David C. Reeves, President, North American Products, ChevronTexaco Corporation.. * 39. GReport of the Permanent Subcommittee on Investigations' Majority Staff entitled, Gas Prices: How Are They Really Set?.. 322 * May be found in the files of the Subcommittee GAS PRICES: HOW ARE THEY REALLY SET? ---------- TUESDAY, APRIL 30, 2002 U.S. Senate, Permanent Subcommittee on Investigations, of the Committee on Governmental Affairs, Washington, DC. The Committee met, pursuant to notice, at 9:34 a.m., in room SH-216, Hart Senate Office Building, Hon. Carl Levin, Chairman of the Subcommittee, presiding. Present: Senators Levin, Lieberman, Akaka, Durbin, Carnahan, Dayton, Collins, Stevens, Voinovich, and Bunning. Staff Present: Linda J. Gustitus, Chief of Staff for Senator Levin; Mary D. Robertson, Chief Clerk; Laura Stuber, Counsel; Dan Berkovitz, Counsel; Edna Falk Curtin, Detailee/ General Accounting Office; Cliff Tomaszewski, Detailee/ Department of Energy; Kim Corthell, Minority Staff Director; Eileen Fisher, Investigator to the Minority; David Mount, Detailee/Secret Service; Joyce Rechtschaffen, Staff Director and Counsel, Governmental Affairs Committee; and Laurie Rubenstein (Senator Lieberman). OPENING STATEMENT OF SENATOR LEVIN Senator Levin. Good morning, everybody. Today the Permanent Subcommittee on Investigations opens 2 days of hearings on how gas prices are set in the United States. Gas is the lifeblood of our economy, and through luck, pluck, hard work, and ingenuity, we have been able to have the gasoline that we need in this country. Most of us take for granted the fact that in most urban areas we can go a few blocks and find a gas station that has gas, and with the 5 minutes it now takes to fill up our tanks, we can be off and about our business in no time. It is easy to lose sight of the fact that the gas that we put in our tanks is the product of an incredibly complicated, worldwide network of countries, companies, and individuals who, using advanced technology and science, take crude oil from under the ground or under the seas, then put it in tankers the size of two football fields, ship it across oceans or through long pipelines to ports in the United States, pipe it into refineries, heat it under the most dangerous circumstances, and produce gasoline in that process. That gas is then piped or barged across the country to terminals where trucks unload and deliver it to individual gas stations. It is an amazing process that goes on day after day, hour after hour--24/7, as they say--to enable America's ready access to the liquid that makes our lives run. With the central role that gas plays in all of our lives, it is no wonder that the public is highly attuned and sensitive to its price. And when the price of gas jumps dramatically at the pump without any apparent reason, and when all stations regardless of brand appear to raise and lower their prices at the same time and by the same amount, the public understandably gets suspicious. That is what happened over 11 months ago when we started this investigation. The Midwest had just experienced for the second year in a row a price spike leading into the Memorial Day holiday. Exhibit 1 \1\ over to my left shows those gas spikes. Exhibit 11 \2\ shows the 2001 spike and shows that it was not due to increases in the price of crude oil. Exhibit 11 over there is the one that is on the left, and Exhibit 1 is the one that is on the right. Consumers were upset. They didn't trust the answers from the oil companies that the price spikes were just supply and demand at work. --------------------------------------------------------------------------- \1\ See Exhibit No. 1 which appears in the Appendix on page 250. \2\ See Exhibit No. 11 which appears in the Appendix on page 260. --------------------------------------------------------------------------- Since the spikes in spring of 2000 and 2001, the Midwest also witnessed a Labor Day price spike last year, and nationwide, gas prices have increased in the last few months faster than at any time in the past 50 years. Price spikes are becoming a way of life in the United States and not without serious consequences. As we can see from the next exhibit, Exhibit 3,\3\ at the same time approximately each year not only does the groundhog look for his shadow but for rising gas prices as well. But there are serious consequences to this new pattern. Sudden increases in gasoline prices are costly to the consumer and disrupt our economy, because the cost of transportation, which is based on the cost of fuel, affects the cost of all of our goods and services. Last year's increases in the price of gasoline helped push the American economy into a recession, and this year's increases are threatening the current recovery. --------------------------------------------------------------------------- \3\ See Exhibit No. 3 which appears in the Appendix on page 252. --------------------------------------------------------------------------- For every 1 cent per gallon increase in the price of gas, the income to oil companies goes up $1 billion a year. To try to get to the bottom of questions about gas prices, I asked the staff of our Permanent Subcommittee to investigate just how gas prices are set. After an extensive investigation, the Majority staff of the Subcommittee issued a 400-page report laying out their findings. The report looks in detail at three regions of the country: The West Coast (California in particular); the Midwest (Michigan, Ohio, and Illinois in particular); and the East Coast (Maine and the Washington, DC, area in particular). The Majority staff found that the mergers in the oil industry over the last few years and the closing of many refineries over the past 20 years have increased the concentration in the refining industry, that is, there are far fewer refining companies. And as we can see from Exhibit 4,\4\ there have been many, many mergers that have been approved in recent years. And just to list a few of them, in 1998 Marathon and Ashland Oil merged their downstream assets; in 1998, British Petroleum (BP), merged with Amoco; in 1999, Exxon Corporation merged with Mobil Corporation; in 2000, BP Amoco acquired ARCO. Many of these are mega-mergers. --------------------------------------------------------------------------- \4\ See Exhibit No. 4 which appears in the Appendix on page 253. --------------------------------------------------------------------------- Under one accepted test for concentration, 28 States would now be considered tight oligopolies. Now, Exhibits 7 and 8 \5\ will demonstrate this. As you can see from these two exhibits, which use the 4-firm concentration ratios--and that is an accepted measurement of concentration of oil companies and their control of the market in a particular area--there has been a dramatic increase in the number of States with high levels of concentration between 1994 and 2000. In fact, the number of States which have a high level of concentration have doubled from 14 to 28 during those 6 years. --------------------------------------------------------------------------- \5\ See Exhibits No. 7 and 8 appear in the Appendix on pages 256 and 257. --------------------------------------------------------------------------- The red areas show the levels at which the numbers reflect a tight oligopoly, which is a 4-firm concentration ratio of more than 60 percent of the market. And as you can see from these charts, the District of Columbia is the most concentrated market, followed by Hawaii, Alaska, and a number of States in the Midwest, including my home State of Michigan. As is true in this industry, as in any other industry, the more competition, the better for the consumer; the less competition, the worse for the consumer. But when an industry is concentrated, individual companies can have a significant effect on the price of a product, like gasoline, by the decisions that they make on supply. And that is what is happening today, in a number of markets, at least, in the United States. The reality is that a tight balance between demand and supply and low inventories are major contributors to price spikes, because in that tenuous condition, with the demand for gas being inelastic, that is, staying pretty constant despite the price, two things happen: In normal times when the market is concentrated, prices can be spiked before holidays, for instance, with less fear of competition driving it back down; and in times when there is a market disruption, the market responds wildly to the slightest problem or potential problem. We experienced major price spikes in the Midwest in just 2 years for these reasons. Internal documents from several oil companies confirm that oil companies view it to be in their economic interest to keep gas inventories low and supply tight. Several documents from California show that refiners in California sought in the mid- 1990's to prevent imports into California in order to make the market tight. One external Exxon memo advises the company to ``not do deals that supports other's importing barrels to the West Coast.'' Similarly, an internal Mobil memo counsels against importing gasoline, saying that it would depress profit margins. California refiners also sought to limit the overall refinery capacity in that State. One Mobil document talks about how to block the proposed startup of the Powerine refinery. ``Needless to say, we would all like to see Powerine stay down.'' It then proposes accomplishing this by buying all its product and marketing it themselves. ``Especially,'' this memo says, ``if they start to market below our incremental cost of production.'' And then the memo notes that buying Powerine's product the previous year had worked and it was ``a major reason that the RGF premium''--the reformulated gas premium--``. . . went from 1 cent per gallon to 3 to 5 cents per gallon.'' A Texaco memo discusses how to use changes in fuel specifications to reduce supplies. The memo says, ``Significant events need to occur to assist in reducing supplies and/or increasing the demand for gasoline.'' One example of a significant event, the memo says, would be to seek the elimination of the requirement for an oxygenate which, the memo says, would make oxygenate usage go down, which would then have to be replaced by gasoline and, therefore, reduce the supply of gasoline. The memo says, ``Much effort is being exerted to see that this happens in the Pacific Northwest.'' California refiners also exported gas, that is, shipped gas out of California--to keep the market in that State tight. An ARCO internal document discusses the need to export to prevent supply from building up in the State. The memo indicates that ARCO should export in order to intentionally alter the supply/demand balance within California and not just as a passive response to prevailing economic conditions. In that same presentation, one strategy discussed is to ``exchange and trade selectively to preserve market discipline.'' Another document in the Subcommittee files indicates that one company would export gasoline out of California to the Gulf Coast, even at a loss, with the rationale that such losses ``would be more than offset by an incremental improvement in the market price of the much larger volumes of [gas] left behind.'' Another company's plan indicates that exporting gasoline can ``improve market conditions,'' and that the company was willing to ``take [a] hit on price to firm up the market.'' An internal BP document from 1999 reflects similar thinking with respect to the Midwest. The document reflects a discussion among senior BP executives of possible strategies to increase refining margins by reducing the supply of gasoline in the Midwest. It discusses ``opportunities'' to increase Midwestern gas prices by 1 to 3 cents per gallon by reducing the supply of gasoline. Options included: Shutting down refining capacity; convincing cities outside of the Midwest to require reformulated gas that was not readily available in their areas, thereby pulling supplies from the Midwest; exporting product to Canada; lobbying for environmental regulations that would slow down the movement of gasoline in pipelines; shipping products other than gasoline in pipelines; and providing incentives to others not to provide gasoline in Chicago. BP officials told the Subcommittee staff that these ideas were only part of a ``brainstorming'' session. Well, what they were brainstorming about at a high level was manipulating supply in ways that are deeply troubling, and we will go through that document in some detail later this morning. In another document from the Midwest, an internal Marathon document, Marathon even called Hurricane Georges a ``helping hand'' to oil producers because it ``caused some major refinery closures, threatened offshore oil production and imports, and generally lent some bullishness to the oil futures market.'' And that is the heart of the problem with respect to gas prices in the United States, at least in certain regions of the country. The refining market is so concentrated that oil companies can act to limit supply and from time to time spike prices to maximize profits, and because there is insufficient competition, and other companies' supplies are also kept tight, there is little to no challenge to that action. That is the major problem, or at least one major problem, as I see it. The ability to control supply allows oil companies to spike prices in a concentrated market without adequate competition to challenge them. And, also, the few companies that control the market often keep their prices in sync with each other, going up and down together in a fixed relationship to each other. That is another part of the staff analysis. Most oil companies and gas stations, at least in these concentrated markets, try to keep their prices at a constant price differential with respect to one or more competitors. For example, one company decided that its station in Los Angeles should price the lower of ARCO stations plus 6 cents per gallon, or the average price of major branded stations in the area. Another oil company followed a pricing policy in Baltimore as follows, ``We will initiate upward, we will follow Amoco, and Shell quickly.'' Different companies' prices in specific markets tend to go up and down together, with companies tending to stake out a position in each market vis-a-vis the competitors and holding that position. Hence, it will often appear that, over time, gasoline prices in that market move together in a ribbon-like manner, so that as a brand moves up and down, it nevertheless remains at a constant differential with respect to other brands. Look at the retail pricing chart for Illinois for June 2001, and one from Maine for January to August 2002. Those are Exhibits 9 and 10,\1\ and you see that ribbon-like move with brands of gasoline staying in the same relationship to each other price-wise as prices go up and down. --------------------------------------------------------------------------- \1\ See Exhibits No. 9 and 10 appear in the Appendix on pages 258 and 259. --------------------------------------------------------------------------- In Michigan and Ohio we found a clear leader-follower pricing practice. Speedway, owned by Marathon, has a pricing practice that bumps up the retail price of gasoline on Wednesdays and Thursdays, and that is Exhibit 2.\2\ As the price leader in Michigan, once Speedway goes up, the other brands follow. And you can see those bumps on that chart on the right. The typical pattern after that is for Speedway to come down pretty quickly in price, while the other brands follow them down more slowly. Other companies follow similar practices in other areas. --------------------------------------------------------------------------- \2\ See Exhibit No. 2 which appears in the Appendix on page 251. --------------------------------------------------------------------------- The Majority staff report also addresses several other important issues with respect to gasoline pricing, including zone pricing, recommended retail prices, the advent of hyper- markets, which are the discount superstores like Wal-Mart and Cosco that now sell the lowest priced gasoline in the market, and the impact of boutique fuels, which are fuels required for specific locations to address particular environmental situations. This morning we are going to hear from top marketing executives of five major oil companies: Marathon Ashland, British Petroleum or BP, ExxonMobil, ChevronTexaco, and Shell Oil. And then on Thursday, we will hear from Senator Wyden, who has been looking into the subject of gas prices for a long time; from three Attorneys General (the Attorneys General from California, Connecticut, and Michigan), all of whom have been active in challenging gasoline price increases in their States; and we will hear from a panel of economists and industry experts on the issues that are raised in the report. I want to just take a moment to say a special thanks to the Majority staff who worked so hard on this report and put together such a thorough product. I also want to express my appreciation to Senator Collins and her staff for their support and to Senator Durbin and his staff, who assisted in the interviews. When you think about the complexity of the issues and the size of this industry and the task of reading through tens of thousands of pages of material, a small team produced a well- written report in less than a year, and we are grateful to them for that effort. [The prepared statement of Senator Levin follows:] STATEMENT OF SENATOR CARL LEVIN Good morning ladies and gentlemen. Today the Permanent Subcommittee on Investigations opens two days of hearings on how gas prices are set in the United States. Gas is the lifeblood of our economy, and through luck, pluck, hard work and ingenuity we've been able to have the gasoline we need in this country. Most of us take for granted the fact that in most urban areas, we can go a few blocks and find a gas station that has gas and with the five minutes it now takes to fill up our tanks, we can be off and about our business in no time. It's easy to lose sight of the fact that the gas we put in our tanks is the product of an incredibly complicated, worldwide network of countries, companies, and individuals who, using advanced technology and science, take crude oil from under the ground or under the seas, put it in tankers the size of two football fields, ship it across the ocean to ports in New York, California, and the Gulf Coast, pipe it into refineries, heat it under the most dangerous circumstances and produce gas in that process. That gas is then piped or barged across the country to terminals where trucks unload it and deliver it to individual gas stations. It's an amazing process that goes on day after day, hour after hour, 24-7 as they say, to enable America's ready access to the liquid that makes our lives run. With the central role that gas plays in all of our lives, it is no wonder that the public is highly attuned and sensitive to its price. And when the price of gas jumps dramatically at the pump without any apparent reason, and when all stations regardless of brand appear to raise and lower their prices at the same time and by the same amount, the public gets suspicious. That's what happened over 11 months ago when we started this investigation. The Midwest had just experienced for the second year in a row a price spike leading into the Memorial Day holiday. (Exhibits 1 and 2) Consumers were upset; they didn't trust the answers from the oil companies that the price spikes were just supply and demand at work. In Michigan, the price of gas seemed to leap up overnight by the same amount across all brands of gas at all stations. If there were real competition in the industry, people asked, why would the prices of different brands go up and down together and just before the holidays? Since the spikes in spring of 2000 and 2001, the Midwest has also witnessed a Labor Day price spike last year and nationwide, gas prices have increased in the last few months faster than at any time in the past 50 years. Price spikes are becoming a way of life in the United States and not without serious consequences. (Exhibit 3.) At the same time each year not only does the groundhog look for his shadow but for rising gas prices as well. But there are serious consequences to this new pattern. Sudden increases in gasoline prices are costly to the consumer and disrupt our economy, because the cost of transportation, which is based on the cost of fuel, affects the cost of all our goods and services. Last year's increases in the price of gasoline helped push the American economy into a recession, and this year's increases are threatening the current recovery. Increased gas prices also represent a significant shift in wealth. For every 1 cent/gallon increase in the price of gas, the income to the oil companies goes up $1 billion a year. To try to get to the bottom of questions about gas prices, I asked the staff of our Permanent Subcommittee to investigate just how gas prices are set. After interviewing representatives from the oil companies, distributors, service station owners and dealers, trade association representatives, lawyers and economists; after analyzing data from the Energy Information Administration and wholesale and retail price data purchased from the Oil Price Information Service; after reviewing over 250,000 documents subpoenaed from a number of major oil companies and one pipeline company, the Majority Staff of the Subcommittee issued a 400 page report yesterday laying out their findings. The report includes an analysis of the operations and structure of the oil industry with particular focus on the downstream portion--that is, from the refinery to the pump. Due to staff and time constraints, the staff looked in detail at just three regions of the country: the West Coast (California in particular); the Midwest (Michigan, Ohio and Illinois, in particular); and the East Coast (Maine and the Washington, D.C. area, in particular). The Majority Staff's findings are contained in the Executive Summary at the front of the report and provide the basis for these two days of hearings. (For those unable to obtain a hard copy, the report is available on the PSI website.) The Majority Staff found that the mergers in the oil industry over the last few years and the closing of many refineries over the past 20 years have increased the concentration in the refining industry, that is there are fewer refining companies. (Exhibit 4.) Under one test for concentration in at least 9 states the refining and marketing industry is highly concentrated and in at least 28 states it is at least moderately concentrated. Under another test for concentration, 28 states would be considered tight oligopolies. Let me explain. The Department of Justice and the Federal Trade Commission measure market concentration in two ways. One is the Herfindahl-Hirshman Index or HHI; the other is the 4-firm concentration ratio. The report describes how each of these measures of concentration works. This morning, we have charts showing these measures for all 50 states and the District of Columbia. (Exhibits 5-8.) As you can see from these charts, there's been a dramatic increase in the number of states with moderate to high levels of concentration between 1994 and 2000. The red areas show the levels at which the numbers reflect high concentration. Under Department of Justice Guidelines, an HHI of between 1000 and 1800 is ``moderately concentrated,'' and an HHI over 1800 is considered to be ``highly concentrated.'' A 4-firm concentration ratio of more than 60 percent shows a ``tight oligopoly.'' As you can see from these charts, D.C. is the most concentrated market, followed by Hawaii, Alaska, and a number of states in the Midwest; my home state of Michigan is considered a ``tight oligopoly'' under the 4-firm ratio and just below ``highly concentrated'' using the HHI index. As is true in this industry as in any other, the more competition, the better for the consumer; the less competition, the worse of the consumer. But when an industry is concentrated, individual companies can have a significant effect on the price of a product, like gasoline, by the decisions they make on supply. That's what's happening today, in a number of markets in the United States. The reality is, that a tight balance between demand and supply and low inventories are major contributors to price spikes, because in that tenuous condition, with the demand for gas being inelastic, that is, staying pretty constant despite the price, two things happen: 1) in normal times when the market is concentrated, prices can be spiked before holidays, for instance with less fear of competition driving it back down; 2) in times when there is a market disruption, the market responds wildly to the slightest problem or potential problem. We experienced major price spikes in the Midwest in just two years for those reasons. Let's walk through each of those prices spikes. Low inventories have helped to create the conditions for price spikes in the Midwest, which have occurred when demand has increased (near driving holidays) and/or the supply of gasoline was disrupted. Not unlike oil companies nationwide, oil companies in the Midwest have adopted just-in-time inventory practices, resulting in crude oil and product stocks that frequently are just above minimum operating levels. And, in the spring of 2000 and 2001, the conversion from the production and supply of winter-grade gasoline to summer-grade gasoline further contributed to low inventories just prior to a seasonal increase in demand. With the stage set by those two factors, the oil companies took actions over these past two years in accordance with their profit maximizing strategies that significantly contributed to the price spikes when disruptions in supply occurred: --During the spring of 2000, three major refiners determined it wasn't in their economic self interest to produce any more RFG [reformulated gas] than that required to meet the demands of their own customers, and so in that year they produced 23% less RFG than in the prior year, not enough to supply everyone who wanted to purchase it. That contributed to the short supply in the spot market for RFG, contributing to the price spike of spring 2000. While Marathon did have surplus RFG, it withheld some of it from the market so as to not lower prices. --In the summer of 2001, major refiners deliberately reduced gasoline production, even in the face of unusually high demand at the end of the summer driving season, contributing significantly to the price spike of 2001. Nationwide, in the winter of 2001-2002, demand fell and inventories rose following the tragic events of September 11, 2001. With reduced demand and higher inventories, prices fell. As a result, refining profits fell and refiners cut back on production in order to obtain higher profits. Along with the increase in the price of crude oil and market speculation, these reductions in production and the increase in industry concentration significantly contributed to the run-up in price in the late winter and continuing into the early spring of this year. Internal documents from several oil companies confirm that the oil companies view it to be in their economic interest to keep gas inventories low and the supply and demand balance tight. Several documents from California show that refiners in California sought in the mid-90's to prevent imports into California in order to make the market ``tight.''
One internal Exxon memo advises the company to ``not do deals that supports other's importing barrels to the West Coast.'' Similarly, an internal Mobil memo counsels against importing gasoline, saying it would depress margins. California refiners also sought to limit the overall refinery capacity in the state. One Mobil document talks about how to block the proposed startup of the Powerine refinery. ``Needless to say,'' the memo says, ``we would all like to see Powerine stay down.'' It then proposes accomplishing this by buying all its product and marketing it themselves. ``Especially,'' the memo says, ``if they start to market below our incremental cost of production.'' The memo then notes that buying Powerine's product the previous year, when it was below Mobil's ``incremental cost of production'' had worked and it was ``a major reason that the RFG premium . . . went from 1 cent per gallon to 3-5 cents per gallon.'' A Texaco memo discusses how to use changes in fuel specifications to reduce supplies. The memo says, ``Significant events need to occur to assist in reducing supplies and/or increasing the demand for gasoline.'' One example of a significant event, the memo says would be to eliminate the requirement for an oxygenate which, the memo says, would make oxygenate usage go down which reduces total volume of gasoline supplies. The memo says, ``Much effort is being exerted to see that this happens in the Pacific Northwest.'' California refiners also exported gas--that is, shipped gas out of California--to keep the market in that state tight. An ARCO internal document discusses the need to export to prevent supply from building up in the state. The memo indicates that ARCO should export in order to intentionally alter the supply/demand balance within California and not just as a passive response to the prevailing economic conditions. In that same presentation, one strategy discussed is to ``exchange and trade selectively to preserve market discipline.'' Another document in the Subcommittee files indicates that one company would export gasoline out of California to the Gulf Coast, even at a loss, with the rationale that such losses ``would be more than offset by an incremental improvement in the market price of the much larger volumes of [gas] left behind.'' Another company's plan indicates that exporting gasoline can ``improve market conditions,'' and that the company was willing to ``take [a] hit on price to firm up market.'' An internal BP document from 1999 reflects similar thinking with respect to the Midwest. The document reflects a discussion amongst senior BP executives of possible strategies to increase refining margins, and it mentions ``significant opportunities to influence the crude supply/demand balance.'' It notes that these ``opportunities'' can increase Midwestern prices by 1 to 3 cents per gallon.'' The memo discusses strategies to reduce the supply of gasoline in the Midwest. It lists some possible options, including: shutting down refining capacity, convincing cities to require reformulated gas that is not readily available, exporting product to Canada, lobbying for environmental regulations that would slow down the movement of gasoline in pipelines, shipping products other than gasoline on pipelines that can carry gasoline, and providing incentives to others not to provide gasoline in Chicago. BP officials told the Subcommittee staff that these ideas were only part of a ``brainstorming'' session and that none of the options for reducing supply were adopted. We'll go through this document in some detail later this morning. In another document from the Midwest, an internal Marathon document, Marathon even called Hurricane George a ``helping hand'' to oil producers because it ``caused some major refinery closures, threatened off-shore oil production and imports, and generally lent some bullishness to the oil futures market.'' And that is the heart of the problem with respect to gas prices in the United States today--in certain regions of the country--the refining market is so concentrated, that oil companies can act to limit supply and from time to time spike prices to maximize profits, and because there is insufficient competition, there is little-to-no challenge to that action. That's the major problem as I see it. The ability to control supply allows oil companies to spike prices in a concentrated market without adequate competition to challenge them. The Majority Staff made some other significant findings. Oil companies do not set wholesale (rack) or retail prices based solely upon the cost to manufacture and sell gasoline; rather wholesale (rack) and retail prices are set on the basis of market conditions, including the prices of competitors. Most oil companies and gasoline stations try to keep their prices at a constant price differential with respect to one or more competitors. For example one company decided that its station in Los Angeles should price the lower of ARCO stations plus 6 cents per gallon, or the average price of major branded stations in the area. Another oil company followed a pricing policy in Baltimore as follows: ``We will initiate upward, we will follow Amoco, Shell quickly . . . we will be slow to come down in a dropping market.'' Because many oil companies and gasoline retailers set their retail price on the basis of the prices of their retail competitors, prices in each specific market tend to go up and down together. And oil companies tend to stake out a position in each market vis-a-vis the competitors and hold that position. Hence, it will often appear that, over time, gasoline prices in that market move together in a ``ribbon-like'' manner--so that as a brand moves up and down it nonetheless remains at a constant differential with respect to the other brands. Look at this retail pricing chart for Illinois for June 2001, and this one from Maine for January-August 2001. (Exhibits 9 and 10.) In Michigan and Ohio we found a clear leader-follower pricing practice. Speedway, owned by Marathon, has a pricing practice that bumps up the price of gasoline on Wednesdays or Thursdays. As the price leader in Michigan, once Speedway goes up, the other brand follows. The typical pattern after that is for Speedway to come down in price pretty quickly, while the other brands follow them down more slowly. You can see this very clearly in these charts from January to August 2001 and April 2001. (Exhibits 11 and 12.) Oil companies also use a system of what they call ``zone pricing'' in order to maximize the prices and revenues at each gas station. Since under the antitrust law, they are prohibited from selling wholesale product at a different price to similarly situated retailers, the oil companies have developed a system for differentiating among retailers in the same immediate area. In doing so, they can charge the retailers different wholesale prices for their gasoline. The way they accomplish this is by dividing a state or region into zones. A zone is supposed to represent a particular market, and the stations in that zone are supposed to be in competition with each other. The oil companies use a highly sophisticated combination of factors to identify particular zones. For example, if most people buy their gas on their way home from work instead of on their way to work, a station on one side of a rush hour street may be treated as in one zone and the same brand station on the other side of the street in another zone. The oil company will then charge those two gas stations different prices for their gasoline, because the station on the side of the street with easy access for evening rush hour traffic may be able to get a higher price for its gas than the station on the other side of the street. That's the kind of thinking that goes into the zone pricing system, and it allows the oil companies to charge the highest possible amount for their gas in a given area. Another pricing practice the Majority Staff uncovered has to do with how gas station owners set their retail prices. The Majority Staff learned that for those stations that lease from a major oil company (about one-fourth of the 117,000 branded stations) the oil company actually recommends to the station dealer a retail price. Now by law, the oil company is prohibited from telling a lessee dealer what it can charge for gasoline, but that doesn't keep oil companies from ``recommending'' a price. And the Majority Staff was told by several dealers that if they don't charge their retail customers the recommended price, the next delivery of gas from the oil company will reflect any increase instituted by the dealer. These dealers are saying that if they decide to price their gas at $1.40/gallon when the oil company recommends $1.35, the next delivery of gasoline to the station (and deliveries are sometimes daily for busy stations) will have a 5 cent/gallon increase in the price to the retailer. If these allegations are true, then the practical effect would be that the recommended price is subtly or not so subtly being enforced. The Majority Staff report also address several other important issues with respect to gasoline pricing--including the advent of hypermarkets, those are the discount super-stores like Wal-Mart and Cosco that now sell the lowest priced gasoline in the market; and the impact of boutique fuels, fuels required for specific locations to address particular environmental situations. This morning we will hear from the top marketing executives of five major oil companies: Marathon Ashland, BP, ExxonMobil, ChevronTexaco, and Shell Oil. On Thursday we will hear from Senator Wyden, who has also been looking into the subject of gas prices; three Attorneys General, from California, Connecticut and Michigan, all of whom have been active in challenging gasolines price increases in their states; and we will hear from a panel of economists and industry experts on the issues raised in the report. I want to take this opportunity to say a special thanks to the Majority Staff who worked so hard on this report and put together such a thorough product. The Subcommittee's thanks go to Dan Berkovitz, the lead writer of the report; Laura Stuber, counsel to the Subcommittee who oversaw the dozens of interviews with individual gas station owners and operators and ably drafted portions of the report and oversaw its development; Edna Curtin, a detailee from the General Accounting Office who did a substantial portion of the price analysis and chart development; Cliff Tomaszewski, a detailee from the Department of Energy who provided background research on the oil industry and the production and marketing of gasoline; Bob Roach, chief investigator who was responsible for the discussion of the Wolverine Pipeline case; and Mary Robertson, the Subcommittee's Chief Clerk who again, amazed us all with her ability to pull together a complex report for production. I also want to express my appreciation to Senator Collins and her staff for their support and to Senator Durbin and his staff who assisted in the interviews. It has been a team effort, and when you think about the complexity of the issues, the size of the industry, and the task of reading through tens of thousands of pages of materials, it is highly impressive that such a small team produced such a well-written report in less than a year. Senator Levin. Senator Collins. OPENING STATEMENT OF SENATOR COLLINS Senator Collins. Thank you, Mr. Chairman. First, let me thank the Subcommittee Chairman, Senator Levin, for convening these hearings to examine the pricing of gasoline and the causes of price spikes. Oil and gasoline are vital to virtually every aspect of our economy, which depends on stable and reasonable energy prices to prosper. Consumers are justifiably concerned and confused about the high price of gasoline. From the first week to the last week of March, for example, gasoline prices rose about 23 cents per gallon nationwide. This increase is a record for a 4-week period. This price jump is particularly noteworthy as it pre- dates both the seasonal transition from winter to summer gasoline that takes place beginning May 1, as well as the beginning of the driving season that typically starts around Memorial Day. While price spikes have been most dramatic in the Midwest, Maine and other regions of the country have not been immune to price spikes and price volatility. In recent weeks, gas prices in Maine have edged up sharply, with recent price increases ranging from 8 to 20 cents in just 1 week's time. Just as inexplicable are gasoline prices that are significantly higher in one Maine town than in other towns further from supply points. High gasoline prices have a negative effect on the U.S. economy overall, but particularly on low-income families and small businesses. Geographically, Maine is a large State, and many Mainers have to commute long distances to get to work, to go to school, and to go shopping. Gasoline prices affect all sectors of the economy by raising the cost of transportation. I have met frequently with truckers, for example, in my State who talk about the impact of rising diesel prices on their ability to earn a living. As our country struggles to strengthen the economy, it is vital that high gasoline prices or price spikes not derail these efforts. The gasoline industry has changed dramatically over the past 20 years. Perhaps the most significant change that has occurred is the increased concentration in the industry that the Chairman has mentioned, including such mergers as Marathon and Ashland Oil; Exxon and Mobil; BP and Amoco, and then ARCO; and Chevron and Texaco, to name just a few. The two largest mergers, I would note, between Exxon and Mobil, and BP and Amoco, were approved during the Clinton Administration, as was the Marathon and Ashland Oil merger. Clearly these mergers have had an impact on competition within the marketplace. This trend has resulted in increasingly concentrated refining and marketing industries, which can then result in higher prices for consumers. According to the 2002 annual report on competition in the retail petroleum markets prepared by Maine's Attorney General, Maine's gasoline markets are relatively concentrated, which means that the level of competition within these markets is generally low. Maine's more rural counties tend to be extremely concentrated, meaning that there is even less competition. Competition is more healthy in the more populous areas of my State. Overall, however, the Attorney General's report indicates that concentration has been inching up gradually over the past few years, a troubling development. Another change is the closure of more than half of the refineries in the United States. Yet refining capacity has remained nearly what it was before the refinery closures. This is due to increased efficiencies and a very high rate of capacity operation, about 96 percent. By contrast, the average capacity utilization rate in other U.S. industries is 82 percent. This means that the 150 refineries still operating in the United States are responsible for producing ever more product as demand continues to grow. It also means that there is no room for error, either through a refinery breakdown or a demand miscalculation on the part of refiners. Yet another significant development has been the proliferation of gasoline blends. Prior to 1995, only conventional gasoline was sold in the United States. Now there are more than 16 different blends of gasoline due to various Federal, State, and local fuel requirements. As a result, when an area has a supply disruption due, for example, to a refinery fire or a pipeline rupture, it is more difficult to meet the demand with gasoline from another area, particularly if one of those areas also requires a unique blend. Many of Maine's gasoline distributors have told me that they are very concerned about the impact of the proliferation of gasoline blends and the difficulties this creates in getting enough of the appropriate type for each market. Not only do the number of blends make it harder to get each type of gasoline for each market, but it also creates the need for additional infrastructure. In particular, terminals need more tanks to store each type of gasoline. These are other costs that are undoubtedly passed on to the consumer in the form of higher prices, and I want to explore with our witnesses the impact of boutique fuels on prices. In Maine, we have two types of gasoline. Conventional gasoline is sold year round in much of the State. But during the summer, in the southern counties, because of concerns over water quality, we use a State-required blend that helps to improve water quality, yet doesn't appear to result in as severe groundwater pollution as the Federal reformulated fuel. In Massachusetts, eastern New Hampshire, and Connecticut, however, Federal RFG is sold, which makes a total of three types of gasoline required in just one small corner of New England. Today we will hear testimony from representatives of several of the largest oil companies. I look forward to discussing with them the increased concentration in the industry, which I view as a negative development, as well as to hear their explanation of gasoline price spikes and the recent price hikes that people in Maine have been experiencing, as well as citizens elsewhere. I look forward to hearing what can be done to avert price spikes that cost consumers millions of dollars and threaten our economic recovery. Senator Levin. Thank you, Senator Collins. We will use the early-bird rule here. Senator Akaka. OPENING STATEMENT OF SENATOR AKAKA Senator Akaka. Thank you very much, Mr. Chairman. I want to thank you for holding the first of 2 days of hearings on this very important and timely matter. The rising cost of gasoline across the United States is alarming, and I applaud your efforts to uncover the reasons for this trend so that we may devise a plan to protect American consumers. I would like to take this opportunity to thank you for this report and the good work by your staff. High gasoline prices are not new to Hawaii. According to the Subcommittee report, Midwestern gasoline prices spiked to the highest in the Nation during the spring of 2000 and 2001. During this time, prices in the Midwest eclipsed those in the State of Hawaii to earn the dubious distinction of highest in the Nation. For more than 20 years, Hawaii has consistently had the highest gasoline prices in the Nation. From 1995 through the first half of 1998, gasoline prices in Hawaii averaged more than 30 cents per gallon higher than the U.S. mainland prices. We don't have price spikes in Hawaii. We have had one long continuous spike. On any day that you check www.gaspricewatch.com, you will find a gas station in Hawaii at the top of the list. On Monday, for example, the record for the highest price for regular unleaded gas in the Nation was held by a station in Pukalani, Hawaii, at $1.89 per gallon. According to the Attorney General of Hawaii, higher prices cannot be attributed to higher refining costs within the State of Hawaii or higher transportation costs to the State. For example, the price of gasoline in Hawaii has exceeded the cost of buying refined gasoline in California and transporting it to Hawaii by more than 20 cents per gallon. Moreover, the cost of transporting crude oil to Hawaii or refining gasoline in Hawaii is not higher than similar costs on the mainland. As such, the State's higher retail prices may be the result of having a highly concentrated market. Hawaii has only two refineries and four firms selling wholesale gasoline. This leaves the State with one of the highest concentration levels of refining and gasoline supply in the Nation--a significant problem according to your report, Mr. Chairman. Once again, Hawaii has the highest gasoline prices in the Nation. Just last week the American Automobile Association reported that the national average price of regular unleaded gasoline was $1.41 per gallon. At the same time the average regular unleaded gas price in Hawaii was approximately $1.69 per gallon. California was second with an average of $1.66 per gallon. Such high prices hurt the hard-working men and women in Hawaii and in the rest of the country. As your report states, this could push the American economy back into a recession. Currently Hawaii State lawmakers are seeking information on how gas prices are set as they look at ways to bring the State's gas prices more in line with the national average. Over the weekend a conference committee of the Hawaii State legislature reached an agreement on a bill to regulate gas prices in Hawaii. I understand that many other States are concerned with this issue and may be looking at similar proposals. I am hopeful that Chairman Levin's interest in gasoline prices will spur continued attention to this issue, specifically for States with higher prices such as Hawaii. Because Hawaii has such consistently high gasoline prices, it generally does not draw the attention that unusual price spikes command. I would like to know, and my constituents would like to know, what happens at the pump. Why are some States always faced with higher gasoline prices than others? I anticipate the testimony we receive today and the information in your report, Mr. Chairman, will aid in answering this critical question and lead to lower prices for States like Hawaii. Thank you very much, Mr. Chairman. Senator Levin. Thank you, Senator Akaka. Senator Lieberman. OPENING STATEMENT OF SENATOR LIEBERMAN Senator Lieberman. Thanks very much, Senator Levin. I want to commend you and your staff and Senator Collins and her staff for working so hard on a matter of such critical importance to the American economy and to millions of American consumers. You have produced a very substantive, thoughtful and important report, and as Chairman of the full Senate Governmental Affairs Committee, may I say I am very proud of the quality and constructiveness of this report. When gasoline gets dramatically more expensive, as it seems to do every spring, summer and other times of the year, all Americans pay the price. The entire economy feels the pinch. Just this spring, as the Permanent Subcommittee on Investigation's Report points out, retail prices have increased faster than at any time in the past 50 years. American consumers obviously remain wary of future price hikes, puzzled and angered by the forces that seem to make the price of gas as volatile as gasoline is combustible. They are not alone. Even those in government with a statutory responsibility to understand the energy industry have been working hard to learn precisely how gas prices are set. This Permanent Subcommittee on Investigation's Report is a major contribution to that effort, and it appropriately focuses our concentration on the oil industry's growing concentration. Over the past 20 years and particularly over the past 5 years, big oil companies have been merging, and these larger and larger corporations have been squeezing small refineries out of the market. They are also controlling more and more gas stations, setting prices and carving out market share through sole supplier agreements and zone pricing plans. But the American consumer is often left at the short end of the pump, at the mercy of wild price fluctuations and big price spikes. That is made worse by the fact that while their own pocketbooks are being pinched, consumers see the oil companies making huge profits. As PSI's report points out, the increase in gas prices from 1999 to 2000 had been matched only once in history, and the year 2000 income for major energy companies from refining and marketing was up 57 percent from 1999. In other words, the hundreds of additional dollars paid by the average consumer for gasoline resulted in unusually large profits for the oil industry. Over the course of a year every 10-cent increase in the price of gasoline results in approximately $10 billion in additional oil company revenues. Now, a free market economy like ours is a wonderful thing, but the price of that freedom, as we have learned from the Enron debacle, is constant vigilance against market abuses. And the question before us today is: Are the interests of consumers being served by the increasing domination of the gasoline and oil markets by fewer and fewer large companies? Each of the mergers that has changed the landscape of the oil industry has been approved by the Federal Trade Commission, but given the effects of these mergers on the marketplace, it does seem to me to be worth asking whether the Federal Trade Commission is using all the right criteria for evaluating these mergers, and whether its policy of ordering newly-merged companies to divest their refineries is in fact good for the American consumer. The net effect of those divestitures, as has been pointed out, has been to reduce the responsiveness of the marketplace when demand goes up and therefore increase the likelihood of price spikes. As William Baer, then Director of the FTC's Bureau of Competition, said in 1999, ``Competition is critical to this industry, and that concentration, as well as increases in concentration, even to the levels that the antitrust agencies call moderately concentrated, can have substantial adverse effects on competition.'' The main point being that concentration can have adverse effects, and from this report certainly appears to have had such effects on competition. Mr. Chairman, I want to conclude by pointing out how critical an energy policy priority today's hearing should underline, and that of course is energy diversification. The tremendous volatility of gas prices is in part the result of volatility of global politics and economics. We have had turmoil in Venezuela, fourth largest provider of imported American oil. We have had, obviously, a serious and ongoing crisis in the Middle East. So that even in a maximally competitive and healthy marketplace, these global changes would make oil prices volatile, and therefore would put periodic price pinches on American gasoline consumers. That calls on us to have the foresight to diversify our energy supply to plan new sources of energy, rather than continuing our long-term reliance on oil so that the U.S. economy and policy is not at the mercy of such fluctuations. The energy bill passed by the Senate last week, in my opinion, offers us an opportunity to start doing that. But let me come back to the beginning, Mr. Chairman. I thank you and your staff for an extraordinary piece of work that is clearly in the public interest. Thank you very much. Senator Levin. Thank you very much, Senator Lieberman. Senator Carnahan. OPENING STATEMENT BY SENATOR CARNAHAN Senator Carnahan. Thank you, Mr. Chairman. If you were to ask most Americans what the current price of gasoline is, I am certain that they would be able to tell you. They can probably even tell you what the price is at two different stations in comparison. Americans pay attention to gas prices. Why? Because travel, and thus fuel, impact virtually every part of their lives, from driving to work, to taking the kids to after-school activities, to whether or not they can afford a family vacation. And the ripple effects of gas price spikes extend to businesses as well. As gas prices rise, costs to businesses also increase. And when the cost of doing business is greater, someone has to pay. Whether directly or indirectly, gas prices have a tremendous impact on the American family's bottom line. Consumers are the ones that bear the burden of spikes and increases in gas prices. For those living on a fixed income, like most seniors in Missouri, the price spikes have an even greater negative effect. Last summer, for the second year in a row, the Midwest experienced significant increases and fluctuations in gas prices, and we want to know why. So I applaud Senator Levin for initiating and overseeing this investigation. When constituents ask why our gas prices are increasing, they deserve an answer, and this report provides that answer. However, that answer is complex, and we find it is not just one factor that is the cause, but rather, a set of market trends that have combined to cause price spikes. Several of these trends are troubling. First is the more frequent fluctuation in gas prices. Oftentimes prices fluctuate more in a month than they previously did in years. Second, there is the refiners' ability and willingness to influence prices by controlling supply. And third, the decrease in competition brought on by mergers in oil companies and with it an increase in prices. The message of this report is unsettling. The situation is worse than it has been in a long time, and there are no signs that these trends that have caused volatility will end any time soon. These are significant findings that we need to keep in mind as we develop policies that impact the gasoline market. In such a volatile and concentrated market, we must be vigilant on behalf of consumers. And I hope that this Subcommittee will continue monitoring this issue and help us to develop policies that protect our economy, our businesses, and our consumers. Thank you, Mr. Chairman. Senator Levin. Thank you very much, Senator Carnahan. Senator Voinovich. OPENING STATEMENT OF SENATOR VOINOVICH Senator Voinovich. Thank you, Mr. Chairman, for holding this hearing. The impact of high and unpredictable gasoline prices is a problem that has plagued consumers in my home State of Ohio for the past few years, and I would like to commend the Chairman for the time that you and your staff have put in on this important issue. I would also like to welcome our witnesses, particularly Gary Heminger, who is the President of Marathon Ashland Oil and who has a large installation in the State of Ohio, and one of our great corporate citizens; and Mr. Pillari, even though I am very unhappy with BP moving their North American Headquarters out of Cleveland, Ohio, to Chicago, you still have a large presence in our State. I will never forget that while I was Governor of Ohio, because of an enormous investment of money made by BP, we brought down the emissions in the Toledo area and helped us obtain our ambient air standards there which was very, very helpful. Two years ago the full Committee, at my request and several other Senators, held a series of hearings looking into this same issue: Gasoline price spikes. It is very interesting that the players have changed but the companies are the same here before us. At that time, politicians, analysts, and business owners were busy pointing to a whole host of reasons for the 2000 price hikes. Alleged price gouging and collusion among oil companies was one thing. Lack of domestic production, reformulated gasoline, economics and the law of supply and demand; pipeline and other transportation problems; you name it. At the time the Federal Trade Commission also was asked to investigate the Midwest gasoline price situation. I would like to point out that that was the Federal Trade Commission that was under the jurisdiction of President Clinton. I supported the investigation, because I believed that my constituents had the right to know why their gasoline prices were high and if the actions by the oil companies were behind the high prices. In March 2001 the FTC issued their report and found that there was no evidence of collusion. The report did find that the high gas prices were caused by a mixture of structural and operating decisions with primary factors including refinery production problems, low inventory levels, and pipeline breaks. And, Senator Levin, you and I experienced them. We had a break in the Wolverine pipeline coming down from Michigan and then there was another one, the Explorer coming up from Texas, that were both ruptured. The FTC report also found that the damage was minimized because the industry responded quickly with an increased supply of gasoline to the Midwest. Unfortunately, similar price increases were seen last year and we have seen similar gas prices this year and will, I am sure, see even more of them with what is going on in the Middle East and Persian Gulf. Well, there have been signs that gasoline prices are dropping. That is of little consolation to families in the Midwest where prices are still high. I am concerned about that, just like everyone else. I watch those gas station prices. Most people who have been around, as long as I have been, remember the Arab oil embargo of 1973, when costs went up, gas shortages were everywhere, and people sat in long lines to get gas. Some of the younger people in this country do not remember it. I remember it. At that time the United States only relied on 35 percent foreign oil to meet our domestic needs. Today our reliance on foreign oil averages 58 percent. And when we had the crisis a couple of years ago, it got up to over 60 percent. The American people want to know why nothing has been done in the last 29 years to reduce our dependence on foreign oil. In my opinion, we botched one opportunity when we in the Senate did not provide for exploratory drilling in ANWR. I have been around this business over 35 years. All too often in government, when a problem comes up, we have a tendency to treat it as if it were a barking dog. Give it a bone, a little attention and it stops barking, and when it stops barking, ignore it until it starts barking again. That is what we have done in this country in terms of the supply of gasoline. Such neglectful treatment of such a vital component of our Nation's economy is unconscionable. We lack an energy policy by this country, and hopefully we are going to have one by the end of this session. With the Senate's passage last week of the energy bill, I think we are one step closer to preventing these unpredictable gas price spikes. However, in my opinion, there are still many issues that must be addressed before we are going to be able to have a reliable and predictable gasoline supply. The report prepared by the Democratic staff of the Subcommittee recognizes that the number of refineries in this country went from a high of 324 in 1981 to 155 in 2001. Additionally, I think it is important to remind my colleagues that there have been no refineries constructed since 1976. Additionally, it is extremely unlikely that a new refinery will be built because of the difficulties with siting new refineries, many of them environmental, and many of them have to do with the rate of return on building a new refinery. I would like to hear from the witnesses why we cannot get more refineries built in the United States of America. In 1982 there were over 300 refineries in this country; just over 68 percent of their capacity was being utilized. Today our Nation's refineries operate at near peak capacity. If a refinery has a problem, you can almost see it immediately reflected in the price of gasoline. While increased refining capacity has increased by nearly 1 million barrels per day since 1986, that still does not replace the 3 million barrels per day that was lost in the closure of 120 refineries during the 1980's. At the same time I am concerned about our Nation's infrastructure for distributing gasoline. In 2000, distribution problems were one of the major contributing factors to the extreme price hikes experienced by my constituents. I already mentioned the two pipelines. Until they were back operating at full capacity, they significantly limited the amount of gasoline that was being brought into Ohio, resulting in higher prices. This situation is not unique. Nationwide our pipelines are operating at capacity, and if a break or other problem is experienced, then the gasoline being distributed to gas stations will be limited. The best way to eliminate this problem with our distribution system is to improve our infrastructure. Only by expanding pipeline capacity can we improve reliability and competition and lessen the risk of unexpected price hikes. Finally, I would like to point out that the report prepared by the Subcommittee focuses only on the downstream industry, leaving out one of the most variable factors in gasoline pricing, the price of crude oil. According to the Energy Information Administration, in March this year crude oil accounted for 41 percent of the cost of gasoline. Over the last 4 years crude oil prices have varied dramatically--listen to this--from $11 a barrel to $33 a barrel. It only makes sense that if you have significant differences in crude oil prices, then you will see price spike in gasoline. I would like to thank the witnesses for being with us today and I look forward to your testimony. Senator Levin. Thank you very much, Senator Voinovich. Senator Bunning. OPENING STATEMENT OF SENATOR BUNNING Senator Bunning. Thank you, Mr. Chairman. Gasoline is what makes this country move. We rely on it to get to work, pick up our kids from school, travel on business, and deliver goods and services to companies and homes across this country. Americans use 123 billion gallons of gasoline each year. Did you hear me? 123 billion gallons. In the Commonwealth of Kentucky we used about 2.1 billion gallons in the year 2000. We are all concerned about fluctuations in gasoline prices. It affects how much disposable income Americans have left over at the end of the week. It determines the health of our economy and the ability of businesses to operate. I routinely hear from Kentuckians who are concerned about gasoline prices, particularly after prices spiked last year post September 11. Gas companies and gasoline stations should be fair with their customers, and any activity like price gouging or collusion should not be allowed. There is probably no other commodity Americans regularly purchase that fluctuates as much as gasoline. Refiners and retail stores should be held to the highest standards. Recently price fluctuations seem to have become wilder and lots of people want to know what has been going on. If they are like me the average consumer does not know why prices have been going up and down, but they would like to know more. So this hearing gives everyone a chance to explain things and gives us a chance to look at the regulatory and delivery systems we have now. I have heard reports that margins between supply and demand in the gas market have become smaller in recent years, and so mistakes in matching up the two can lead to price swings. Some also complained about market concentration among retail brands and how that affects price and availability. I do not know if either of those claims are true, but I am interested in hearing from those in the industry who have come here today. Also as a part of any discussion, we also have to make sure that the government role as regulators does not contribute to the problem. In fact we need to know what we can do in the opposite direction to encourage companies to make investments in our Nation's infrastructure, including what Senator Voinovich said, in new refineries that will help ease this problem in the future. For example, I understand some producers are having problems building a pipeline that could move gas and help alleviate some of the gas price problems that occurred last summer in the Midwest. The industry is trying to build a new pipeline called the Cardinal that would run 150 miles through Ohio and West Virginia and would end up in Kentucky. The Corps of Engineers is hassling this project, not allowing it to be completed and making it very difficult to complete. Red tape has slowed this process. We need to work harder to construct a smarter more efficient regulatory framework. I appreciate the time our witnesses have taken to come and testify. I look forward to hearing from them. Thank you, Mr. Chairman. Senator Levin. Thank you very much, Senator Bunning. Let me also note the presence of Senator Wyden, who I indicated will be testifying before us on Thursday. He has joined our panel and he has been long involved in investigating gas prices and trying to understand and transmit to the public the reasons for the gas price spikes that we face. Senator Levin. Let me now introduce our panel of witnesses who are with us this morning. We are grateful for their presence and appreciate their presence. They are all executives from five of the top oil companies in the world. And we invited these witnesses because they are in charge of U.S. operations for each company, so that they have the expertise to answer some of the questions that we will be asking. We have at the witness table James Carter, who is the U.S. Regional Director of ExxonMobil; Gary Heminger, President of Marathon Ashland Petroleum; Ross Pillari, Group Vice President for U.S. Marketing of BP; David Reeves, President of North American Products for ChevronTexaco; and finally, Rob Routs, President and CEO of Shell Oil. And we look forward to hearing your views, and pursuant to Rule VI, all witnesses who testify before this Subcommittee are required to be sworn, and I would ask you to please stand and to raise your right hand. Do you swear that the testimony that you will give before this Subcommittee this morning will be the truth, the whole truth, and nothing but the truth, so help you, God? WITNESSES: I do. Senator Levin. Thank you. We will be using a timing system today, and approximately 1 minute before the red light comes on, you will see lights change from green to yellow, giving you an opportunity to conclude your remarks. All your testimony will be printed in the record as written. We ask that you limit your oral testimony to no more than 10 minutes. We will have a lunch break approximately at 12:30. Mr. Carter, please proceed. TESTIMONY OF JAMES S. CARTER,\1\ REGIONAL DIRECTOR, U.S., EXXONMOBIL FUELS MARKETING COMPANY, FAIRFAX, VIRGINIA Mr. Carter. Thank you, Mr. Chairman. I am Jim Carter, Regional Director, U.S., ExxonMobil Fuels Marketing Company. I appreciate this opportunity to discuss the causes for price volatility in the gasoline marketplace and our recommendations to help deal with these fluctuations. --------------------------------------------------------------------------- \1\ The prepared statement of Mr. Carter with an attachment appear in the Appendix on page 130. --------------------------------------------------------------------------- ExxonMobil markets fuel products in 47 States and the District of Columbia. Our goal is to provide reliable supplies to our customers at competitive prices while respecting the environment and protecting the safety of the communities we serve. In the interest of time, I will summarize my remarks and ask that my written testimony be entered in the record. Senator Levin. It will be. Thank you. Mr. Carter. Our company understands the public sensitivity to price swings and the impact of fluctuating prices on consumers' budgets. The market for gasoline is one of the most visible of all consumer goods. Customers see our prices every day, as some of you have mentioned, and readily know when they are rising and falling. In fact, customers often contact us when they are rising. I aim to leave you today with the following messages: Gasoline prices reflect a fiercely competitive market operating with high transparency and a tight supply/demand balance. The market efficiently sets gasoline prices that reflect supply and demand balances, and consumers benefit in the long term when the free market is allowed to work. U.S. refiners and gasoline marketers compete vigorously, as evidenced by low margins and returns. Over the last 20 years, combined refining and marketing returns on capital have averaged 5 percent. New players have recently entered both of these businesses. Marketing has evolved over the past several decades from a focus on automotive needs such as service and gasoline to now service and convenience. The market today includes not only so- called major brands such as Exxon and Mobil but also convenience store chains, supermarkets and discount retailers or hyper-markets. The traditional major suppliers combined have 45 percent of the gasoline retail market today. Over the next 3 to 5 years the hypermarket share is projected to grow from 3 to 4 percent today to almost 16 percent, which is higher than ExxonMobil's current market share. With more choices than ever before, gasoline consumers are clearly benefited by this increased competition. Both gasoline margins and retail prices have declined over time. After adjusting for inflation, average retail gasoline prices have exhibited a general downward trend during the past 80 years. Of course, there has been some interim fluctuation based on true oil prices. Measured in 1999 dollars, gasoline prices have declined from around $2.50 in 1920 to about $1.50 in 2000, even as taxes have increased. Today taxes make up 30 percent of the retail price. There are three main causes for gasoline price volatility: Changes in crude oil prices, market transparency, and the proliferation of fuel specifications. Crude oil prices currently comprise about 40 percent of the retail gasoline price. Since late January crude oil prices have increased by over $7 a barrel, accounting for 15 to 20 cents of the total gasoline price increase of roughly 30 cents per gallon. Instant availability of global news has made markets highly transparent. Prices in commodity futures markets respond quickly to world events. High transparency makes markets more efficient, but it can also increase volatility. Today's many boutique gasoline specifications place significant demands on the refining industry. Summer grades are more difficult and expensive to make because they require additional processing to meet environmental standards. This reduces refining capacity in the summer when demand is the highest. A disruption at a single refinery can quickly upset the balance. Boutique gasolines also present logistics challenges. They limit distribution system flexibility and reduce interchangeability of supply among terminals. Industry consolidation, which the Subcommittee has raised as an issue, based on refining concentration analysis by State, has not contributed to increased price volatility. Refining concentration should be analyzed regionally, as most States are not self-contained refining markets. Even with recent mergers, there are still a large number of independent refiners and marketers. To minimize the effects of market disruptions and increase industry capacity we recommend three changes. First, reduce the number of boutique gasolines. That will increase our flexibility in refining and distribution. Second, appropriately sequence future changes in product specifications to eliminate overlap and bunching of requirements, which will help ensure that necessary investments can be completed without affecting supply stability. Finally, ensure appropriate interpretation and enforcement of regulations that affect capacity and supply. I would be happy to address your questions that you might have. However, I hope that you will understand that due to the competitive concerns, it would not be appropriate for us to discuss company sensitive data. I'd prefer to address that in another setting. Thank you for the opportunity to comment. Senator Levin. Thank you very much, Mr. Carter, and we in our exhibits have also tried to protect those proprietary matters that would cause disclosure of information which would not be appropriate to competitors, and we have made that effort as well. Mr. Heminger. TESTIMONY OF GARY HEMINGER,\1\ PRESIDENT, MARATHON ASHLAND PETROLEUM, FINDLAY, OHIO Mr. Heminger. Thank you, Mr. Chairman, and Members of the Subcommittee. I thank you for allowing me the opportunity to meet with you today. --------------------------------------------------------------------------- \1\ The prepared statement of Mr. Heminger with attachments appear in the Appendix on page 146. --------------------------------------------------------------------------- I am Gary Heminger, President of Marathon Ashland Petroleum. Mr. Chairman, I, too, have a written report for the record. Senator Levin. Thank you. Mr. Heminger. We are a Midwest company headquartered in Findlay, Ohio. We have major facilities and a number of employees in several of the States of the Members, including 2,000 employees in Illinois, 2,500 in Indiana, 3,200 in Kentucky, 3,200 in Michigan, and 8,000 in Ohio. Unlike many refiners we consistently supply all segments of the gasoline market including independent distributors and retailers. In fact, these customers represent our largest single customer market. We appreciate the Subcommittee's interest in this very important topic and agree with a number of findings in the just-released report of the Subcommittee staff, including No. 1, the finding that our new Cardinal and Centennial Pipeline projects should make a positive difference to the Midwest consumer. We obviously agree. No. 2, the finding that the mandated winter to summer fuel changeover reduces inventories just before the warm weather driving season, that has a price effect. And No. 3, the finding that our company made and sold 33 percent more reformulated gasoline in 2000, a period when many other refiners had cut back their production. A central question in this hearing is whether my company deliberately withheld reformulated gasoline from the market in the spring of 2000 to boost prices. The answer is an emphatic no. The fact is that Marathon Ashland Petroleum produced 33 percent more reformulated gasoline than the year before and we sold every drop. Let me repeat that. We produced 33 percent more and sold every drop. Any assertion to the contrary is just plain wrong. Our pricing procedures also follow sound business models. We consider our cost of supply, the amount of supply, the anticipated demand and a range of market indicators. Fuel markets everywhere follow the price of crude oil. However, individual markets have their own unique sensitivities. In the Midwest, for example, consumers use 25 percent more fuel than the Midwest refineries produce. The balance is shipped to the region by pipeline or barge usually from the Gulf Coast. Any disruption in transportation service has the potential to produce price volatility. We understand that the ups and downs of gasoline price upset consumers. Despite volatility, the Lundberg survey found that motorists in the Midwest actually paid 1.6 cents per gallon less than the U.S. average from 1998 to 2001. In fact, adjusted for inflation gasoline now sells at close to an all-time low. This is true for very few other products. But then few markets are as uniquely competitive as the one that brings America's motorists to approximately 180,000 retail gasoline outlets, a market that is growing even more competitive with the emergence of hypermarket gasoline retailers. I believe that few companies have been as responsive and customer focused as Marathon Ashland. I am extremely proud of the people and how they responded during the periods of supply imbalance in 2000 and 2001. During those years we increased our refining throughput, testing to the design limits, our plants already running at the high end of historic norms. When a major pipeline failure took about 400 million gallons out of the market, we ran additional transport trucks 24 hours a day, 7 days a week to supply our customers as best we could. We flew in additional drivers to fill the greatly expanded route schedules and driving times. We also took the highly unusual step of shipping gasoline from far away as Newfoundland. We increased our sales. In fact we sold more product than we produced. In 2000, for example, we sold approximately 2 billion gallons more gasoline than our plants refined, an outcome possible only because we dedicated our logistics resources to bringing fuel from where it was made to where it was needed. We took extraordinary steps to keep our customers supplied. One reason the supply disruption of 2000 and 2001 produced such dramatic price effects is that the Nation's refining and delivery systems are severely constrained, particularly during periods of peak demand. Understanding this context is important to appreciating why prices may spike when a refinery goes down or a pipeline connection to the Gulf Coast is interrupted. It is estimated that the Midwest has a refined product shortage of about 42 million gallons a day, and this puts a great burden on our ability to move fuel from where it is made to where it is needed. Yet our distribution is highly constrained. During periods of peak demand pipelines can't grant suppliers all the shipping capacity they need. If there is an outage for a reason, there is very little if any makeup capacity. At Marathon Ashland we're trying to address these issues. On the production side we have a new coker at our Garyville, Louisiana, refinery that produces enough gasoline for about 60,000 cars a day with no additional crude oil throughput. A major capital investment project is now under way at our Catlettsburg, Kentucky, refinery in addition to numerous smaller projects completed or under way. We are constantly looking at cost effective ways to improve our refineries to increase production, reduce emissions, and improve efficiency. We're also working to address the delivery issue. Earlier this month the Marathon Ashland joint venture began operation on Centennial Pipeline, a new refined products pipeline that connects the Midwest with the Gulf Coast. We also plan to build the Cardinal Products Pipeline to link one of the Midwest fastest-growing markets, Columbus, Ohio, with the Ohio River and our Catlettsburg, Kentucky, refinery. These projects are expensive. In fact, just since its inception in 1998 Marathon Ashland has invested a total of more than $2.5 billion in refining, marketing and transportation. We plan to continue to invest heavily to meet clean fuel regulations and the growing needs of our customers. Three of our Midwest refineries, St. Paul Park, Minnesota; Canton, Ohio; and Detroit, Michigan, are very small. They lack either the inherent efficiencies of larger facilities or the location advantage of Gulf Coast refineries. Every refinery in this size or class is vulnerable. Were it not for the efficiencies realized from the combination of the downstream assets of Marathon Oil and Ashland, Incorporated, it is questionable whether either company would have been able to survive as an independent refining and marketing company. Marathon Ashland and its employees are committed to help the Midwest growing energy needs. These government measures would help: Regulatory certainty, appropriate rule phase-in, policies that encourage investment in the industry, and expedited permitting. The Department of Energy indicates petroleum hydrocarbons are likely to be the predominant source of transportation fuel in America for at least the next 20 years. Government and industry need to work together to help assure supply reliability and affordability for America's fuel customers. I look forward to making the effort a productive and long- lasting one. And I appreciate the opportunity to appear before this Subcommittee. Thank you, Mr. Chairman. Senator Levin. Mr. Heminger, thank you very much. Mr. Pillari. TESTIMONY OF ROSS J. PILLARI,\1\ GROUP VICE PRESIDENT, U.S. MARKETING FOR BP, WARRENVILLE, ILLINOIS Mr. Pillari. Thank you, Mr. Chairman. Good morning. My name is Ross Pillari and I am a Group Vice President of Marketing for BP. BP is a supplier of fuels for transport and power in the United States under the BP, Amoco, and Arco brands. I, too, have submitted a written report for the record, Mr. Chairman. --------------------------------------------------------------------------- \1\ The prepared statement of Mr. Pillari appears in the Appendix on page 157. --------------------------------------------------------------------------- Senator Levin. Thank you. Mr. Pillari. I am pleased to appear here this morning to speak on behalf of my company and address the issues of gasoline price volatility. It is a subject that attracts the attention of many interested parties, but most importantly is on the minds of our customers as they make their buying decisions. The price of gasoline is also a business issue for the thousands of gasoline dealers, distributors, refiners, and energy companies who invest their personal and corporate funds in this volatile and intensely competitive business. As each of these businesses works to manage within this complex market volatility, they are faced with trying to explain increasing gasoline prices such as we have seen in the last 60 days. However, when gasoline prices are low, as they were in January, in some markets reaching as low as $1.05 a gallon, there are generally few questions, and little understanding that this effect is also a function of volatility. Yet it is important to note that in this period and in similar periods of volatility, this country has, on average, maintained the most reliable supply and the most efficient distribution system at the lowest prices in the world. This is an important fact because it demonstrates our ability to dampen at least some of the effects of volatility. In the long run gasoline prices are directly related to crude oil prices. Over 90 percent of the change in gasoline prices is directly related to changes in the price of crude. In just the past 24 months crude prices have bounced from lows of around $10 per barrel to highs of over $28 per barrel, as have already been mentioned. And gasoline prices have moved in tandem. The increased gasoline price volatility over the last 18 months is consistent with the volatility in the price of crude oil. Crude oil prices react to world events. Crude oil prices react to world economic demand. The market will naturally adapt to the ebbs and flows of this demand, resulting in normal market-based volatility. As crude demand increase, crude supply has historically increased to meet it. We have seen additional resources brought online in the Gulf of Mexico and other locations around the world. In just one of these areas, the Gulf of Mexico, my company is spending billions of dollars to find these new resources. These investments for additional supplies are based on an assumed long-term price for crude oil. But this is not likely to be a static price. It is more likely to be a volatile price based on the many factors I have already mentioned. This same volatility will naturally flow through and have an effect on the gasoline product markets. However, the cost of crude oil is just one of the factors that influences gasoline price volatility. As we have seen in the past, supply disruptions from unexpected and in some cases catastrophic refinery problems, pipeline outages, and import patterns will also cause volatility in our gasoline markets. Volatility tends to rectify itself with the natural actions of the marketplace. Changes in gasoline price affects supply so that the market reaches the equilibrium price where supply and demand is in balance. During this balancing process, the market experiences price volatility and initiates the market-based actions that will attract the very supply that will dampen this affect. Nowhere was this more in evidence than in the actions taken by our company to supply gasoline to the Midwest and the West Coast during supply disruptions of the past two summers. BP reacted to these market conditions by taking a number of actions including blending chemical feedstocks into the gasoline pool to maximize volumes, moving barrels from our Toledo refinery into Detroit to free up Chicago-based refinery barrels for sale or supply in that market, transporting gasoline from European refineries to the Midwest, moving gasoline components from our Kwinana, Australia, refinery to the West Coast, and delivering additional volumes into Chicago via Explorer Pipeline when space was available. As a result of these efforts, BP was able to make more of its gasoline available to the Midwest and West Coast, and also to dampen the price effect of the disruptions, but not without temporary price volatility as the market corrected itself. At the street level the U.S. gasoline market has gone through a dramatic change over the last 10 years, primarily driven by consumer demands for quick service, convenience products, and low prices. These changes continue. And the driver of these changes is the consumer. The consumer is demanding better and more progressive retail options for purchasing gasoline. These new outlets, whether investments by a jobber, an integrated oil company, or a grocery store chain, are complex and multi- faceted businesses. They require multimillion dollars investments. There is no slack in the economic drivers of this system that would allow for increasing costs or inventory to dampen or absorb price volatility. But we must look at the facts and analyze the impact of these market factors over the last few months. While we have seen volatility in gasoline prices due to world crude oil market volatility, we have actually experienced lower retail prices over the first part of this year. According to DOE statistics, the price of gasoline during the first quarter of this year has averaged about $1.20 per gallon compared with $1.48 during the same period last year. We have seen the price move from a low in January of nearly a dollar, as I mentioned before, in some markets to their recent highs, in some cases as high as $1.60 in the Illinois market, which are still nearly 15 to 20 cents below the highs of last year. But as the price of crude oil has begun to stabilize, so have retail gasoline prices. They are beginning to come down already. At the same time gasoline production in the United States has increased by 3.6 percent over last year, and nationwide inventories of both RFG and regular gasoline are at or above their prior year levels. No single factor is the cause of volatility. It is the totality of these factors that makes the market work so effectively in achieving each period of equilibrium. Consumers in the United States continue to benefit from the intensely competitive U.S. refining and marketing industry. More sophisticated and cost efficient business models are constantly evolving in the marketplace at an ever- quickening pace. In the last few years the market has seen the entry and growth of large format independents, convenience store chains, the addition of gasoline at hypermarkets and grocery store chains, and the accompanying growth in their market share. The consumer has more offers and better offers to choose from. At the same time the need to realize economies of scale, reduce costs, access new markets and better manage risks, while continuing to deliver value to shareholders has resulted in a number of mergers, acquisitions, and consolidations. The net result is that cost reductions and efficiencies from mergers have resulted in greater value for the consumer as evidenced by prices the same or lower than in previous years. To this end we continue to operate our refineries at high levels of production, maintain our inventories at levels required to meet our customers' needs, and establish our role as a preferred supplier. The marketplace works. And while it is working, it will reflect the realities of the actions required to balance supply and demand. Artificial interventions are likely to result in consequences and unpredictable results. As we have throughout this discussion, BP is prepared to continue to work with this Subcommittee and to be as helpful to you as possible. I will be pleased to take questions. Senator Levin. Thank you very much, Mr. Pillari, and we thank you all, by the way, and your companies, for your cooperation with this Subcommittee. We have sought out a significant amount of information. We have obtained that information, and we are appreciative of it, and we appreciate your willingness to continue to work with the Subcommittee on that basis. Mr. Reeves. TESTIMONY OF DAVID C. REEVES,\1\ PRESIDENT, NORTH AMERICA PRODUCTS, CHEVRONTEXACO CORPORATION, SAN RAMON, CALIFORNIA Mr. Reeves. Thank you, Mr. Chairman and Senators. It's my pleasure to be here today to testify before the Subcommittee. My name is Dave Reeves and I'm the President of North America Products, which is the ChevronTexaco entity responsible for refining, marketing, and distribution in the United States. --------------------------------------------------------------------------- \1\ The prepared statement of Mr. Reeves appears in the Appendix on page 161. --------------------------------------------------------------------------- In the United States we refine and market gasoline under the Chevron brand, and I'll be referring throughout my testimony to our United States' operations as Chevron. Although our corporate name is ChevronTexaco, we do not own, operate, or supply any of the former Texaco refineries or retail outlets in the United States. The FTC required that those facilities be sold as a condition of our merger last year. To cover the issues the Subcommittee asked us to address, let me talk briefly about gasoline production and delivery. Chevron operates six fuel refineries in the United States with a total refining capacity of roughly 900,000 barrels a day. Our largest refineries are located in Pascagoula, Mississippi, and El Segundo and Richmond, California. We have one medium-sized refinery in El Paso, Texas, and two smaller refineries, one in Hawaii and one in Salt Lake City. Chevron's share of the gasoline market in the United States is roughly 6 to 7 percent. We sell gasoline in 28 States and the District of Columbia through about 8,000 Chevron branded retail service stations. Over 90 percent of our stations are operated by independent jobbers or dealers who choose to brand with Chevron. Less than 10 percent of our stations are owned and operated directly by Chevron. We market on the West Coast, throughout the South, Hawaii, Alaska, and in portions of the Rocky Mountains. We are a smaller marketer in the Mid-Atlantic region through jobber-served stations. We do not refine or market in the Midwest or the Northeast. With respect to the Subcommittee's question about the adequacy of the industry infrastructure, I can best comment on my company. We continue to invest substantial sums to ensure that our infrastructure is adequate to meet our customers' needs. For example, our Pascagoula, Mississippi, refinery has begun work on its clean fuels project. When completed next year it will be one of the first refineries in the Nation capable of producing both low-sulfur gasoline and on-highway diesel fuel outside California. The project will be completed in advance of the national deadlines, primarily to meet local fuel requirements in Birmingham, Alabama, and Atlanta, Georgia, which are key marketing locations for the Pascagoula refinery. In general, while I think it has been noted that the capacity of the industry is strained in some parts, I do believe it will continue to grow to meet demand as long as the conditions to do so are economic. One concern of the Subcommittee is the series of mergers over the last 6 or 7 years, and like mergers in other business sectors, the mergers have been driven, I believe, by both a need to improve efficiency by reducing costs, and a need to compete in a world that requires strong companies capable of finding, developing, and delivering energy for the future generations. Those were major factors in the merger with Chevron and Texaco. Turning to gasoline pricing, I believe the Subcommittee's report accurately reflects that gasoline prices are set based on competition. They are the result of the combination of complex factors of supply, demand, and competitive forces. At Chevron our primary aim is to keep our independent dealers and jobbers competitive with the station down the street. As a result of competition, gasoline prices in constant dollars have been generally declining over a 20-year period and are a good value compared to many other goods and services, and to gasoline prices in many other countries. I recognize that those facts alone may be little comfort to families whose budgets are strained when gasoline prices increase rapidly, and I recognize that gasoline prices do tend to fluctuate, both up and down, more than many or most other products. It's important to recognize in addition that there are many factors that cause price fluctuations, including rapidly-changing crude oil prices, the ever-growing demand for gasoline, temporary refinery outages, and in some cases the annual changeover from winter grade to summer grade gasoline specifications. That changeover reduces inventories at the same time seasonal demand begins to increase for the summer driving season. Gasoline prices have also been a concern of many government agencies, and there have been obviously many investigations of gasoline pricing and fluctuations in the last several years. Those investigations have consistently shown that there have not been any conspiracies or antitrust violations, but rather that the fluctuations simply reflect that the market is working as it should. For example, the California Energy Commission concluded that the price spike in California in 1996 was caused primarily by a fire at a competitor's refinery, which removed some 10 percent of the supply for several months. Gasoline prices did in fact increase rapidly, which dampened demand and created the incentive to import gasoline from as far away as Finland. Prices then returned to lower levels. And as the Energy Commission put it, ``The market worked.'' I've reviewed the Subcommittee's report, and while I can't say that I have fully digested all 396 pages, I'd like to offer a few additional comments on it. First of all the report appears to miss the most basic reason for fluctuations in gasoline prices, and that is the changes in crude oil. The report notes that the average gasoline price across the United States went up by 35 cents from early 1999 to 2000. Two things are important about that observation. First, the report uses early 1999 as the starting point even though gasoline prices were at historic lows at that point so that the increase appears larger than if the report focused on a different time period. And more importantly, as Senator Voinovich noted earlier, it fails to take into account that the cost of raw materials, crude oil, increased by an even greater amount during that period of time. In addition the report refers to the various mergers and acquisitions that have taken place, most of them in the last decade, and suggests that they have reduced competition. I believe that they have increased competition. The mergers created stronger companies which were more efficient and thus better able to compete. The FTC also typically required the merging companies to divest refining and marketing assets, where retaining the assets could have been a competitive problem. The end result, as shown by the Subcommittee's charts--I think it's on page 84 in your report \1\--is that industry gross margins and operating costs have been declining, while net margins and rates of returns have remained fairly constant and low. Industry rates of returns have averaged about 5 to 6 percent, reflecting the fierce competition that we face. Consumers have been the beneficiary of the competition. --------------------------------------------------------------------------- \1\ See Permanent Subcommittee on Investigations' Majority Staff Report, Gas Prices: How Are They Really Set, which is reprinted in the Appendix on page 322. --------------------------------------------------------------------------- One more observation on the report. It refers to documents used in a California case entitled Aguilar dealing with California gasoline prices. What is not particularly clear in the report, however, is that all three levels of courts in California considered those very same documents and determined that they did not establish any wrongdoing. The trial court and the California Court of Appeals threw out the case as unfounded, and the California Supreme Court unanimously affirmed that decision. Finally, the Subcommittee has asked what can be done regarding gasoline price fluctuations. Speaking for Chevron, our people are doing our very best to operate our refineries and distribution system safely and reliably. It is our No. 1 priority. We devote a lot of resources to making sure that we continue progress to being world class in reliability. We're also doing our best to be fully ready to meet new government requirements for fuels. The government can also take steps to ensure that reliable supplies of gasoline and other fuels are available for the American consumer. For example, the government can set performance-based standards for fuels, so that refiners have the freedom to use the most efficient methods to meet those standards. The government can also take steps to minimize and eliminate things that interfere with markets such as mandates and subsidies, and the government can streamline permitting wherever possible, which we believe can be done without compromising environmental protections. Thank you again, Mr. Chairman and Senators for the opportunity to testify before your Subcommittee today, and I would be happy to answer any questions as the hearing goes on. Senator Levin. Thank you very much, Mr. Reeves. Mr. Routs. TESTIMONY OF ROB ROUTS,\1\ PRESIDENT AND CHIEF EXECUTIVE OFFICER, SHELL OIL PRODUCTS US, HOUSTON, TEXAS Mr. Routs. Thank you, Mr. Chairman. Whatever I am going to say is going to be a repeat by now, but I would like to go through my remarks, anyway. --------------------------------------------------------------------------- \1\ The prepared statement of Mr. Routs appears in the Appendix on page 170. --------------------------------------------------------------------------- Mr. Chairman, Members of the Subcommittee, for the record, my name is Rob Routs, and I am the president and CEO of Shell Oil Products US Shell Oil Products US is a marketer of fuels, lubricants, services, and solutions to consumer and business-to-business customers in the automotive, commercial, and industrial sectors. Shell Oil Products US operates refineries, a lubricants business, and a pipeline and terminal system. Together with its affiliate Motiva Enterprises LLC, Shell Oil Products US supplies nearly 22,000 branded service stations. I have been asked to share with the Subcommittee our thoughts on the United States' motor fuels market and the factors that contribute to the volatility of the price our customers pay at the pump. America's growth has been fueled in large part by the stable supply of reasonably priced energy. In fact, the price of gasoline has remained fairly constant when adjusted for inflation. A recent analysis by the American Petroleum Institute stated: ``In inflation-adjusted 2002-dollar terms, today's price is low compared to the historical 84-year record of recorded pump prices. In fact, motor gasoline prices are 45 percent lower than the 1981 record high of $2.64 per gallon. Between then and now, the real cost of motor gasoline to consumers fell by $1.19 per gallon. This decline can be attributed largely to lower crude costs, but manufacturing, distribution, and marketing costs are lower as well.'' Shell remains committed to ensuring that we meet the needs of our customers by providing them with a reliable supply of quality products at competitive prices. Still, there are a number of factors that have contributed to the volatility of the recent past. These factors still exist today and will continue to influence the price of gasoline in the future. One of the greatest challenges we face as an industry is supplying an ever increasing number of boutique fuels to an ever expanding number of niche markets. Prior to 1990, there were six kinds of gasoline sold in the United States. Today, requirements imposed by Federal, State, and local governments have contributed to the creation of an ever expanding number of motor fuels and other petroleum products. Again, according to the American Petroleum Institute, ``One pipeline company, Atlanta-based Colonial, delivers 90 different products for 85 shippers to 270 terminals and more than 1,000 storage tanks. In any given month, Colonial may ship 30 different grades of gasoline.'' When a region, State, or city requires a unique fuel, it becomes a fuel island, unable to use nearby supply should the delivery of their special blend be interrupted. The smaller the market, the more isolated they become, and the more difficult it is for us to move products into that area on short notice. Not only are we being asked to supply a greater number of fuels, but the specifications of these fuels often change with the seasons. These seasonal fuel variations require us to draw down inventories as we switch from one fuel to another. We conduct this fuel switch in April and May and September and October. When we switch fuels in the spring, we must draw down inventories to ensure that our fuel remains compliant. During this time markets are particularly exposed to volatility should a supply disruption occur. In an effort to address the proliferation of the fuels in America, we have been working with Congress on the establishment of a study to look at the issue. This study is included in the Senate's energy bill. We look forward to participating in the development of policies and programs intended to reduce the number of fuels used in this country without compromising environmental quality. At the same time, the infrastructure for producing and distributing fuels has been running at a very high utilization rate. America's refineries, for example, were running at 94 percent utilization last summer. At these high rates, there is little reserve capacity that can be turned on when demand peaks or another source of supply shuts down. Likewise, pipelines, particularly those that bring product to inland markets, are also operating at or near capacity. In recent years, oil has been as low as $10 a barrel and as high as $30 a barrel. Today that same barrel costs $25. The factors influencing the cost of crude are global in nature. Crude oil is a commodity that is traded on various exchanges around the world. As with most commodities, supply and demand--real and perceived--determine what participants in the market are willing to pay for a barrel of oil. As a result, factors that range from regional conflict to the shut-in of platforms in the Gulf of Mexico can all influence the price of crude oil. These types of events can often contribute to short- term price volatility. Finally, the business of refining and marketing fuel is itself changing as merchant refiners and non-integrated marketers have grown. They rely on the spot market for selling and acquiring product, and it is often the gasoline spot market that leads prices higher during disruptions in the supply and distribution system. Together, boutique fuels, high utilization rates, seasonal fuel requirements, fluctuating crude prices, and the growth of merchant refiners have all contributed to the volatility in the price of gasoline that has become common over the last couple of years. Given that the price of a gallon of gasoline is determined by a marketplace that is influenced by a variety of factors, many of which are not within the control of those who refine, market, and distribute fuel, is there anything that can be done to ease this volatility? First, we must stem the proliferation of boutique fuels so that product can be shifted from one market to another when supply disruptions occur or demand peaks. As I said earlier, we support the establishment of a study to look at this issue and provide recommendations. Second, we must look for ways to streamline the permitting and construction of new and expanded facilities used in the production, transportation, and distribution of fuels. More importantly, we must let the free market work and avoid the development of schemes intended to control or influence the price of gasoline. In the years ahead, I expect that we will continue to see mergers, acquisitions, and divestments in the oil industry. Like any business, we continually search for opportunities that will make us more competitive relative to our peers. The efficiencies and synergies we often recognize through these types of transactions allow us to continue to provide our customers with a competitively priced product. In some instances, the consolidation in the industry, particularly in refining, is being driven by the huge capital investments needed to meet ever more demanding regulatory requirements. Many smaller companies simply cannot justify the investment in plants and facilities needed to produce today's cleaner burning fuels. Finally, the Subcommittee has expressed an interest in how we price our product. Let me first say that the members of our industry never discuss amongst themselves how we price our product. Not only would that be illegal under Federal antitrust statutes, but it would also disadvantage our ability to stay competitive in the marketplace. I can tell you that we price our product relative to the market and that we are constantly striving to provide our customers quality motor fuels at a price that is competitive. Of course, the cost of crude is the single greatest cost in a gallon of gasoline. Many other elements contribute to the price of a gallon of gasoline. According to the Energy Information Agency, ``Federal, State, and local taxes are a large component of the retail price of gasoline. Taxes, not including county and local taxes, account for about 28 percent of the cost of a gallon. Within this national average, Federal excise taxes are 18.4 cents per gallon, and State excise taxes about 20 cents a gallon. Also, some States levy additional sales taxes, some applied to the Federal and State excise taxes. Additional local county and city taxes can have a significant impact on the price of gasoline. ``Refining costs and profits comprise about 14 percent of the retail price of gasoline. This component varies from region to region due to the different formulations required in the different parts of the country. ``Distribution, marketing, and retail station costs and profits combined make up about 12 percent of the cost of a gallon of gasoline. From the refiner, most gasoline is shipped first by pipeline to terminals near consuming areas, then loaded into trucks for delivery to individual stations. Some retail outlets are owned and operated by refiners, while others are independent businesses which purchase gasoline for resale to the public. The price on the pump reflects both the retailer's purchase price cost and the other costs of operating the service station. It also reflects local market conditions and factors, such as the desirability of the location and the marketing strategy of the owner.'' Remember, the final price for a gallon of gasoline is determined by the retailer. And that price, which is included in the last 12 percent from the above, is set after he or she adds their costs or profits to the price they pay for the product. I hope that I have helped you understand the many factors that influence the price of a gallon of gasoline and why that price sometimes can be volatile. I hope you can also appreciate the substantial capital investments and long-range planning that is required for the oil industry to quench the thirst our country has for the fuels that keep us mobile. Yet despite all of the challenges I have outlined, and many more I have not, I believe a gallon of gasoline remains a great bargain in constant dollars. I look forward to answering any questions you might have. Thank you. Senator Levin. Thank you very much, Mr. Routs. Thank you all for your statements. Let me just say at the outset that I think we all recognize that the price of gas is directly affected by the factors that you have all identified. That is not in dispute. We chose to look at the downstream market. We did not look at, for instance, the price of crude oil as a factor, even though it is obviously a major factor. By the way, the price of crude oil was not a factor in the price spikes of 2000 and 2001. It was those price spikes which really caused me to begin this investigation. And as we saw from the earlier charts, those spikes had nothing to do with the price of crude oil. There are other factors which you have mentioned: The growing number of boutique fuels, increasing and inelastic demand for gasoline in the United States, supply disruptions, reduction in the number of refineries, and a number of other factors which you mentioned. Those are factors. But what we want to focus on is what our staff investigation disclosed, which is strong evidence that you don't simply respond to market factors, but that you actively help to create and maintain a tight market. Now, where there is little competition--in other words, in areas of high concentration--the creation and maintenance of tight supply gives undue power over price to those companies that are engaged in that market. I want to go through some of the documents that the staff identified and go through the words of the company--not mine, not consultants, not my staff, but the words of the companies themselves in these documents. I want to start with a document that is found in the BP files from 1999. This is found on pages 274 and 282 of the staff report.\1\ I have enlarged portions of it so we can all look at it. It is from a meeting of the Business Unit Leaders, or BULs, at BP on June 1, 1999, and it discusses BP's Midwest/ Mid-Continent strategy, in the words of the document. --------------------------------------------------------------------------- \1\ See Permanent Subcommittee on Investigations' Majority Staff Report, Gas Prices: How Are They Really Set, which is reprinted in the Appendix on page 322. --------------------------------------------------------------------------- Now, we were told that the BULs, as they are called, are companies' executives at the senior vice president level, so these are top people in the BP organization. First of all, Mr. Pillari, how many are of these senior executives who attended this meeting? About how many? Mr. Pillari. Probably about six or seven. Senator Levin. Thank you. Now, this meeting is not just a casual meeting. It is taking up the time of top executives at BP. It is a continuation of a discussion that started in April because the first part of the agenda for the meeting is a recap of the presentation from that April meeting. The presentation makes it clear that the purpose of the meeting was to come up with a strategy for the company, and this was not just presented by a low-ranking employee to the top executives, some employee who was dreaming up options on his own or her own. To be presented at this level, it had to have had some direction or support from a high level, presumably under the supervision of a senior officials. And, obviously, it is the product of a lot of work and a lot of thought. One part of this document refers to the Midwest/Mid Continent as a niche, I assume a market niche. I am just wondering first, Mr. Pillari, what is---- Mr. Pillari. Those are actually designations of two of the business units. There was a Midwest Business Unit and a Mid Continent Business Unit. So it would be describing those two organizational functions. Senator Levin. What is meant by niche? Mr. Pillari. Well, since I wasn't there, I don't actually know. I'm assuming if you look at it, that given we were organized around the Midwest and the mid-continent, they would look at that geographic market and refer to it as the geography of the mid-continent and the Midwest. Senator Levin. Now, at the top box on page 277,\1\ the presentation says that, ``We can influence niche value [1 to 3 cents per gallon] but our actions need to be significant [greater than 50,000 barrels per day] to be sustainable [more than 3 years].'' I take that to mean that you can affect the price of gasoline in the Midwest by 1 to 3 cents a gallon if you take certain actions, and just stop me if that is an inaccurate presentation of what it is because I want to get to the point. Then the memo goes on to present ways that you can achieve that increase in the price of gasoline. And so to achieve that goal, there are a number of options that are discussed at that meeting and presented, I gather many of which or most of which were not adopted but nonetheless considered as options to achieve that goal. And the rest of the page goes on to make some general observations about the Midwest market. The second dot from the bottom says that, ``There are significant opportunities to influence the crude supply/demand balance.'' And then it goes on to say--or to discuss the market levers that are available to BP to influence the supply/demand balance in the Midwest, and I want to look at market lever No. 1, and this is on page 281.\1\ This is the product short market lever. There are two pages in the presentation on product short market levers. One is product short (1), which is page 281, and then there is product short (2), and I want to go over these thoughts that were presented to these executives, these options that were presented. --------------------------------------------------------------------------- \1\ See Permanent Subcommittee on Investigations' Majority Staff Report, Gas Prices: How Are They Really Set, which is reprinted in the Appendix on page 322. --------------------------------------------------------------------------- On product short (1)--Exhibits 13,\2\ I am informed. On product short (1), the first bullet is ``shut down niche internal supply.'' That would mean reducing supply inside of the Midwest. Then it goes through a number of ways to achieve that. The first way to achieve that reduction of supply is ``to offer supply agreements in exchange for capacity shutdown,'' which means that BP would promise to supply gasoline if other refiners would agree to shut down their refineries or their capacity at their refineries, which would give BP greater control over supply. --------------------------------------------------------------------------- \2\ See Exhibit No. 13 which appears in the Appendix on page 262. --------------------------------------------------------------------------- I understand you did not adopt that recommendation. First, I am wondering why you did not adopt that recommendation. Mr. Pillari. Well, sir, first of all, I would say you are correct when you say these were presented to the business unit leaders. They were rejected by the business unit leaders. They were rejected because it is inappropriate to have this kind of activity in the marketplace, and it's naive to think that activities like this could influence the marketplace. Senator Levin. So the people who were presenting these options to the senior executives were presenting a bunch of inappropriate options. They had been first presented in April and then presumably not rejected in April but then recapped in June. Is that correct? Mr. Pillari. The issues presented in April--and if I could, the context for this group, it was a study group that was involved in the integration of the company back then. So we were looking at the Midwest and the mid-continent where we had two refineries, two logistics systems, and two of everything. And the study group was asked to go away and think through scenarios or possibilities or options as a result of this integration. In April, they returned to the business unit leaders and to the group and said there were some obvious things. We could rationalize the number of trucks that we had because we were now going past similar retail outlets. So we had synergies that we could make that were very obvious. In April, none of these issues was discussed. In June, it's my understanding--because I wasn't there, but it's my understanding that these options were presented to the BULs, who rejected them and they never went past that group. Senator Levin. All right. Did the people who presented these inappropriate options, were they fired or disciplined in some way? Mr. Pillari. They have certainly been counseled and trained on understanding the appropriate way to behave and the regulations in the marketplace. These were not senior people who did the studies. Senator Levin. To the other oil companies here, have you ever entered into a supply agreement or offered to enter into a supply agreement in exchange for the shutdown of refinery-- excuse me, in exchange for the shutdown or reduction of refinery capacity? Mr. Carter. Mr. Carter. Absolutely not. Senator Levin. Mr. Heminger. Mr. Heminger. No, Mr. Chairman. Senator Levin. Mr. Reeves. Mr. Reeves. No, Mr. Chairman. Senator Levin. Mr. Routs. Mr. Routs. No, Mr. Chairman. Senator Levin. Thank you. The second option presented to the BULs was to purchase capacity and to shut it down. I assume that that means to buy a refinery and shut it down. Have any of you ever engaged in that activity? Mr. Carter. Mr. Carter. No, Mr. Chairman. Senator Levin. Mr. Heminger. Mr. Heminger. No, Mr. Chairman. Senator Levin. Mr. Pillari. Mr. Pillari. No, Mr. Chairman. Senator Levin. Mr. Reeves. Mr. Reeves. I'm sorry. I missed the question, Senator. Senator Levin. Have any of your companies ever purchased capacity and then shut it down? Mr. Reeves. No, sir. Senator Levin. Mr. Routs. Mr. Routs. To my knowledge, no, sir. Senator Levin. OK. We are going to talk a little bit later about a Mobil memo from California when Mobil was considering what to do with the Powerine refinery. Is that the right pronunciation of ``Powerine''? Mr. Carter. Mr. Chairman, I believe it's ``Powerine.'' Senator Levin. What to do with the Powerine refinery that was undercutting the price of gasoline by providing reformulated gas, or RFG, at a low price. The memo discussed buying all of Powerine's output as well as just shutting it down. We will come back to that memo. The third option, back to BP's memo, lobby for the elimination of oxygenates/tax breaks for same, and the two oxygenates are MTBE and ethanol. Now, the thinking here in presenting this option is that oxygenates as an additive reduces the amount of gasoline otherwise needed, so that by eliminating oxygenates, you replace the oxygenates with gasoline and thereby increase the demand for gasoline. Now, as a matter of fact, is it not true, Mr. Pillari, that BP has lobbied for the elimination of MTBE? Mr. Pillari. Sir, we've done a number of things. First of all, we're the largest buyer of ethanol in the United States. We are concerned about some of the health issues around MTBE, and we have discussed openly with many constituencies our concern about that and how it could be alleviated. Senator Levin. My question was a little different from that, not whether you have discussed with other entities or other people, but whether or not BP has lobbied for the elimination of MTBE and the oxygenate requirement. Mr. Pillari. I'm not aware of lobbying to eliminate MTBE. We still use MTBE. I am aware of the discussions around---- Senator Levin. If it were eliminated, you wouldn't be using it, though. My question is: Have you lobbied for the elimination of the requirement? Has your company lobbied? It is a very direct question. Mr. Pillari. I'm not aware of it, sir. Senator Levin. OK. Let me ask the other companies: Do you agree with the assessment that the elimination of the oxygenate requirement will increase the demand for gasoline in the Midwest, thus tightening the available supply? First of all, do you agree with that? I am not asking you yet whether you lobbied for it, just whether you agree with the--that the elimination of that requirement would have that effect. Mr. Carter. Mr. Carter. I haven't looked at that specifically, but I'd be happy to answer the question about the lobbying. Senator Levin. OK. Mr. Heminger. Mr. Heminger. Mr. Chairman, taking MTBE out will reduce available supply; however, it would be replaced by ethanol. Senator Levin. OK. Thank you. Would you agree with that? Mr. Pillari. Yes, I agree with that statement. Senator Levin. Mr. Reeves. Mr. Reeves. We don't market in the Midwest, so I'd rather not answer conditions there, but directionally, I agree with these gentlemen on that. Senator Levin. OK. Mr. Routs. Mr. Routs. Directionally, I agree. I believe, though, that there will be enough ethanol around to replace MTBE. Senator Levin. I am talking about elimination of the oxygenate requirement period. Now the question is: Have you lobbied for the elimination of that requirement? Mr. Carter. Mr. Carter. We have been opposed to the oxygenate mandate because it, in fact, requires us to use MTBE, and we have been in favor of phasing down the use of MTBE in gasoline. Senator Levin. OK. So is it fair to say you have lobbied for the elimination of that requirement? Mr. Carter. Yes. Senator Levin. Thank you. Mr. Heminger. Mr. Heminger. Yes, Mr. Chairman, we have lobbied to reduce MTBE. Senator Levin. And to eliminate oxygenate requirement generally? Mr. Heminger. I would say not to eliminate oxygenate requirements generally. We believe there should be no backsliding whatsoever in the Clean Air Act. Senator Levin. In the what? Mr. Heminger. In the Clean Air Act. Senator Levin. So you have not lobbied for the elimination of the oxygenate requirement. Mr. Heminger. Not to the best of my knowledge.\1\ --------------------------------------------------------------------------- \1\ See Exhibit No. 27, May 13, 2001 clarification letter from Marathon-Ashland which appears in the Appendix on page 281. --------------------------------------------------------------------------- Senator Levin. Thank you. And you don't know? Mr. Pillari. Well, your question was on MTBE. On oxygenates in general, we have said we prefer a results-based regulation such that we would have the option to use oxygenates, particularly ethanol, where it makes the most sense. Senator Levin. Which, I think, in plain English means that you would therefore prefer the elimination of the requirement, leaving it optional. Mr. Pillari. Correct. Senator Levin. Now, when I asked you before, did you lobby for the elimination of the oxygenates/tax breaks for same, you said not to the best of your knowledge. Mr. Pillari. I'm sorry, sir. I misunderstood the question. I thought you were asking me specifically about MTBE. Senator Levin. No. I was very precise. It was oxygenates. Mr. Pillari. Well, then I misspoke. I heard the question incorrectly. We would prefer to have the option to use oxygenates rather than have it mandated. Senator Levin. OK. Then is it fair to say that you have lobbied for the elimination of that requirement? Mr. Pillari. Yes. Senator Levin. Therefore, you have, in fact, done one of the things, at least, that is in that document, because that document says that in order to reduce supply, No. 3, that you will lobby for the elimination of oxygenates/tax breaks for same, and you now acknowledge that you have done that. Previously you said you didn't do any of these things, you didn't adopt any of these recommendations. Now you acknowledge you have, in fact, done one of the three things that were recommended. Mr. Pillari. What I would say, sir, is that the desire to have an option to use oxygenates so that we can use ethanol where it makes the most sense actually increases the gasoline pool, and that decision is about increasing the production of gasoline and the clean aspects of gasoline. It has nothing to do with this report. Senator Levin. Let me just go back to this. I want to get this really clearly for the record. Have you lobbied for the elimination of oxygenates? Mr. Pillari. We have lobbied to make oxygenates optional for a results-based formula. Senator Levin. So it is fair to say that you have lobbied to eliminate oxygenates as a mandate? Mr. Pillari. Correct. Senator Levin. And you are saying that is different from what that recommends? Mr. Pillari. Yes, it is. Senator Levin. OK. We also have a memo from Texaco--that is now part of Shell that we will discuss a little bit later-- stating that the elimination of the oxygen mandate would be a good way to tighten supply in California. Is that accurate? Let me ask you that right now since we are on this subject. Mr. Routs. Is that the memo that was produced in the Aguilar case, sir? Senator Levin. Yes. Mr. Routs. First of all, Shell was not involved in the situation 10 years ago. Senator Levin. Let me ask Texaco then, if you don't know the answer to that. Did Texaco state that the elimination of the oxygen mandate would be a good way to tighten supply in California? Mr. Routs. This is the first time I have seen this internal memo in Texaco the way you produced it. The reference to Shell in the memo is--I mean, I'm not aware of anything, and we haven't been able to trace anything in this short time period, sir. Senator Levin. Let me then ask---- Mr. Routs. Let me put it this way: It's my belief in the situation that we're seeing today that importing into California--importing CARB gasoline into California wouldn't have been the cheaper option. I think they were dreaming in what they were doing at the time. Senator Levin. OK. Well, we are going to come back to that document. Now, the fourth option that was presented to the executives at BP was to eliminate exemptions for small refiners. Was that---- Mr. Pillari. Well, that was rejected. Senator Levin. Right. So you didn't take any steps in that. Now, increase product demand, this is product short (1) on page 281.\1\ The first option, lower prices. I know you didn't implement that. The next way to increase product demand is to convince swing cities on Gulf Coast supply to require reformulation that is not readily available from the Gulf Coast, in other words, to pull RFG from the Midwest to those other cities, even though they may not need it. So here you have the consideration by BP of promoting government regulation, promoting the use of RFG, which is a boutique fuel, to reduce supply in the Midwest. --------------------------------------------------------------------------- \1\ See Permanent Subcommittee on Investigations' Majority Staff Report, Gas Prices: How Are They Really Set, which is reprinted in the Appendix on page 322. --------------------------------------------------------------------------- Now, here is what EPA says about this. This is not just me. It is the EPA. In its report on boutique fuels, it says that, ``Some refiners have promoted boutique fuels in order to create tight markets for those fuels.'' That is an EPA finding. Yet we have Lord Browne, who is the head of BP, saying that boutique fuels cause price spikes. So EPA has found that some refiners have actually promoted boutique fuels to create the tight markets for those fuels, and I think the head of your company-- is he still the head of it--Lord Browne? Mr. Pillari. Yes, he is. Senator Levin. Says that boutique fuels cause price spikes, or help cause price spikes. Now, I want to jump to product short (2), which is page 282,\1\ and this is, again, options presented to your executives to reduce supply. --------------------------------------------------------------------------- \1\ See Permanent Subcommittee on Investigations' Majority Staff Report, Gas Prices: How Are They Really Set, which is reprinted in the Appendix on page 322. --------------------------------------------------------------------------- The first category on this page for reducing supply is to ``export products from the Midwest.'' Second, to ``move product into southern Ontario.'' I presume by that you mean to just take product from the Midwest and export it to Canada to make supplies tight in the Midwest. Third item, ``use Xylene line or others to move product south or out of the area.'' Next category is options called ``fill import logistics'' which would make it difficult to import products into the Midwest, and the first option in this category is to ``ship crude substitutes and/or intermediates/blendstocks on product lines.'' That sounds like a plan to use products--to use the pipelines for products other than gasoline so that the pipelines won't be available to carry gasoline to the Midwest. Have you ever followed that strategy at BP? Mr. Pillari. All of these that you have just mentioned have been rejected and never implemented. Senator Levin. The next option is ``don't incent pipeline conversions to products,'' threat of swing or seasonal production to deter. That sounds complicated, but I think the option that was presented there to the BP executives is that BP would threaten to increase its own production and thereby depress prices if other companies seek to create more pipeline capacity into the Midwest. That threat you say was presented and then it was rejected. The next strategy, to incent--``incentivize,'' I presume that means--``Koch not to ship into Chicago.'' Koch is a major supplier of reformulated gasoline in Chicago, and this strategy is to get Koch not to ship into Chicago. You weren't at the meeting, but perhaps you can help us out with this. What kind of incentives could BP use had they adopted that strategy to get Koch not to ship into Chicago? Do you know? Mr. Pillari. I have no idea, sir. Senator Levin. OK. The next option is to lobby for elimination of drag-reducing agents for environmental reasons, and this is No. 8 on page 282.\1\ Now, those are chemicals that are put into pipelines to make the product in the pipeline move more easily and more quickly, and by using DRAs, pipelines can ship gasoline faster and at less cost than if DRAs are not used. This suggestion is that you should lobby to eliminate the use of DRAs, slowing the delivery of gasoline into the Midwest, and to use the argument that DRAs are not good environmentally. Did you, in fact, lobby for the elimination of DRAs? Mr. Pillari. No, sir. To my knowledge, we did not since all of these options were rejected. Senator Levin. Thank you. Did any of the companies here lobby for the elimination of DRAs, do you know? Mr. Carter. Mr. Carter. No, Mr. Chairman. Senator Levin. Mr. Heminger. Mr. Heminger. No, Mr. Chairman. Mr. Routs. No, Mr. Chairman. Mr. Reeves. No. We have increased the use. Senator Levin. The next category on this chart is ``change behavior of shippers to support niche uplift,'' which we assume means to raise prices in this area. These proposals were to increase the cost of transporting product to the Midwest, and one way would be to support market-based tariffs which would presumably lead to increased costs for transporting product to the Midwest, and the other way would be to simply raise tariffs. Has BP supported higher tariffs on products going to the Midwest? Mr. Pillari. No, sir. Senator Levin. Thank you. And the last option is ``reduce product inventory in the niche'' or in the area. And you say that you did not act to do that? Mr. Pillari. No, all of this was rejected, sir. Senator Levin. Thank you. Now, on June 28, 2001, in a Chicago Tribune article, Sir John Browne, who is your CEO, talks about price volatility in the United States. This is Exhibit 14.\1\ Mr. Browne is quoted as saying that the shortage of refining capacity is not causing the price spikes. Do you agree with that? --------------------------------------------------------------------------- \1\ See Exhibit No. 14 which appears in the Appendix on page 266. --------------------------------------------------------------------------- Mr. Pillari. Sir, what he was referring to was a briefing that I had given him about the problems with the Explorer pipelines, the CITGO fire problems. So the context of this discussion would have been is it a basic refining problem or are there logistics interruptions. Senator Levin. And, in his judgment, is there a shortage of refining capacity? Mr. Pillari. Well, I think what he was saying is we--and he means BP--does not need any more refineries in the United States. Senator Levin. All right. He says that the problem is ``that products can't flow easily to where shortages develop.'' It seems pretty clear that shortages--that short supplies are intended by companies--that you intend to have a tight supply. And we just went through a lengthy presentation of top officials about how to achieve that goal. We were told that those particular methods were not used. But the presumption here is that the people who made that presentation were aiming to achieve that goal of tightening supply for BP. I mean that, it seems to me, has got to be indisputable. They may at this meeting have rejected or not used those methods, although we have a difference over the one issue involving lobbying to eliminate the oxygenate requirement. Nonetheless, the goal of a tight supply in a market was the purpose of looking at all of those options. Is that correct, Mr. Pillari, that that was the purpose of considering those options? Mr. Pillari. Sir, I would be speculating on what they did since I wasn't there---- Senator Levin. Not what they did. What the purpose of the presentation was. Mr. Pillari. I would be speculating on the purpose of the presentation. The request that they were given was to take a look at the integration of all the facilities in this area and develop some scenarios so that management could then decide the way forward. Senator Levin. All right. Would you agree with me that those suggestions are outrageous? Mr. Pillari. Yes, I would. Senator Levin. If these are outrageous recommendations, didn't anyone call these folks on the carpet? Mr. Pillari. Yes. It's my understanding that the BULs did, which is why the business unit leaders would never have taken it forward. I mean, these were rejected immediately. The people were counseled on the inappropriateness of it, and it never went any farther than that. Senator Levin. And did the senior person who was overseeing that presentation ever say to the people making the presentation this is wrong, it should not be presented to our executives? Mr. Pillari. I don't know exactly what they had said, but since it never came forward and since I know that they were counseled, I would assume that something like those words were said. Senator Levin. OK. Let us know for the record, would you? Mr. Pillari. I will.\1\ --------------------------------------------------------------------------- \1\ See Exhibit No. 29, letter from Ross J. Pillari, dated May 16, 2002, which appears in the Appendix on page 285. --------------------------------------------------------------------------- Senator Levin. Find out. Mr. Carter, the Majority staff report contains a document from February 1996, and that is on page 225.\2\ It is a series of E-mails between Mobil officials discussing how to block the proposed startup of the Powerine refinery or to at least prevent its output from reaching the market. Apparently, according to the E-mail, Mobil had successfully kept the Powerine product from reaching the market the previous year, and the way they did that was they bought all the Powerine product and then Mobil marketed it. --------------------------------------------------------------------------- \2\ See Permanent Subcommittee on Investigations' Majority Staff Report, Gas Prices: How Are They Really Set, which is reprinted in the Appendix on page 322. --------------------------------------------------------------------------- In one of these E-mails, one Mobil official said the following: ``Needless to say''--and this is Exhibit 15,\3\ by the way, now on page 228. ``Needless to say, we would all like to see Powerine stay down. Full court press is warranted in this case and I know Brian and Chuck are working this hard.'' --------------------------------------------------------------------------- \3\ See Exhibit No. 15 which appears in the Appendix on page 26700. --------------------------------------------------------------------------- What do you think is meant by ``full court press'' to keep Powerine down, to keep their production down? Mr. Carter. Mr. Chairman, Powerine was a refinery in California that had chosen not to make the investment required by California regulators to produce and sell gasoline that was in compliance with the regulations there, to clean up the air in California. And they had petitioned the California Air Resources Board, the regulatory authority, to be allowed to sell gasoline that was not in compliance with the regulations of California. And we opposed that. We had made a unilateral decision to upgrade our own refinery. We had spent millions and millions of dollars to produce gasoline that was in compliance with the air regulations of California. Having another refinery be able to sell environmentally unfriendly gasoline and not make the investments to upgrade their refinery seemed to us to present a playing field that wasn't level, and we did, as we have a right to do, oppose their selling of this gasoline. And that's what I understand to be meant there. Senator Levin. So you didn't buy their product. You bought the product before they in any way changed it or affected it? Mr. Carter. That's correct, sir. Senator Levin. Powerine was selling RFG below the cost of MTBE, and you bought it and marketed it at a higher price. Is that what you understand that E-mail to be saying? Mr. Carter. I don't understand exactly what they did the year before. They did say they bought Powerine's output and marketed it through Mobil. I'm not sure what price they charged for it. Senator Levin. You are not aware of the fact that they had bought that at a higher price, your company bought it at a higher price and then marketed it? Mr. Carter. I'm not sure I understand you, sir. We bought it at a higher price and then marketed it? Senator Levin. That is correct, and you marketed it instead of allowing them to market it. Mr. Carter. I'm aware that we marketed it, yes. I'm not aware of what price we paid. Senator Levin. So what you are saying is that you were trying to protect the environment? You weren't trying to protect your own company? Mr. Carter. In the case of Powerine producing gasoline that wasn't in compliance with the regulations of the California Air Resources Board, we thought it was unfair, that it was an unlevel playing field, and they should have to make the same investments that we made and comply with the regulations. Senator Levin. And how would buying all their production achieve that? Mr. Carter. I believe that was in the prior year, sir, before---- Senator Levin. But you were proposing to do the same thing. It says, ``might be worth buying out their production and marketing. . . . Last year when they were dumping RFG at below cost of MTBE, we purchased all their avails and marketed ourselves which I believe was a major reason that the RFG premium last year went from [1 cent per gallon] in January to [3 to 5 cents per gallon] thru to their shutdown.'' In other words, the price of RFG went up 3 to 5 cents because you shut them down the year before. Isn't that what that E-mail says? Mr. Carter. I believe, if I can get the question right---- Senator Levin. Page 228.\1\ --------------------------------------------------------------------------- \1\ See Exhibit No. 15 which appears in the Appendix on page 267. --------------------------------------------------------------------------- Mr. Carter. If in the case they started the refinery up and produced non-compliant gasoline, was it an option for us to buy it and resell it, and that was the second option. The first option was to oppose that they produce non-compliant gasoline to protect our investment and to make the playing field as level as we thought we could. A second option was to buy the gasoline in that case. Again, I believe this was in the Aguilar case. This has been thoroughly investigated. It went to the California Supreme Court, and our company was not found to be in violation of any regulations or laws. Senator Levin. That is not the question here whether or not you violated a law by doing this. The question is whether or not that was a way of maintaining the control over the supply of a product. That is what we are talking about here today. And the way you did that was that, according to this E-mail that is on page 228, it ``might be worth buying out their production and marketing ourselves, especially if they start to market below our incremental cost of production.'' It doesn't say anything here, by the way, about environment but, nonetheless, this is what the E-mail says. ``Last year when they were dumping RFG at below cost of MTBE, we purchased all their avails and marketed ourselves which I believe was a major reason that the RFG premium last year went from [1 cent per gallon] to [3 to 5 cents per gallon] thru to their shutdown.'' So you benefited economically when there was 3- to 5-cent premium for RFG gas in California, and after you purchased all of their production so that they couldn't undercut your price, you benefited by having a higher price for all of your output. Isn't that what happened? Isn't that what that says, that E-mail? Mr. Carter. We were protecting our investment. We thought that was the best way to level the playing field. Senator Levin. And then it says, ``. . . if they do start up, I'd seriously consider this tactic.'' Did you? Mr. Carter. I don't believe they started up, sir. Senator Levin. OK. Senator Collins. Senator Collins. Thank you. I want to follow up on an issue that the Chairman has raised about the industry's lobbying efforts on MTBE and the oxygenate requirement in general, because I think the record is confused right now as to motivation of the various industry representatives here today in lobbying on these issues. In Maine, the MTBE additive has caused some serious groundwater contamination, and, thus, in our State the legislature, and the governor, supported by the entire congressional delegation, have called for a phase-out of MTBE. The implication, however, in the BP-Amoco exhibit that Senator Levin used is that the oil companies lobbied to remove the oxygenate requirement because it would reduce the supply of gasoline and presumably drive up prices. All of you in response to Senator Levin's question have commented on your various lobbying efforts regarding the oxygenate requirement. So I want to ask you directly for the record: What was your motivation in lobbying for the removal of the requirement for MTBE in particular or the oxygenate requirement in general? And I realize, Mr. Heminger, that you gave a slightly different answer than your colleagues in this area. Mr. Carter. Mr. Carter. Thank you, Senator. As I previously said, we thought that phasing out of MTBE or phasing down of MTBE was a good idea. We had used some MTBE prior to the Clean Air Act Amendments, but it was a very small amount. The Clean Air Amendments that require the oxygenate, in effect, because of the supply of oxygenates, basically dictated that we use MTBE and we thought it should be phased out. So for that reason, we thought that elimination of the oxygenate mandate was a good idea. Senator Collins. But was your motivation to also try to tighten to supply and drive up prices? Mr. Carter. No, Senator. Senator Collins. OK. Thank you. Mr. Heminger. Mr. Heminger. Yes, Senator. When we looked at MTBE, we, too, understand the problems it has with groundwater, and we did not lobby to tighten the supply. In fact, we supported ethanol as a replacement for the MTBE. We have a very small manufacturing capacity of MTBE, but we did support the new proposal to increase the amount of ethanol. Senator Collins. Mr. Pillari. Mr. Pillari. Yes, our position on oxygenates is not related to a supply decision. Our position on oxygenates is related to our desire to have clean fuels and to have them be results- based and to have the option to use oxygenates when it's the most efficient, economic way to make clean fuels. Senator Collins. Mr. Reeves. Mr. Reeves. Yes, Senator, we have actively proposed and supported the phase-out of MTBE, primarily because our customers and regulators around us prefer not to have it in the fuel. In 1990, when the oxygenate mandate became a part of the Clean Air Act, we actually did design in the use of MTBE as we expanded our refining capacity in California to meet the new requirements of California fuel. We continue to support the Governor in California to remove MTBE, are somewhat disappointed that he extended that ban delay, delayed it an additional year, and we would continue to support it. It really is not targeted at a volumetric issue. It's because the customers and regulators prefer to have it out. Senator Collins. Mr. Routs. Mr. Routs. We have supported it because customers and regulators have asked us to remove MTBE. We have also very actively, through API, supported the growth of ethanol in the country to address just the issue that you're talking about, to make sure that the total volume sold is stable. Senator Collins. Mr. Reeves, in your testimony you talked about the seasonal transition between summer and winter gasoline, and most of you identify the changeover to summer fuels as one of the reasons for causing an increase in prices. You also blame the start of the summer driving season. I guess my reaction to that is you know that is going to happen each year. You know that consumers are going to drive more during summer months. You know that you are going to have to make this seasonal transition between winter fuels and summer fuels. So you also know from experience that there can be glitches such as refinery fires or a pipeline breakdown. So why don't you plan better? I mean, it seems to me that you could take steps to deal with this issue and, thus, remove one of the price spikes that are so harmful to our economy and so burdensome to consumers. Mr. Reeves. Mr. Reeves. Thank you, Senator. Perhaps it is a good idea to get a mental picture of what's actually happening as inventories are drawn down and the transition between one grade to another occurs. I think as other people have mentioned, something like 97 or 98 percent of the fuel that is delivered out to the retail stations actually goes through terminals, not delivered directly from the refinery. And when you go to a terminal, there is a diesel tank and a jet fuel tank and probably three tanks for various grades of gasoline. And what happens is you have to draw those gasoline tanks down out at the terminal level and then replenish it with the new specification fuel for whatever seasons you're moving into. So there really is no capacity in the pipeline terminals out. Now, you could argue that we could choose to invest, to expand put in more tanks and carry more inventory. I think generally in the concept of inventory, while I think it's true inventory can help dampen volatility, I happen to believe that if you have to invest and carry a lot of inventory, the average price would actually increase, and our incentives are to keep as low working capital as we possibly can. So I guess that would explain our motivation, Senator. Senator Collins. Well, that does bring me to my next question. Every 10-cent increase in gasoline prices results in approximately $10 billion in revenues to oil companies over the course of a year. So if you have a spike of even short duration, it results in considerable profits to the oil companies. And yet I am hearing today that one of the reasons for price hikes and for price volatility is a lack of capacity, a lack of refining capacity, not enough pipelines. Given those kinds of profits, why aren't investments being made? If I look, three of the companies that are here today were in the top 50 on the Fortune 500 list released in April. Clearly there are profits available that could solve some of these infrastructure problems that have been cited repeatedly as the causes of these glitches that produce these very onerous price spikes. So why aren't additional investments being made to keep your refineries in better condition and to build additional storage tanks? Mr. Carter, we will start with you and go down the line. Mr. Carter. That's an excellent question, Senator, and, in fact, we have made considerable investments to upgrade our capacity and to be able to produce more of these boutique gasolines. If we take the Midwest, for example, in the year 2000 we started up our investment to make RFG with ethanol at our Joliet refinery, and we never operated that unit before. It was brand new. And we had some difficulty when we first came out of turnaround. We learned to use it better, and the next year we made even more gasoline there that met the requirements there. In addition to that, we learned to make components that can be blended to make RFG with ethanol at our Baton Rouge refinery, and we found new barges to ship that material up the Mississippi River to the Midwest. I think this was one of the advantages of the merger between Exxon and Mobil. That probably wouldn't have happened short of the merger. So we've taken a lot of steps. That's just one example. Senator Collins. Mr. Heminger. Mr. Heminger. Thank you, Senator, and as Senator Bunning stated, for 4\1/2\ years now, we have attempted to build a new pipeline and invest in a pipeline that would take product from the Catlettsburg refinery in Kentucky up to Columbus. In addition to that, I'll show a picture here of Creal Springs. This is the endpoint of the new Centennial pipeline which has the capacity to move 200,000 barrels a day into southern Illinois. This is just a picture which illustrates the 2.2-million-barrel tank farm that we have built, and that system is now operating and has the ability to bring that to the Midwest. And, last, I stated our refinery in Garyville, Louisiana, invested $300 million to build a new coker which provides enough fuel for another 60,000 cars per day. So we have invested heavily. Senator Collins. Mr. Pillari. Mr. Pillari. Yes, Senator. We've invested in our Toledo and Whiting refineries to be able to make more RFG product in the last 2 years, and we have maintained our terminaling system as it has been. I would say in coming back to the fundamentals of this that one of the things that has to happen with investing in terminals or inventory is it has to be a good economic decision for the long run, not just for 3 or 4 days. And I think in our company's case, we are more of a buyer on the marketplace than maybe some others. We buy almost 40 percent of our product from other suppliers. Senator Collins. Mr. Reeves. Mr. Reeves. Thank you. I think it's fair to say that over the last decade or so, the vast majority of our investments in the refining and marketing business have been to do two things: Improve the reliability and meet the environmental standards on refining, and to grow our retail business. That's it essentially--and they're roughly equal. I think you've heard a lot of testimony in the opening comments about the returns on the refining investment--the refining and marketing business in the United States which have historically been very low. The industry does not attract a lot of discretionary capital, and, therefore, we just have chosen to invest in the things that we need to do to run reliably and make sure that we get the value out of the assets that we already own. And if I could just correct the record, Senator Levin asked me earlier on a question which we passed by quickly, did we ever buy or sell--buy capacity and then shut it down. And I said no. During the Gulf merger in 1985, there were some refineries that came with that merger. One was in Philadelphia that ultimately did shut down. It was one of those that you heard of. So we didn't buy it to shut it down, but it was shut down. And then we have sold--we did sell our Port Arthur, Texas, refinery to Clark back in the early 1990's, just to correct the record. Senator Collins. Mr. Reeves, I want to follow up on that point then. Why would you shut down a refinery when there is a shortage of refining capacity? Mr. Reeves. Well, certainly at the time Philadelphia was shut down, that wasn't the case.\1\ It was in the middle of the 1980's. There was plenty of surplus refining capacity, and it was uneconomic to run. --------------------------------------------------------------------------- \1\ See Exhibit No. 30, May 14, 2002 clarification letter from ChevronTexaco which appears in the Appendix on page 287. --------------------------------------------------------------------------- Senator Collins. Mr. Routs, my original question. Mr. Routs. Senator, in the 1990's, we invested about a billion and a half in our refineries for clean fuels and CARB fuels. We are looking forward to investing over the next 5 to 7 years another billion dollars in low-sulfur gasoline, low- sulfur diesel, the consent decree that we have done with the EPA on the emission side of the business. We started up last year a $300 million coker in Deer Park in Houston that is delivering more product to the market. And we're investing a lot of money and human capital in getting the reliability of our refineries and systems up, because in the end, getting our refineries to run properly is going to create more volume for the market. We've had in the past some trouble doing that, and right now we're investing 200 man-years in order to train people properly to get the most out of those places, and that will help the consumer. On the pipeline side, we've heavily supported the expansion of the Explorer pipeline that is now in the process of getting expanded by about 100,000 barrels. That will bring more volume into Chicago. And we're actually in construction of the Two Rivers pipeline which will bring more volume from the mid- continent into the Ohio region. So there is a fair bit of investment going on as we speak, and that should help the end consumer in the years to come. Senator Collins. Mr. Chairman, since two--well, now one of our colleagues has not had a chance to question yet and the hour is late, I am just going to make one final comment in the hopes of letting Senator Bunning question before we break for lunch, and that is that consumers are not the cause of refinery glitches, whether it is a fire or--nor are they to blame for industry supply miscalculations, nor are they to blame for infrastructure shortcomings. It concerns me that every year, as predictable as Memorial Day, are price spikes; we just know that is going to happen. And it seems to me that the industry could do more to try to even out the pricing and prevent those spikes. And I still don't feel like I have gotten a good answer to why these investments have not been made before now, why they are not being made more aggressively, and that is what leads people to conclude, perhaps completely unfairly, that the industry is manipulating supplies or wants tight suppliers or wants shortages in order to drive up prices and, thus, profits. So I think at the least that you need to give us a better understanding of what you are doing to learn from past experience and prevent these disruptions that are so burdensome to our economy and to the average consumer. Thank you, Mr. Chairman. Senator Levin. Thank you very much, Senator Collins. Senator Bunning. Senator Bunning. Let me start off by saying nothing lights up my phone more in my local office, in my Washington office, when we see a 10- or a 15- or, for that matter, a 20-cent-per- gallon increase today or tomorrow, and then over a period of time it gradually reduces down maybe about to where it was, and then all of a sudden we have another increase of 15 cents a gallon, like we did 2 weeks ago. Nothing more infuriates the consumer because they do not understand the complications that go into it. The question I want to ask, can you explain how zone pricing works for each of your companies? The Subcommittee report points out that some retailers here in Washington, DC, felt that they were not able to compete with other stations just across the river in Virginia, for instance, because of the zone they were in. How do you respond to this? Is it the zoning price that causes the great big fluctuations or is it something else? We will start with the ExxonMobil people. Mr. Carter. Thank you, Senator. The way we establish zones is we go into the marketplace, and we look at competition. And where we have a group of dealers that face similar competition, we set up a price zone for them so we can price to them, at a level which allows them to compete with their local competition, and we do that all over the country. We have been doing it for at least 30 years, my entire career. Senator Bunning. Let me explain. I can go over in Virginia and buy gas 25 cents less for unleaded regular than if I buy it in Washington, DC. Is that taxes or what is it? What causes that? Mr. Carter. I'm not familiar with the taxes in Washington, DC. I would be happy to get back to you with that. I can tell you that it is extraordinarily difficult to build a service station in Washington, DC. We would love to build more stations here. The last time we tried to build a new-to-industry station here, we spent over a million dollars to buy a piece of property on the expectation we would be able to get a permit, that the community would welcome another service station. In fact, after a number of years, we could not get a permit, and we had to sell that piece of property at a significant loss. So there are fewer stations in Washington, DC, because of permitting---- Senator Bunning. I know that land costs are high, but---- Mr. Carter [continuing]. And the land costs. Senator Bunning. Are they trying to recoup the land costs from the price of the gasoline, do you think? Mr. Carter. We, and our dealers, try to recoup our cost, and the dealer is ultimately--there are no company-operated stations in Washington---- Senator Bunning. So it is dealer operated. Mr. Carter. Right, it's the dealer that does the pricing. Mr. Heminger. Senator, Marathon Ashland Petroleum does not market here in Virginia or Washington, DC. Senator Bunning. OK, but you have a zone pricing. Mr. Heminger. But for zone pricing, within our Marathon- brand stations, we have zone pricing, and each station is set up on its own price grid, and therefore a zone. And they are priced individually against the grid or against the competition on that zone. So I would say each one of those grids is competitive against its own other market competitors. Senator Bunning. No matter how much the cost of the product that you are sending into that zone? Mr. Heminger. The cost of the product is a big part of how we decide to set the price on a daily basis. Senator Bunning. What we are getting at is the Midwest, obviously, because of the huge spikes in the prices that occurred in the Midwest in the past couple of years. That is what I want to know. I know you are located right in the middle of the Midwest, did the Midwest structure differ from where you sell out of the Midwest? Mr. Heminger. Within the Midwest, I see the Midwest, as other parts of the country, but specifically the Midwest, as being one of the most fiercest, competitive areas in the marketplace. Every day we look at our prices. And we have a very small number of customers that are on zone pricing, the balance are through our Speedway stores, which are direct- operated stations. Every day we look at those, and our strategy has always been, as we shared with the staff, is to be the lowest price on the street. And every day as you---- Senator Bunning. That is hard to do because there's independents who probably buy a product from you and someone else who will take a lesser of a margin on that same gallon of gasoline that drives the price down. I use convenience stores and other independents. I do not know where they are getting their product, but obviously the wholesale price of that gasoline that they are buying, they are getting a less markup on because they are underselling your Speedway stations in my area. Mr. Heminger. Well, Senator, we attempt to match the lowest price on the street, and therein goes the volume that we sell on a daily basis. If we do not match the lowest price on the street, and we are a very big supplier to the balance of the independents in the marketplace, you are absolutely correct, but if we don't match the lowest price on the street, just a penny, therein goes our sales. So we watch that every day to ensure that we are competitive on the street. Senator Bunning. Let me ask you something different because it is really--BP has a station in Highland Heights, Kentucky. It is the lowest priced gasoline in my whole area, but BP also has a station right across from my office in Northern Kentucky that is one of the highest priced gasoline in my area--as much as 20 cents more a gallon. Now how do I explain that to somebody who calls me and says, ``What are you doing about the price of BP's gasoline over here in Fort Wright, Kentucky, when I can go over in Highland Heights, Kentucky, and buy it for 20 cents a gallon cheaper?'' Mr. Pillari. Well, first of all, I'm pleased that you have noticed us. I hope you are a customer. Senator Bunning. I wouldn't know your two stations. Mr. Pillari. I have never been to those stations, but in that area we are basically jobber and dealer. So those locations in that area would buy product from us and then set their own retail price, and each dealer or jobber would determine how they want to set that price. Some of them prefer a low-volume, high-price strategy to get the cash they need to run their business. Others will prefer a lower price and try to get a higher volume to get the cash to meet their economic needs. And so you can see big swings within the market based on how each individual---- Senator Bunning. Even in your own stations. Mr. Pillari. Yes. Senator Bunning. Even with your BP markets. Mr. Pillari. Yes, absolutely. Senator Bunning. Mr. Reeves. Mr. Reeves. Thank you. Of course, we don't operate in the Midwest, so I will give you a broader answer than just the Midwest. Senator Bunning. All right, zone pricing. Mr. Reeves. Zone pricing. I'll go back to the original question, thanks. I always think of zone pricing, and I was reminded actually this morning, when I paid my hotel bill, zone pricing sounds mysterious, but it's really meeting local, relevant competition, and that's why hotel bills are different in Washington, DC, or across the river in Virginia or in Kansas City or elsewhere. It's the dynamic of meeting competition, and that's our basic philosophy. Zone pricing is just that. It is figuring out what's a relevant area of competition, and who do you want to compete against and why, and figuring out where to set your price relative to those, so that you can get the volume that you need and the balance between volume, and price, and margin is what generates the cash to run the business. And it sounds mysterious, and it sounds complicated, but it is actually as simple as meeting local competition. Senator Bunning. It is hard to explain to the average consumer---- Mr. Reeves. Very hard. I've been trying to do it for a lot of years. Senator Bunning. And that is who we are trying to explain it to every day, why there is a 15--today, we were buying gasoline at 94 cents for regular unleaded at one time just like 4 months ago, and now it is at $1.44 for regular unleaded in the same area. So that's a 50-cent-per-gallon increase, and boy that will bring the consumer right to your door. Mr. Routs. Basically, the same story. It's all determined and set by the competition in the neighborhood. I must say cases like you mentioned of across the river and across the street we will look at because it is not a very healthy circumstance when one side of the road has one price and the other side of the road has another price. Then you start looking at things like is there a median in the street, and are people going to take that detour to actually go to the lower price range? So all of that is being balanced in order to arrive at the right situation in the end. Senator Bunning. I know how the price of gasolines compare over the last 30 years, and even longer. We are getting a bargain, actually, here in the United States. If you travel anywhere, our prices per gallon are much cheaper than they are, for instance, in Europe and other places. But the Midwest seems to chronically be short of product. Please explain why that is. Mr. Heminger. Senator Bunning, as I testified, the Midwest imports approximately a million barrels per day of gasoline and diesel fuel above and beyond what is manufactured in the Midwest, and when you go back and look at the amount of product that is coming in from the Gulf Coast, there were two major pipelines, an Explorer pipeline and TEPPCO pipeline, which had the ability to ship about 750,000 barrels a day into the Midwest at peak. We just started up, as I stated, the Centennial pipeline, which will have the ability to bring another 200,000 barrels a day. Since the Midwest only refines approximately 75 percent of its demand, it's important, and the only way to really bring it, we bring a little bit from the East Coast, from the harbor market, but the majority of it comes from the Gulf Coast. The Gulf Coast is the flywheel supply to the United States. And we have attempted here to lay this new pipeline that is going to go from Catlettsburg, a 240,000-barrel-a-day refinery, into Ohio to take some of the pressure off of the Midwest. And as I stated earlier, we're still 4\1/2\ years into the project to try to get a permit. Senator Bunning. A regulatory quagmire, I understand that. Mr. Heminger. Yes. Senator Bunning. We will try to get you out of that, but the point being that there is 75 percent only being produced in the Midwest that is being used. That is correct. You talk about capacity and refineries. Are any of your companies thinking about building new refineries, since it has been well over 20-plus years that we have built new refineries in the United States, any of you? Mr. Reeves. No. Mr. Routs. We are not. Mr. Pillari. No, sir. Mr. Heminger. No, sir. Senator Bunning. And the reason is that it is not environmentally possible, it is not economical? What is the reason? Mr. Routs. I think it's been said before the refining business over the last 10 years has had returns of an average of about 5 percent. Senator Bunning. So it is cheaper to bring it in. Mr. Routs. That's right. Senator Bunning. Just buy it and put our dependency on foreign crude and foreign gasoline at a higher--we are going to be over 60 percent very shortly. Mr. Routs. If you will allow me, Senator, we had a refinery in Wood River in the mid-continent, and we decided to sell that to Tosco at the time because of the very low returns that refinery had. So that's the kind of a view we had on the refining industry at the time. Senator Bunning. Thank you very much, Mr. Chairman. Senator Levin. Thank you, Senator Bunning. I think we are going to, if it is all right with our witnesses, I think what we will do is work right through the lunch hour. We may be able to finish by 1:30, depending on whether colleagues come back or not. Is that agreeable with all of you? Mr. Pillari. That is fine. Senator Levin. I want to go back to the ExxonMobil E-mail that is on Page 228. It is Exhibit 15.\1\ Mr. Carter, this is where--back to Powerine, where it says, ``Needless to say, we would all like to see Powerine stay down. Full court press is warranted in this case and I know Brian and Chuck are working this hard.'' --------------------------------------------------------------------------- \1\ See Exhibit No. 15 which appears in the Appendix on page 267. --------------------------------------------------------------------------- Can you tell us what that ``full court press'' entailed? Mr. Carter. Yes, Senator. My understanding is that that meant that we were going to oppose their petition before the regulatory body in California to allow them to manufacture and sell in California gasoline that didn't meet the air requirements. Senator Levin. Is that all that was done? Mr. Carter. To my knowledge, that's correct, sir. Senator Levin. Mr. Pillari, on Page 219,\2\ I want to refer you to a document from 1996. This document came from ARCO, which BP Amoco acquired in 2000. It is a presentation to senior ARCO managers, and it says the following: --------------------------------------------------------------------------- \2\ See Permanent Subcommittee on Investigations' Majority Staff Report, Gas Prices: How Are They Really Set, which is reprinted in the Appendix on page 322. --------------------------------------------------------------------------- ``From time to time, APC,'' which is ARCO, ``may need to endure brush fires to discipline the market, exchange and trade selectively to preserve market discipline.'' Can you explain to us what you think ARCO meant by ``disciplining the market'' or ``preserving market discipline.'' Mr. Pillari. Sir, I don't know what they meant. This was quite a long time ago before we were involved. Senator Levin. Have you ever heard the term ``preserve market discipline''? Have you ever used the term or heard it? Mr. Pillari. No, sir. Senator Levin. This is another example where it is not just sort of market factors which are controlling, this is another example of companies taking very specific actions to impact that market--in this case, exchange and trade. Now I want to talk to you about this memo on Page 273.\2\ This is a document from the Marathon files, dated October 1, 1998, and it appears that Marathon was pleased that Hurricane George came through and knocked out a refinery. Here is what the document says: ``As OPEC and other exporters' efforts to rein in output began bearing fruit, nature stepped in to lend the oil producers a helping hand in the form of Hurricane George, which caused some major refinery closures, threatened off-shore oil production and imports, and generally leant some bullishness to the oil futures markets. However, this storm-induced optimism is likely to prove temporary, leading to some pullback in prices prior to the heavier worldwide demands for crude in late fall and early winter.'' Mr. Heminger, it is quite an amazing document, actually, that you would view the hurricane as nature providing oil producers a helping hand. What do you have to say about that memo? Mr. Heminger. Mr. Chairman, first of all, I apologize for any inference whatsoever that is taken from this document or anything taken out of context in this document that states that my company would find pleasure in any natural disaster. That is totally an incorrect interpretation. What that document is, is on a monthly basis we basically recite the EIA, OPIS, other industry magazines, other industry reports about what is going on in the crude oil market and what we expect the future price is going to be. This merely recites what was stated at that point in time for the cause of the increase in crude oil prices. But we have employees in the Gulf of Mexico working on a LOOP platform, we have employees at our parent company working on production platforms and a number of employees working in the marine business that would be off of the Gulf of Mexico. We certainly would never want anything to happen to anyone. Senator Levin. Well, first of all, I think you will agree I read the whole paragraph. I did not take words out of context; is that not correct? Mr. Heminger. That's correct, Mr. Chairman. Senator Levin. And, second, I want to get to the heart of the matter, which is that reining in output, reducing supply helped oil producers; is that correct? Mr. Heminger. What that document is discussing is crude oil prices only. And when it talks about they had to shut down platforms, in a hurricane disaster and safety procedures, you have to shut in the platforms, and many times we shut in pipelines that are bringing off-shore crude oil into the marketplace. Senator Levin. How does that help producers? How does closing, major refinery closures, it says here, help oil producers? Mr. Heminger. Closing a major refinery, Senator, never helps a producer. Senator Levin. Let me read it to you again, putting aside the reference to Hurricane George for a minute. ``As OPEC and other exporters' efforts to rein in output,'' reduce output, ``began bearing fruit, nature stepped in to lend the oil producers a helping hand, in the form of Hurricane George, which caused some major refinery closures.'' Now, putting aside the fact that it was Hurricane George which did that, the closing of major refinery closures is referred to in that document as lending oil producers a helping hand. Mr. Heminger. I cannot--I did not write the document, first of all, but closing a major refiner or refinery would never help a producer because that would take additional demand off of the marketplace. And what that report back at that time was discussing was the global crude oil market. And as you are aware, OPEC's back- and-forth stance on whether they're going to produce more or produce less, that was specifically speaking to reports from the EIA and from other industry reports talking about the global crude oil market. Senator Levin. Do you know who wrote this document? Mr. Heminger. I'm aware, yes, sir. Senator Levin. Who is it? Mr. Heminger. A gentleman in our Economics Department. Senator Levin. Have you talked to the person and said, ``My God, what are you saying here? You are saying exactly what Senator Levin is saying, which is that reducing supply can help us here. Controlling supply, having a tight supply is good for oil producers. That is what Senator Levin is saying, and my gosh you put it all there right in the first paragraph''? Did you talk to this man about this? Mr. Heminger. I have not spoken to this man yet, no. Senator Levin. I am sure you will after this hearing. Mr. Heminger. Yes, sir. Senator Levin. Now let's go to the first few words. ``As OPEC and other exporters' efforts to rein in output began bearing fruit.'' That is bitter fruit for most consumers. When OPEC reins in output, it is bitter fruit for the consumers of America. We fight that, and yet here is your economist saying that when OPEC and other exporters rein in output, it bears fruit. How does he--explain those words. Mr. Heminger. First of all, reining in production, from a producer's standpoint, has no benefit whatsoever to the downstream part of our business. So I never like to see increased crude oil prices. Senator Levin. It says here it ``lends oil producers a helping hand.'' ``Nature stepped in.'' Putting aside the reference, the crude reference out of Hurricane George, OK, put that aside, just the fact that OPEC is reining in output is bearing fruit, that is a positive reference. Bearing fruit means it is good. Your economist says that is good. You are saying it is not. Your document says it is. Why? It lends oil producers a helping hand, and it talks about closing major refineries. That is a plus. It is evidence of exactly what the report's conclusion here is, it seems to me, but I want to just again give you a chance, just on the OPEC issue, reining in output is referred to as bearing fruit, and I just want to be sure you are saying, from your perspective, that is wrong. Mr. Heminger. From my perspective, that is discussing about a crude oil producer, not a refiner and a marketer. Senator Levin. Your company is a refiner and marketer, is it not? Mr. Heminger. Yes, Mr. Chairman. Senator Levin. ``And this storm-induced optimism is likely to be temporary.'' The good news is like to be temporary; isn't that what this is saying? Mr. Heminger. Any time there is a natural disaster and we have to take our employees out of the Gulf of Mexico or close down a refinery is generally very temporary, and it's never good. Senator Levin. The staff report, now turning to California, found that ``a number of refiners sought to limit the amount of supply in order to get higher margins. And to reduce supply, the refiners sought to increase exports, limit imports, eliminate the oxygenate mandate and prevent additional refinery capacity from operating.'' I just want to repeat it. This is what the staff report finds, and it has got the evidence set forth right there, bountifully. ``A number of refiners sought to limit the amount of supply in order to get higher margins.'' How do you reduce supplies? Refiners sought to increase exports from California, limit imports to California, eliminate the oxygenate mandate and prevent additional refinery capacity from operating. I want to just look at a couple of memos here now on limiting imports into California. First, on Page 218, and it is Exhibit 18.\1\ This is a Texaco memo, and the Texaco representative is reporting a conversation that he had with a representative from Shell regarding Texaco's plan for manufacturing gasoline under new standards that were brought about to take effect in the fear that Texaco would import gasoline. So that is the fear. This is 1992. Now the Texaco official reports that the Shell representative said the following: --------------------------------------------------------------------------- \1\ See Exhibit No. 18 which appears in the Appendix on page 271. --------------------------------------------------------------------------- ``Shell and the other oil companies are extremely concerned about Texaco's silence--'' Let me read that again. ``Shell and the other oil companies are extremely concerned about Texaco's silence and the lack of activity concerning our plans toward CARB Phase 2 compliance.'' The Shell representative called Texaco a ``wild card'' and said, ``We are nervous about it.'' The Texaco official said that an ARCO plant manager expressed the same concerns at a refinery managers meeting in April. I am going to address this to you, Mr. Routs, because you now speak for not just Shell, as I understand it, but for part of the old Texaco; is that correct? Mr. Routs. Indeed. We went into a joint venture with Texaco in 1998 and bought them out in 2002. Senator Levin. The document here, the memo, talks about Texaco's silence. What silence would that be referring to? Mr. Routs. Not having been involved in these discussions, Senator Levin, I have no idea. I have to assume that the industry was announcing what they were going to do about this whole thing, in terms of capital investment, and that Texaco hadn't announced, but again that is a speculation, but that's what happens in other parts of the world. Senator Levin. The memo refers to Texaco as a ``wild card.'' Do you know what that means? Are the other companies known or---- Mr. Routs. It's not the kind of language that I would allow in my company today, Senator. Senator Levin. OK. Is it standard practice within your company to ask other refiners about their plans for refining gasoline? Mr. Routs. It is not. Senator Levin. That would be borderline collusion, wouldn't it? Mr. Routs. That would be absolutely forbidden, and our lawyers---- Senator Levin. Because it might be collusion. Mr. Routs. Our lawyers would take action. We think it's anticompetitive, yes. Senator Levin. OK. Now the Shell representative here apparently said of Texaco imports, ``Shell will seek a tax on the importation of RFG.'' Do you know anything about that effort, Mr. Routs? Mr. Routs. I don't know anything about the effort, Senator. Senator Levin. It looks like a direct threat to Texaco. That would surely be an anticompetitive action, would it not? Mr. Routs. Believe me that I find it incredible that if a conversation like this has taken place in the past, that it is absolutely not acceptable in our norms and ethics of today and at the time, for that matter. Senator Levin. Let me just interrupt for one second. We decided, I hope, with everybody's consent, although you weren't here to give it to me, that we would work right through the lunch hour. And so you can, any time you are ready, if you have additional questions, I can just stop and pick up---- Senator Voinovich. You are going to continue? Senator Levin. I am going to continue for some time. Senator Voinovich. This is Governmental Affairs, and we are involved in looking at the entire operation of the government and how it operates. If I recall correctly, when I met with a representative from BP in my office, he indicated to me that they didn't need more refineries here in the United States, and also there was an indication that the boutique gasoline problem, our various RFG formulas, were not that big a problem. I heard this morning that these various numbers of gasoline, over 91--you used to have 6 and now you have 90--is a problem, that looking at that situation and changing it would help ease the spikes that we are seeing. The other thing that I am concerned about is that if we only have limited refinery capacity and if one of them goes down, again, we see prices spike. I would like to eliminate all of the causes that you have put on the table that cause spikes. Now we can't do much about the issue of crude oil, and that is a problem that we have had, and we are going to continue to have for a long time. I think it is going to get a whole lot worse before it gets better, but that is something that we are going to have to spend some time with. But the issue of refineries, I would like to hear from all of you how do we get another refinery built here? I think we need more refineries. The first question is do we need more refineries? I want to hear from each one of you, do we need more refineries? Mr. Carter. Senator, my company doesn't need any more refineries. We have done a really excellent job of expanding the ones we have. They are large refineries. They are highly efficient. Under previous regulations, we have been able to expand those and have added considerably to our capacity over the years. This incremental growth of refining capacity, however, is threatened by current New Source Review regulations. They are difficult to interpret. They are being interpreted retroactively. The DOE and EPA are studying those. We have submitted a report to them with our recommendations. I would be happy to get you a copy of that report, but in our view, that is the largest threat out there to increasing refinery capacity. Senator Voinovich. So, as far as your company is concerned, you have the facilities and, with clarification of New Source Review, you think you'd be OK in terms of your refinery; is that right? Mr. Carter. With that exception, and also in my testimony, I mentioned the new sulfur regulations, potential phase-out of MTBE, the need to coordinate these changes in gasoline regulations so that we have the time to make the investments, and they don't gang up on us. The NPC has done a study of that. They have raised some doubts whether the industry will be in position to meet all of the new software requirements, as well as MTBE phase-out. So I think those should be coordinated as well, sir. Senator Voinovich. So we have to coordinate the MBTE phase- out, and you are going forward with the sulfur regulation, but you think you are going to have a problem in complying with it, as Congress has mandated; is that correct? Mr. Carter. The NPC found that. I, personally, have a lot of confidence in my company, but when the NPC looked at the entire industry, they raised some doubts about the industry's ability. Senator Voinovich. How about the sulfur implementation? Mr. Carter. All of these together. Senator Voinovich. Mr. Heminger. Mr. Heminger. Yes, Senator, we have invested heavily in our refineries. In fact, I stated we just invested $300 million to upgrade our plant in Garyville, and we are going to have to invest between $600 and $700 million just to meet the low- sulfur regs for gasoline and diesel by 2006 to 2008 time frame. So we are going to continue to invest, but that is investment just to keep today's capacity where it is. If you take between $600 and $700 million of investment, with basically no return off of that investment because I look at that as ``stay in business'' capital, I would say it is going to hurt us to continue to invest in new refineries. To go back to your other question, would we invest in a new refinery? We certainly would give strong consideration to that. I believe, though, it needs to be on the same pipeline or the same corridor of the pipeline and the infrastructures that we have available in the country today. But as I have also stated how difficult it has been to get a permit to do a very small pipeline, we find it many multiples more difficult to be able to try to increase refining output. Senator Voinovich. Mr. Pillari. Mr. Pillari. Thank you, Senator. We are investing heavily in our core refineries, those that we believe have the best long-term future. As you know, we have been selling refineries. All of them are still operating in the marketplace, but we have been selling them because we believe that the economics of the business support an alternate purchase rather than an investment in a new refinery. Senator Voinovich. Is all of the crude oil that comes into this country refined here or is some of it refined when we bring it in? Is all of it refined in the United States? How much? Mr. Pillari. All of the crude oil that we bring into the country? Senator Voinovich. Yes. Mr. Pillari. Everything we bring into the country is refined here. Senator Voinovich. It is refined in the United States? Mr. Pillari. Yes. Senator Voinovich. Why don't you bring in refined oil? Mr. Pillari. We also bring in refined oil products. Senator Voinovich. So you have options. BP has options. You can either have somebody refine it here or you bring in oil that is refined. Mr. Pillari. Correct. Senator Voinovich. Why doesn't that take care of the problem when a refinery breaks down, if you can just bring it in from someplace else? Mr. Pillari. Well, it takes a little while to get it here, and I think there are two things about it. First off, when something unusual happens, if it is significant, like the fire at the Citgo refinery last year, something that major that takes a lot of product out of the marketplace, it takes a little while, particularly in the Midwest, for the product to come in through the Gulf Coast or through New York or somewhere to get up there. So there are logistics issues for getting up there, and at the same time, you are also then dealing in the spot market, which is reacting to the marketplace. Senator Voinovich. Does BP think we need more refineries in the United States? Mr. Pillari. We think we don't need more refineries. Senator Voinovich. I know that because you got rid of one in Lima, and thank God a company picked it up and it is refining. I don't know what we would have done if they had shut that place down. Mr. Reeves. Mr. Reeves. Similar to earlier answers, Senator, the vast majority of our capital over the last certainly 6 or 8 years has gone into meeting environmental performance requirements, and very much of that driven in California. That is where the majority of our refining capacity lies. Also, looking at California, I find it inconceivable that in California's climate today a new refinery could be built. We also have a large refinery in Mississippi, which is under construction right now to meet the new clean fuel standards. There will be some minor expansion of capacity there, but certainly nothing major. The answer to the second question, which is do we need more refining capacity, ultimately, demand is going to outstrip the capacity of the refining industry in the United States over the next 20 years. The question is how do you meet that? Is it going to be imports? Is it going to be constructed? Generally, today there is adequate refining capacity in the world to import products to meet U.S. demand, and barring any unforeseen circumstances, I would guess that is how it is going to evolve. Senator Voinovich. No new refineries. Mr. Routs. Mr. Routs. No new refineries. Actually, we are going the other way. The refinery coverage is about 70 percent of our branded sales. We have sold over the last couple of years two refineries. They are still operating. But this is a business, as I said earlier, that has very low returns, and where we have to spend billions of dollars in order to meet the requirements of clean fuels and the requirements of emissions. And don't take me wrong, I think those things are necessary to protect the environment, but in the end, it's not a business that makes a lot of money. So what we are looking at actually is to, through a global trading system, to bring more gasoline into the country. Now you asked a question why doesn't it happen all of the time? Time requirements are one, but the other one also is arbitrage. Gasoline might just be more expensive in Europe, and prices have to come in this country, in terms--for gasoline to move from Europe to the United States. So all of those things have to adjust and get balanced before a cargo gets sent this way. Senator Voinovich. So, basically, all of you are saying that none of you are going to build any new refineries. In fact, many of you are selling them because the rate of return on them is not that good, those are environmental problems of going forward with them, and you've got a problem with the ones you have right now because you don't know where you stand on New Source Review; is that about it? But what it basically says is, if a major refinery goes down in the United States, the people in the United States, depending on where it is, can experience what we did 2 years ago in the Midwest; is that right? And if we import it here, we are going to pay more for it because of where it is coming from. So that is a question that we ought to discuss, Mr. Chairman, as to what can we do to create an environment where companies are willing to build more refineries here in this country. My last question adresses the problem of reformulated gas, the various degrees of reformulated gas that we have. What is the answer? Is it a problem or isn't it a problem? Mr. Reeves. Well, I'll take a shot at it, Senator. It is a problem for the distribution system. To date, it has been a problem that can be overcome, but generally creates or at least is a contributing factor to some of the price volatility. I think it's important to remember that those boutique fuels were created as our legislative, and environmental, and regulatory communities, and the business communities tried to seek a balance. They weren't created with ill will, they were created to match local environmental conditions and then place requirements on the people that manufacture fuels that are sold there. So I think the boutique fuel issue, looking ahead of us, is going to be very difficult to overcome because it almost either requires everybody to come up to the highest possible standard, which can place some costs on people that don't currently reflect those costs in their prices, or it asks people to lower their environmental performance expectations in certain markets, to lower them to the average, and I don't see that as a very easy thing to change. Senator Voinovich. Is there anybody from the industry that is looking at these 90 different RFGs to find out if there is an easier way of skinning the cat, and getting the job done and respecting the environment? Are they? Mr. Heminger. Senator, I know the National Petroleum Refining Association and the American Petroleum Institute have been working on that question. Mr. Routs. As the chair of the Downstream Committee of the API, we have been pushing very strongly to get the number of gasolines reduced, and we have had a proposal in, and actually in the new energy bill some of those proposals are going to be worked. So we think there is a solution in sight. It is just a matter of arriving at the right balance between what we can put in our distribution system and what is acceptable to the environment. Senator Voinovich. So your suggestion is that we ought to see if there is a way that we can smooth it out a bit and get rid of some of the jagged edges. But the public has to understand that if you are doing this kind of gasoline, that they are going to have to pay more for it at the pump. I remember well, as governor of Ohio, we had the issue of our reformulated gas in Cincinnati, and the choice was we go RFG or we go to emissions testing. I opted for emissions testing because I knew that if we went to the reformulated gasoline, it would cost more money for our people, and we could comply with the law in a cheaper way by doing the emissions testing. I think that one of the things that the public has to understand is that the environmental considerations have had a dramatic impact on your businesses and that, as you point out Mr. Reeves, in many instances they are proper requirements, but the fact of the matter is that you are going to have to pay for it. There is a public perception that the oil companies are making money hand over fist. I would like to know from you, Mr. Heminger, what has happened to your stock price in the last several years. Are you making out like a bandit because of these spikes at the pump? Mr. Heminger. Well, our stock price is really reflected in both parents, Marathon and Ashland, and I would say that, no, our stock price has been relatively flat over the last number of years. Senator Voinovich. What do you mean by flat? Mr. Heminger. We have not seen any sustainable increase in rates of return. Therefore, we have not seen any growth or any increased value in the market capitalization of our stocks. Senator Voinovich. There was a brief period there where the stock prices went up, and then they came down again, correct? Mr. Pillari, you are worldwide, BP? Mr. Pillari. Correct. Our share price has been almost as volatile as gasoline prices in the last 5 or 6 years. I think today we are probably sitting somewhere in the low fifties. We have dropped $3 or $4 just in the last month or so, and we have been as low as the forties. So we've seen quite a bit of volatility. Senator Voinovich. Mr. Reeves. Mr. Reeves. That would be the same for us. We're right now in the mid eighties, up as high as the mid to high nineties and to the low seventies over the course of the last 2\1/2\ years. Mr. Routs. Royal Dutch shares, same thing happened in the mid sixties. We are right now trading around fifty. Senator Voinovich. Mr. Carter. Mr. Carter. Same answer. Our stock today, I mean, it fluctuates as well, but if you look at it today versus 2 or 3 years ago, it is lower. Senator Voinovich. Mr. Chairman, I have no other questions at this time. Senator Levin. Thank you, Senator Voinovich. Let me ask, first, Mr. Carter a question about a document on Page 214.\1\ It is a document that discusses limiting imports into California, and it is a strategy discussion by officials from Exxon who were looking at the West Coast supply picture. --------------------------------------------------------------------------- \1\ See Permanent Subcommittee on Investigations' Majority Staff Report, Gas Prices: How Are They Really Set, which is reprinted in the Appendix on page 322. --------------------------------------------------------------------------- And then on the last page of that memo, which is Page 214, there are several general strategy considerations, and I want to just make reference to one of them. In the first bullet, there is a proposal that Exxon, ``Should not do deals that support others importing barrels to the West Coast.'' What kind of deals would that bullet be referring to? Mr. Carter. Mr. Chairman, I am not absolutely familiar with the memo. I can tell you about our practices on the West Coast. Many times we have manufactured California-grade gasoline in our refinery at Baytown, Texas, and we have shipped it all the way around, up the West Coast, into California at considerable expense, and in many cases we have lost money on that gasoline. As the report indicates, the California and West Coast marketplace is isolated. It's sometimes long of product, it's sometimes short of product. In short periods, we have often manufactured the gasoline on the West Coast, the East Coast or Gulf Coast and moved it all the way around. I take this memo to refer to those times when the supply is long. That is the only thing I can assume that it's referring to. Senator Levin. Now, there is also a ChevronTexaco memo, which is Exhibit 19,\2\ and this---- --------------------------------------------------------------------------- \2\ See Exhibit No. 19 which appears in the Appendix on page 272. --------------------------------------------------------------------------- Mr. Reeves. I'm sorry, Senator, what page would that be? Senator Levin. This is Exhibit 19. That is on Page 202. Mr. Reeves. Thank you. Senator Levin. This is a study which says the following: ``Exports becoming a more important factor in balancing light product supply and demand.'' So this memo starts or that reference highlights the use of exports of gasoline to keep supplies tight. And then it goes on to make another important statement. It says the following: ``Market is dominated by limited number of large, committed refiner/marketers whose individual actions can have significant market impact.'' Now that is pretty much what our conclusion is in the report, so I am going to read it again. ``Market is dominated by limited number of large, committed refiner/marketers whose individual actions can have significant market impact.'' That's what a highly concentrated market is all about. I'm just wondering whether or not, let's see, this would be you, Mr. Reeves, do you agree with that statement from your document? Mr. Reeves. Well, actually I've been with the Chevron organization long enough that I was actually part of the study team that put this together. Senator Levin. Better yet. Mr. Reeves. So I can reply to it. Senator Levin. Do you agree with what you wrote? Mr. Reeves. I do, yes. I guess I'd parse it into two pieces; one is the large committed refiner/marketer, and it is true that is a reflection of the West Coast competitive structure, and probably the most important word there is ``committed.'' Given the volatility of the West Coast refining and marketing business, it's my belief, when you look back over at history, that small companies who don't have the financial wherewithal to see it through the ups and the downs, have elected not to remain in that business, and so that is the reflection of the large and committed and why it is significant. Individual actions, I think you've seen that actually play out. This is a document I think from 1993 or somewhere back then when we were actually long on product, but even then you could see that if there were significant incidents and disruptions in the marketplace, that there was a lot of volatility in the price. So, yes, I would certainly stand by what we wrote then. Senator Levin. Is the market in California dominated by a few large refiners that can have a significant market impact? Mr. Reeves. Well, the refining capacity has not really materially changed over the last, oh, 9 to 10 years. The ownership has been moving around quite a bit, mostly as a result of the mergers and the required FTC divestments. It is characterized by larger refiner marketers, large integrated oil companies, and now an emerging group, companies like Valero- UDS, who are now actually the largest refiners in the United States or close to it. Senator Levin. Going back to the statement, is it true that the market is dominated still by a limited number of large, committed refiner/marketers, and these now are the key words ``whose individual actions can have significant market impact''? Is that true? Mr. Reeves. I think I've already agreed with that statement, Senator. Senator Levin. You have? I didn't hear a clear agreement with it. Mr. Reeves. It was, yes. Senator Levin. Thank you. Now, relative to an ARCO presentation, this is Exhibit 17,\1\ Page 223, and this advocates exporting gasoline in a number of places. --------------------------------------------------------------------------- \1\ See Exhibit No. 17 which appears in the Appendix on page 269. --------------------------------------------------------------------------- On Page 223, Exhibit 17b, if you look up at the upper right hand, under ``Take Action,'' it says, ``Export to keep the market tight.'' So let me ask, is that still the policy of ARCO? Mr. Pillari. Well, since we have owned ARCO, we have not been exporting product. We are a net buyer of product in the market, and so we are quite short. Senator Levin. And so ARCO did not follow that? Mr. Pillari. I don't know what ARCO did back then. I think this was, what, the mid-nineties or something? Senator Levin. This document, I believe, is 1996. Anyway, you don't know whether that action was taken, whenever the date of the document is? Mr. Pillari. No, I don't, but today we are a net buyer. Senator Levin. Now let me ask ExxonMobil, has ExxonMobil exported gasoline from California to maintain high refining markets? Mr. Carter. No, Mr. Chairman. Senator Levin. I mean, high refining margins. Mr. Carter. The California-grade gasoline we manufacture is sold in California. Senator Levin. All right. Let me ask Shell, has Shell exported gasoline from California to maintain high refining margins? Mr. Routs. No, we have not, Senator. Senator Levin. Thank you. If you take a look at Exhibit 20,\1\ this is a Texaco document from the Aguilar case. This is a 1996 memo, and it is on Page 238. --------------------------------------------------------------------------- \1\ See Exhibit No. 20 which appears in the Appendix on page 273. --------------------------------------------------------------------------- Texaco's ``position is to fight the proposed specification changes because it will increase fuel costs and not deliver commensurate benefits to consumers.'' That sounds good. Then the next paragraph says the following: ``Incremental improvements to refinery margins from reducing supplies can be achieved in a number of ways. One way--'' I want to point out here this is what this report is all about is increasing refinery margins from reducing supplies. This memo says it can be achieved in a number of ways. ``One way would be to promote the more restrictive mandated specification changes to reduce supply of product; another would be for refiners to voluntarily reduce refinery production, without incurring added costs or suffering attrition [admittedly unreasonably idealistic, but the best option.]'' Now the goal then, as stated in this memo, is to reduce the supply of gas in order to increase refining margins; is that correct? Mr. Routs. I can't comment on it, Senator. I don't know what the goal was at the time that this memo was being put together. Senator Levin. OK. Texaco has taken a position of opposing one particular plan for new specifications for fuel. This memo is contemplating changing that position in order to tighten supply; is that correct? That is what the memo was doing, saying maybe we ought to change our position about whether we support or oppose a particular plan for new specifications in order to tighten supply. Am I reading it correctly, to begin with? Mr. Routs. I agree with you that you can read that memo that way, Senator. Senator Levin. Now, in the BP memo that we discussed earlier, BP seemed to be opposing oxygenate requirements or at least was considering it, in order to tighten supply, because without the oxygenate more gasoline is needed. So it appears as though, whether or not companies support or oppose fuel specifications could depend on whether or not those fuel specifications increase or decrease the supply of gasoline. That is what it appears from these memos. Now another proposal in this memo, which is on Page 238, is to ``voluntarily reduce refinery production.'' That just means shutting down a refinery in order to reduce supply; is that right? Did Texaco do that? Mr. Routs. I can't answer that question on behalf of Texaco, sir. Senator Levin. Let me just ask Shell. Has Shell ever done that? Mr. Routs. Could you repeat the question? Senator Levin. Yes. I think you may have answered this before, this issue that is coming up now. Has Shell ever reduced refinery production or shut a refinery just to reduce supply? Mr. Routs. As I said earlier, the main reason why we have sold or shut capacity is because it was no longer economic to run. Senator Levin. All right. I want to go back to what Senator Voinovich was asking about also, which is whether or not the United States needs more refineries. And the answer, I believe, from each of our witnesses was that your company doesn't need more refineries. Is that correct? Mr. Routs. That's right. Senator Levin. With the one exception, I think, of someone---- Mr. Heminger. I said we would consider an investment in refining. Senator Levin. You would consider. The other companies, I believe, said that you have adequate refinery capacity. Is that correct? Mr. Reeves. That's right. Mr. Carter. We don't need another refinery. I did not say we would not add refining capacity, and I talked about the New Source Review requirements and things like that. Senator Levin. OK. That is correct. You don't need another refinery. So the only company that is considering an additional refinery then would be Marathon. Is that correct? Mr. Heminger. We would consider that, yes, sir. Senator Levin. All right. Now let me ask you this question: Putting aside your own company's situation relative to the need for additional refineries, is the United States now short of refineries? Mr. Carter. Mr. Carter. Well, my company is not short. We run our refineries---- Senator Levin. In your judgment, is our country short? Mr. Carter. No, sir. Senator Levin. In your judgment, is the United States short of refineries, Mr. Heminger? Mr. Heminger. I would say we are short of refining capacity because we're importing refined products today. Senator Levin. All right. So you believe our capacity right now is too low? Mr. Heminger. Mr. Chairman, when you look at the rates that we're running all the refineries today, we are running them full out for the majority of the year. And if we're importing-- in fact, the question came up a while back on Venezuela. We're importing a significant amount of refined product from South America and from Europe, so it's clear to our company that more capacity could be used in this country. Senator Levin. OK. Mr. Pillari. Mr. Pillari. Given the imports coming in, I would say we are finely balanced, just a tad bit short. Senator Levin. OK. Mr. Reeves. Mr. Reeves. A similar answer. I think we clearly are importing products, and it is--at least, I think returns are telling us that is the most economic solution right now. If demand continues to grow--and that is an unknown--out over another couple of decades, I think the situation would have to be looked at differently. Senator Levin. OK. Mr. Routs. Imports will cover our needs. It's more economic for us at this point. Senator Levin. I think from at least most of your answers, it is clear at least that there is not--in terms of trying to look at the cause for price spikes, you can't point to the shortage of refineries since most of you say there is no shortage of refineries. Most of you say there is no shortage of refining capacity. Sometimes that is given as the reason for price spikes. But I don't think we can use that excuse. I don't think that particular justification or rationale washes, given at least the bulk of your answers here. I want to talk just a minute about concentration in Michigan. The Department of Energy's Energy Information---- Senator Voinovich. Mr. Chairman, excuse me just a minute. Senator Levin. Please. Senator Voinovich. It is my understanding that when we have had refinery fires and shutdowns, prices have been impacted. Senator Levin. That is correct. There is a disruption in supply. Senator Voinovich. There is a disruption in supply, and that refineries do have an impact on these spikes. Senator Levin. On spikes where there has been a disruption in supply, but our recent spikes are not. The issue also is inventory, not just refining capacity. They maintain 3 days of excess inventory, which means they keep the supply very tight. The report says that gives, in a highly concentrated area, the ability of a few companies then to have an impact on price without fear of significant competition. That is the result of maintaining a very tight supply. That is the finding of the report. Senator Voinovich. The issue is the competition. Senator Levin. That is correct. Senator Voinovich. And whether or not the competition is there in terms of the refineries, and is it cheaper to raise the price than to import refined oil in from some other place. Senator Levin. The issue is lack of competition. That is what our focus has been in the highly concentrated areas, and the fact that there is inadequate competition and what effect that has on price. Senator Voinovich. But the bottom line is that we have been told that the return on investment in building refineries is not that good, and that is why they are getting rid of them and they are selling them off. Also, they have a problem with regulations in terms of building them. Senator Levin. They can argue the return on capital, that is something they may wish to argue, although if you look at all the other industries and businesses, it is somewhere in the middle. But, nonetheless, they can make the argument, but it can't be, under their testimony, that the lack of refineries causes price spikes, because they just said we do have enough refineries. And presumably they don't support price spikes. At least that is what we have been told this morning. Senator Voinovich. Well, I would like them to respond to that. Senator Levin. That would be fine. Are refineries--the shortage of refineries the cause of price spikes? Mr. Carter. Mr. Carter. That was not my testimony, Mr. Chairman. Senator Levin. Thank you. Mr. Heminger. Mr. Heminger. That was not my testimony. Senator Levin. Mr. Pillari. Mr. Pillari. No, sir. Senator Levin. Mr. Reeves. Mr. Reeves. No, I believe it is the regional imbalance that causes the spikes, and then markets require some time to equilibrate. Ultimately they go down. So it is the time lag to resupply. Senator Levin. OK. Mr. Routs. Mr. Routs. I agree with Mr. Reeves. I think we have an ample refining capacity, though not necessarily in the right place. Senator Levin. OK. And, of course, a separate issue here is inventory and the way that is kept very low with a 3-day supply, and when inventory goes down because of the disruption or whatever, at that point you have got a problem. But that is a decision to maintain a low inventory level, which the oil companies have maintained. The EIA, the Energy Information Administration, says that in my State of Michigan four firms--Marathon, BP, ExxonMobil, and Shell--provide about two-thirds of the gasoline sold within Michigan. And it is my understanding that the EIA is measuring which companies are either manufacturing gasoline within the State or bringing it into the State from elsewhere. So we are not talking here retail sales. We are talking about those companies which are manufacturing in the State or bringing it into the State. So the EIA says that this reflects a tight oligopoly in this market. That is not me. That is the Department of Energy which says there is a tight oligopoly in the Michigan market and in other States in the Midwest and California and other States. Do you disagree with this characterization? First let me ask Exxon. Mr. Carter. Well, sir, as I testified, we looked at the Midwest, not at individual States. Individual States are not generally refining markets. If you go back to January 1, 1997, prior to all the mergers that have been discussed here, there were 27 gasoline-producing refineries in the Midwest owned by 19 companies. If you come forward to today, there are still 25 refineries owned by 18 companies, so only one less company. If you use the Herfindahl Index or whatever people use--my economists do that--the Midwest is by that classification ``not concentrated'' in 1997 and it retains that classification today. Senator Levin. Not heavily concentrated? Mr. Carter. ``Not concentrated,'' is the FTC wording. Senator Levin. OK. Mr. Carter. That's in my written report, Mr. Chairman. Senator Levin. OK. Thank you. Mr. Heminger. Mr. Heminger. Mr. Chairman, we believe that the Midwest is one of the most fiercest competitive marketplaces, and I stated that in my testimony. And, in fact, when we look at the Midwest and the State of Michigan, we supply 2 billion gallons more product, so we believe we have acted very responsibly in being able to supply the market. Senator Levin. OK. Thank you. Mr. Pillari. Mr. Pillari. We only make about 60 percent of what we sell in the Midwest. We have refineries in Toledo and Chicago, and the rest we buy on the open market. Mr. Reeves. I'm not qualified to comment on the Midwest. Senator Levin. Thank you. Mr. Routs. Mr. Routs. We have no refineries in the Midwest. Senator Levin. Do you generally agree that high concentration leads to higher prices? Mr. Carter. Mr. Carter. I couldn't disagree with that, sir. Senator Levin. Mr. Heminger. Mr. Heminger. I disagree with that. Senator Levin. OK. Mr. Pillari. Mr. Pillari. I don't think it's automatic. Senator Levin. Mr. Reeves. Mr. Reeves. I would disagree with that as per my testimony. Senator Levin. Mr. Routs. Mr. Routs. I don't think it's automatic either. Senator Levin. Would you generally agree the more competition, the better, in terms of consumers? Mr. Carter. I think competition is good for consumers, yes. Mr. Heminger. I agree. Mr. Pillari. Yes, sir. Mr. Reeves. I would. Mr. Routs. As a consumer, yes, sir. Senator Levin. Let me give you the concentration numbers, that same HHI Index which was referred to, for the United States gasoline wholesale market in 1994. There was moderate concentration in 22 States. That went up to 28 in the year 2000, and there was high concentration in 1994 in 5 States, and that went up to 9 States. So 37 States, according to that same index which you quote, the HHI Index, 37 of those States are either highly or moderately concentrated, and that is an increase from 27 States just 6 years before. Now, those are the HHI numbers that we have in terms of concentration. The other index which is used shows a doubling of the States that are in high concentration areas. So by either index, there has been a significant increase in concentration between 1994 and the year 2000. Let me just ask Marathon a question here. I want to talk to you about a practice that we witnessed in Michigan and Ohio, something that I call Speedway bumps--not speed bumps but Speedway bumps. And I call them that because it is quite apparent in Michigan and Ohio that Speedway takes the lead in bumping up the price of gasoline dramatically on Wednesdays or Thursdays by a dime or more, and then letting it slowly fall over the weekend. And then once Speedway does that, it is apparent that the other brands follow, some to a greater degree--Shell, for example--some to a lesser degree--Mobil, for example. And you can see that in those two figures. This is the last price spike, by the way, that we are looking at. There, again, no relationship to the price of crude, but you can see the difference in rack and retail prices, wholesale and retail prices in Michigan from January to August 2001.\1\ The other one shows Michigan retail prices by brand for the month of April 2001.\2\ You can actually see those Speedway bumps on that right-hand chart and on the left- hand chart. We have enlarged it on the right-hand chart. Up for the weekend, then down; up for the weekend, then down; up for the weekend, then down, and so forth. --------------------------------------------------------------------------- \1\ See Exhibit No. 11 which appears in the Appendix on page 260. \2\ See Exhibit No. 12 which appears in the Appendix on page 261. --------------------------------------------------------------------------- Mr. Heminger, let me ask you about that pricing policy. First of all, do you agree that you appear to be the price leader in Michigan, that other companies, other retailers follow your lead? Mr. Heminger. Mr. Chairman, our pricing policy is every day, as I had in my testimony. We look at our cost, we look at our sales, and we look at how the competitors are pricing, and we elect, as I stated, to always match the lowest price on the street. And then there comes a time when our costs have increased that we elect to raise our retail price to try to recover some of our costs. Senator Levin. Would you agree with me, though, that when you look at the history of pricing and who is a price leader, who follows whom, that in Michigan you appear to be the price leader, that others follow your price? Would you agree with that? Mr. Heminger. Mr. Chairman, every day we attempt to be--to match the lowest price on the street, and there are times--you stated it in your question Wednesday or Thursday. I hope that we are not that predictable. In fact, we look at our prices every day, and we make decisions based on the cost of that given day and time. Senator Levin. Well, you can see Wednesdays or Thursdays on that chart. Those are peaks, little mountains. It doesn't get to Everest until a little later, but there are some peaks, valley, peak, valley, peak, valley, peak, valley, on Wednesday and Thursday. You are just saying that is a coincidence? Mr. Heminger. No, sir. I said that every day we look at our price. There are times--in fact, many times, Wednesday or Thursday is when we will elect or we historically have elected, better said, to increase our price. It is not every week. And when you look at the charts and you really look over the period of time of the spring and summer of 2001, in comparing that back to the crude oil price, and as Senator Voinovich just stated, it wasn't a cause of refineries or it wasn't a cause of crude oil prices in that time frame. It was because of two big fires, one with the Tosco refinery, another one in Lamont, which is southern Chicago, and the prior year it was because of two pipeline failures, is what caused those spikes in the summer months. Senator Levin. I want to talk to you about parallel pricing just for a minute. I want to put the Illinois chart up, if we can get it, for June 2001.\3\ Now, this shows how companies maintain a price relationship to each other, and this is true in many areas. The same company typically will be at this level; the next company, a penny or a fraction of a penny above it; another company, a penny or a fraction above that, and so forth. So you've got like four or five fingers moving down, up or down together, rarely crossing each other. It is called parallel pricing. It is not illegal under current antitrust law. But it sure is no coincidence, either. It may not be illegal, but it is not a coincidence. --------------------------------------------------------------------------- \3\ See Exhibit No. 9 which appears in the Appendix on page 258. --------------------------------------------------------------------------- In a foot race, if all the competitors of equal speed came across the finish line in the same order race after race after race, some would think that something was fishy. Now, when major brands in a market region change their prices at the same time, stay in the same relationship, moving in the same direction and by the same amount, do you not agree that the consumer out there is going to believe and, I will add, reasonably believe that there is a conscious decision to maintain a relationship price-wise between those brands? Would you not agree with that, Mr. Carter? What is a consumer to think when he sees that parallel pricing, that ribbon with the four companies in the same relationship to each other? Mr. Carter. Mr. Chairman, I notice my company is missing from the chart so I don't know from that what my relationship was. We look at our prices every day. We look at the individual zones where our dealers operate. And we try to provide them with a price that allows them to compete in their zone. If you take Washington, DC, the gasoline we are supplying here today was put in a pipeline in the Gulf Coast 30 days ago. If our price is extraordinarily low, we are going to run out before the next amount of gasoline gets here. If our price is extraordinarily high, then we are not going to sell anything. And since this is the end of the Plantation pipeline, we won't know what to do with the gasoline when it gets here. So it's a very careful balancing act to keep our supply in balance and to compete with our competitors. As several of the Senators said, it's a very visible marketplace; everybody can see our prices every day right out on the street without even getting out of their cars. Senator Levin. OK. Do you want to comment on that, Mr. Heminger? Mr. Heminger. Mr. Chairman, as this chart illustrates, Speedway is always the lowest price on the street on this chart, and that has been our strategy, and we hope that our customers look at us as being a value pricer at the street. Senator Levin. OK. Mr. Pillari. Sir, if you take a look at this data, it shows that our company was trying to determine where the consumer would put us in their buying decision, and in some cases our price was up quite a bit higher. And if you look at the end of the period, you would see we were quite down in the middle of the pack. So it doesn't seem to be as consistent as a set approach. Senator Levin. Is parallel pricing illegal? Mr. Pillari. Not to my knowledge, no, sir. Senator Levin. Do you have any problem with making it a presumption that when companies go down or up together and stay in the same price relationship with each other, that that should be evidence that there is something at work which should not be at work? In other words, is there any problem with making that a presumption of illegality that is rebuttable by the industry that you can see? Mr. Pillari. I'm not sure I understand the presumption you're asking me to---- Senator Levin. Parallel pricing, under the current law, which is what that is--where companies stay basically in the same relationship, going up and down together--is not illegal under current law. Would you have a problem with making it presumptively illegal subject to rebuttal? Mr. Pillari. I'll be honest, sir. I don't know what ``presumptively illegal'' means. Senator Levin. OK. Thank you. Mr. Reeves. Mr. Reeves. To answer your question, I would object, and I happen to think that the reflection of a reasonably stable relationship of prices is actually an indication that the market is working exactly as it should. Senator Levin. Even when the companies stay in the same---- Mr. Reeves. Yes, sir. Senator Levin [continuing]. Relationship to each other? Mr. Reeves. And the reason I say that is our pricing is the cumulative effect and response of millions of consumers' decisions, and they choose which brand they care to shop at. They choose for what reasons they choose to shop at a particular company. And the fact that market prices are going up and going down and that individual companies are in relative position, not changing quite often, is, in fact, an indication to me that the market is working. So a presumption of guilt would be completely inappropriate in my view. Senator Levin. Is there any reluctance on your part to say that your company engages in parallel pricing? Mr. Reeves. I don't know the correct definition of parallel pricing. I only know as it's been described here, and I've just said that I think that's a perfectly good reflection of an active and healthy and competitive market. Senator Levin. So you don't know what parallel pricing means? Mr. Reeves. I don't know. Senator Levin. Thank you. Mr. Routs. Mr. Routs. This to me is an example of a highly competitive market where people react to each other or react to each of the pricings. We measure on a daily basis the volumes that go through our stations. If the price is high, we see that the volumes come down immediately. It's very competitive. Senator Levin. And if companies stay in the same relationship to each other price-wise, up and down, does that trouble you? Mr. Routs. No, it doesn't trouble me, sir. Senator Levin. OK. Does it trouble you, Mr. Carter? Mr. Carter. Mr. Chairman, as I stated, I think this marketplace is highly competitive. I went through how we price and so forth. In my testimony I indicated that gasoline prices last year were about $1.50 a gallon, down significantly across time. I understand CNN reported this morning that gasoline prices today are $1.39. In 1999 dollars, I guess that's around $1.30, the lowest prices it's been in a month. I checked into my hotel room last night, and I found this there. I had a bottle of water. A liter of water, about a quart, is $6. If I convert that to per gallon, that's $24 a gallon for water, which comes out of the ground. They don't have to refine it. They don't have to meet all these regulations. And while the marketplace is volatile and I'm concerned about the volatility, I think the absolute price out there is pretty good for consumers. Senator Levin. Well, first of all, I think I'd change hotels. But putting that aside---- [Laughter.] I think if you saw the price of bottled water go up and down together every day, every week, with the same brands staying in the same relationship to each other, I think you would think that something is fishy, too. But my question is: Would it trouble you if brands stay in the same price relationship to each other up and down and up and down? Mr. Heminger. Mr. Heminger. Mr. Chairman, as I say, our strategy is every day to give that value price. We're talking about a global commodity, and if we didn't have NYMEX and if we didn't have the Chicago Exchange, maybe all of those prices wouldn't be transparent. But they are, and all that is traded, and all that reflects costs every day. And we have to take into account how we price our gasoline, and if we want to be the value leader on the street, as this chart illustrates, we really have to pay attention to where our consumers are buying. Senator Levin. OK. Thank you. Would it trouble you if four or five brands stayed in the same price relationship with each other up and down, Mr. Pillari? Mr. Pillari. Sir, I believe the consumers set the price relationship based on their view of the value of each brand, and so it will be where the consumers allow it to be. So, no, it doesn't trouble me. Senator Levin. It doesn't trouble you at all. OK. Mr. Reeves, I think you have answered the question already. Mr. Routs. Mr. Routs. It doesn't trouble me in the sense that I think that is indeed what the market drives us to do. Senator Levin. It drives you to engage in parallel pricing? Mr. Routs. That's not what I said. Senator Levin. What does the market drive you to do? Mr. Routs. The market drives us to be very competitive and to stay close to our competitors in terms of pricing. Senator Levin. OK. Let me ask about zone pricing. It is a very specific question. Are a large number of your zones single-dealer zones? Mr. Carter. Mr. Carter. No, Mr. Chairman. Senator Levin. Do you know about what percentage of the zones are single-dealer? Would it be less than 10 percent? Mr. Carter. I don't know the exact number. I expect that it's less than 10 percent. Senator Levin. OK. Mr. Heminger. Mr. Heminger. Mr. Chairman, they are all single-dealer zones. Senator Levin. Every zone has just one gas station? Mr. Heminger. Yes, sir.\1\ --------------------------------------------------------------------------- \1\ See Exhibit No. 27, May 13, 2001 clarification letter from Marathon-Ashland, which appears in the Appendix on page 281. --------------------------------------------------------------------------- Senator Levin. OK. Mr. Pillari. Mr. Pillari. As far as I know, the only single-station zones we would have would be out in the rural areas, and that would be relatively small. Senator Levin. OK. Mr. Reeves. Mr. Reeves. It would be a very small percentage of ours. Senator Levin. Mr. Routs. Mr. Routs. Fifty-three percent, I am just informed, of our areas are single-dealer. Senator Levin. OK. On the lessee dealers, is it generally correct that lessee dealers do not negotiate the price of the product that you provide to them, that it is set by the company and that they are obligated under the lease to pay whatever they are charged by the company? Is that generally true? Mr. Carter. Well, Mr. Chairman, there are two caveats to that. There are laws that prescribe how we price to our dealers, UCC, I believe. I'm not an attorney, but I get a lot of advice from them. And, second, our dealers feel very free to let us know when they think their price is not a price that allows them to compete. I don't agree that that's negotiation, but certainly they feel free to express their views and we take it into account. Senator Levin. But by the lease, are they obligated to pay the price that you charge? Mr. Carter. That's correct, Mr. Chairman. Senator Levin. Mr. Heminger. Mr. Heminger. Yes, Mr. Chairman, by the lease they're obligated to pay the price, and we have very few lessee dealers. Senator Levin. OK. Mr. Pillari. Mr. Pillari. We have very few also, but, yes, they're obligated to comply with the brand. They can only sell our brand through branded dispensers. Senator Levin. Well, that wasn't my question, though. Are they obligated to pay the price that you charge? Mr. Pillari. Yes. Senator Levin. Mr. Reeves. Mr. Reeves. That would be the case for us as well. Senator Levin. Mr. Routs. Mr. Routs. As far as I'm aware, that's the case, sir. Senator Levin. And do you recommend retail prices to your branded stations? Mr. Carter. We do not today, Mr. Chairman. There was a time when one of our predecessor companies would tell the dealers what the recommended price was. They would also in the same communication tell them that they were free to set it as they chose.\2\ --------------------------------------------------------------------------- \2\ See Exhibit No. 28, May 17, 2002, clarification letter from ExxonMobil, which appears in the Appendix on page 282. --------------------------------------------------------------------------- Senator Levin. OK. Mr. Heminger. Not to our branded stations, Mr. Chairman. Senator Levin. Not to your lessees? Mr. Heminger. We do not recommend the retail price to our lessees or lessee dealers. Senator Levin. OK. Mr. Pillari. Mr. Pillari. It's against policy. Senator Levin. It is? Thank you. Mr. Reeves. Mr. Reeves. We do not encourage that, no. We don't give them a recommended price. Senator Levin. OK. Mr. Routs. Mr. Routs. We don't tell our dealers what to charge. Senator Levin. No, that is not my question, though. Do you give them a recommended price for their retail? Mr. Routs. We have discussions with them about the pricing in the zone, but they can still make their own decisions after that. Senator Levin. You discuss with them, but do you publish a recommended price to your dealers---- Mr. Routs. We don't. Senator Levin [continuing]. Or do you give them in writing a recommended price? Mr. Routs. We don't, sir. Senator Levin. OK. So, orally, what you discuss with them you don't consider to be a recommendation? Mr. Routs. No, we don't consider it a recommendation, and, again, they don't have to act upon the discussion. Senator Levin. Senator Wyden. Senator Wyden. Thank you, Mr. Chairman. First, Mr. Chairman, let me thank you for allowing me to participate. I think this is a superb report, and I would only say that I think you and I both know that this litany of anti- competitive practices that you found and that I found in my inquiry in Oregon--it really extended to the West Coast--these anti-competitive practices have been documented again and again. But the fact is that these problems are growing, and the reason that they are growing is that the law under which they could be stopped is full of loopholes. And what we have found is that unless people are engaged in some textbook case of collusion, which these companies are far too intelligent to do, it is very hard to bring a successful action to protect the consumer. And that is why I am especially interested, Mr. Chairman, in exploring this idea that you and I have talked about in the past, and that is, when there are anti-competitive practices that as of today are not per se illegal and you have a concentrated market, that you create a presumption that this is raising an anti-competitive issue unless information is proven to the contrary. And I am going to address that more fully on Thursday when I testify, but I appreciate the chance to work with you on it. I think for purposes of this afternoon I want to start with you, Mr. Pillari. At an April 25, 2001, hearing before the Commerce Committee, Mr. Malone, who is your Western regional president, refused to make any commitment to stop exporting Alaskan oil to Asia. And as you know, we have seen E-mail that essentially says, hey, this is a no-brainer to export oil from Alaska to Asia at a discount because you can stick it to people on the West Coast of the United States, in Oregon, Washington, and California, in order to make up the difference. Now, the company, of course, has said that this person didn't speak for the company, and I understand all of that. What I would like to do this afternoon is get a sense about your current policy and commitments that you are willing to make to the public. My understanding is you are not exporting Alaskan oil outside the United States today, but I would like to ask you to commit today that BP is not going to export Alaskan oil overseas, period. Can you make that commitment this afternoon? Mr. Pillari. Sir, let me respond by saying we're a net buyer of Alaskan crude oil. We have to buy a significant amount of our needs. So as a net buyer, exporting has not been an issue for us. Senator Wyden. But that is not my question. My question is, because we have obtained E-mail from your company, sir, saying it is a no-brainer. Now, again, these are not my words or the words of some consumer advocate. These are the words of people in your company, calling it a no-brainer to export oil from Alaska to Asia. So what I would like to know is whether you all are willing to make a commitment. Mr. Malone was not. Mr. Malone basically said, ``We're going to export oil any time it's in our economic interest. We're not doing it today, but whenever it's in our economic interest, we are going to export oil overseas.'' So what I would like to hear from you is not about your situation today with you as a buyer or this or that. I would like to hear categorically whether you will commit not to export oil from Alaska overseas. Mr. Pillari. As I said, we're a net buyer. What I would say about the future is it can't be predicted. I don't know what will happen in the future and I would not commit to limit my commercial flexibility. Senator Wyden. Well, that was my understanding. I appreciate your candor, and of course, that is, in my view, why this whole notion of making this country energy independent, something I strongly support, is directly undercut when an oil company executive says, ``Look, I'm not going to commit to anything. If it's in our economic interest, of course we're going to export.'' And that is why so many people on the West Coast of the United States are unhappy about that particular policy. Frankly, I mean, we have a whole host of anti- competitive practices that we are facing. We have had juries handing out awards for redlining for millions of dollars, redlining our markets. I am going to talk about that on Thursday, but I will tell you it is very disappointing to my constituents and people all up and down the West Coast, that you will not commit, at a time when the oil companies are saying, ``We've got to be energy independent, got to make this country strong and energy secure.'' You again have restated what I thought was the position, and that is that you will not commit to banning the exports of Alaskan oil. Let me ask then the panel, if I might, about their views, and put it in the context of the situation with respect to the Arctic National Wildlife Refuge, ANWR. My sense is with the way your companies have been merging, ExxonMobil, BP Arco, ChevronTexaco, spinning off assets right and left in the past few years, any of your companies could end up with leases and drilling rights in the Arctic Refuge. So what I would like to do is just go down the row and see if each one of you would pledge this afternoon not to export any oil you get from the Arctic Refuge if it ends up being opened up to drilling? Why don't we just go right down the row. Mr. Carter. Well, we are a major exploration company. We explore all over the world. We produce a lot of oil and gas. To my knowledge, we haven't been spinning off assets since we merged except as required by the FTC. We do favor additional exploration. If I recall--I'm not an upstreamer, but if I recall correctly, we opposed the export of Alaskan crude, and as you know, the law required it to stay in the United States at one time. To the best of my knowledge, it does stay here. I have no authority to commit us on what would happen if ANWR-- but I can tell you what our practices have been.\1\ --------------------------------------------------------------------------- \1\ See Exhibit No. 28, May 17, 2002, clarification letter from ExxonMobil, which appears in the Appendix on page 282. --------------------------------------------------------------------------- Senator Wyden. I would just like to get an answer because you all are the leaders in the field, to hear a pledge not to export any oil you get from the Arctic Refuge if it is opened to drilling. It is a simple question. I mean it is a chance for you to make a strong statement about energy independence, and if anything, the arctic issue makes it even more stark. I mean everything about this arctic debate has been about let's get that oil and make us energy independent. Now, if you all will not pledge to keep this oil here, if anything, it is going to make us more energy dependent because we will be drilling in Alaska, selling it to Asia at a discount, and sticking it to people on the West Coast of the United States. So I am just going to go right down the row and the question is just that simple. Mr. Heminger. Yes. Senator, my company, we're just refining, marketing and transportation. We have no equity production, so I can't comment. Senator Wyden. OK. Mr. Pillari. Sir, I would not change my earlier view. Mr. Reeves. Senator, to my knowledge, we don't produce much if any crude oil out of Alaska. I would say the answer to your question was, I don't have the authority to make the decision, but if I did, I would say that it would be irresponsible for any company, certainly our company, to try to accurately predict what we would do in commercial circumstances, 5, 10, or 20 years out. Mr. Routs. I cannot comment. I represent Shell's downstream, and have very little to do with the upstream at this point. Senator Levin. Senator Wyden, we suggested that we would try to stop at 1:30, and they have been here a long time. Senator Wyden. Mr. Chairman, you have been kind to me, and I will look forward to Thursday. Senator Levin. Thank you. Let me close first of all by thanking our witnesses. It has been a long hearing, and you have been cooperative in your production of testimony and materials. We again appreciate that as a Subcommittee. Just one word about our responsibility and yours. You represent large and successful corporations, and it is to be expected that you are going to act in ways to maximize your profits. That is what you are in business to do. The government has a responsibility, on the other hand, to the public as a whole. And government's job is to make sure that the markets stay competitive and that anti-competitive practices be prevented, and that the consumers of this country get a fair shake. Our analysis of the oil industry is that it is highly concentrated in a number of markets in the United States, and that in these highly-concentrated markets, major oil companies take actions that limit supply in order to keep prices higher, and because of insufficient competition in those highly- concentrated markets, they can succeed more readily in keeping prices up. The number of mergers in the last few years is dramatic. When you have Chevron merging with Texaco and BP with Amoco, and whoever would have thought that Exxon would merge with Mobil, but it happened. And as the industry has gotten more concentrated, the lifeblood of this country, gasoline, is in the hands of fewer and fewer players, and that means that if those players can effectively control supply in order to have a significant impact on price, a healthy economy is in jeopardy, and that is not what the American public wants. The question is what can we do about this, and I think there are at least a number of steps that we ought to take or consider taking. First, the Federal Trade Commission should be more cautious about approving mergers. The current situation is bad enough in terms of concentration in the oil industry. Any additional mergers should be subject to strict scrutiny, and the presumption should be that any merger that the oil industry is proposing should be not only scrutinized carefully, but the burden of proof, it seems to me, should clearly be on the people who are proposing those mergers and should be against the merger occurring. The presumption should be against any further mergers. Moreover the Federal Trade Commission needs to make sure that when it requires assets to be divested as part of a merger approval, the divested assets are viable as a competitive factor. There is concern that while the FTC has ordered certain divestitures in approving mergers, those divestitures haven't been to a sufficiently viable entity, so that they end up being a competitive force over time. I would recommend that the FTC study the mergers in the oil industry over the last 5 years to determine what the results of the ordered divestitures have been, to find out, in other words, whether the FTC was successful in achieving the desired level of competition that they thought that they were going to achieve. Those are responsibilities of the FTC. Second. I think we ought to at least consider changing the law with respect to the issue of parallel pricing. Right now parallel pricing is legal. To bring an antitrust case with respect to parallel pricing requires additional proof, proof that there was some agreement or collusion or conspiracy. But parallel pricing can be an anti-competitive act, and the courts have said that any plaintiff bringing an antitrust suit with respect to parallel pricing, cannot under current law get to a jury without some showing of agreement or collusion. It seems to me with respect to this issue that we should consider allowing parallel pricing cases to go to a jury if there is sufficient evidence of parallel pricing alone to make that rebuttable presumption, but nonetheless sufficient evidence to get to the jury. Oil companies, through their legal counsel try to avert or try to avoid overt collusion. But the reality is that with exchange agreements, the use of common consultants, public postings of prices, and common statistical resources and analysts, the market can, in the words of one oil company, ``be disciplined.'' And it can be disciplined in areas of significant or heavy concentration without overt collusion. Now, with all the evidence that the plaintiffs in the Aguilar case had assembled to demonstrate anti-competitive behavior in California, the courts threw out a case and granted a motion for summary judgment because of the absence of overt conspiracy. But I think that new circumstances ought to at least have us look at possible changes in current law so that again we would allow proof of the fact of parallel pricing to be enough to withstand a motion for summary judgment and to get a case to the jury. Finally, I think Congress should consider the possibility of requiring the oil companies to maintain a certain level of inventory of gasoline in order to avoid price spikes and price fluctuations. Four countries in Europe have such a requirement: France, Switzerland, Germany, and the United Kingdom. And we ought to at least look at that possibility as an appropriate approach for the United States so that supply is not so tight as it is in these highly concentrated areas. The oil companies have reduced their inventory levels dramatically over the past few years, so that now we have only 3 days worth of emergency supply at the Nation's current consumption rate. The tight balance between supply and demand and the low inventories, when combined with market concentration, have contributed to the recent price spikes and gas price volatility. It may be time to require a cushion of gasoline supply. On Thursday we will hear, in addition to Senator Wyden, from three State Attorneys General, who have been investigating the practices of oil companies for the last few years, as well as from a number of oil experts who can respond to the issues that were raised here today and in the Majority Staff's report. The hearing will begin at 9:30 on Thursday. It will not be held in this room. It will be held in room 342 of the Dirksen Building, which is the Governmental Affairs Committee hearing room. Again, I want to thank our witnesses for volunteering to come forward, for the cooperation of their companies, and for their testimony here today. It will be made part of the record in its entirety as drafted and presented to the Committee, and of course your oral comments here will be helpful to the Subcommittee. We will stand adjourned. [Whereupon, at 1:42 p.m., the Subcommittee was adjourned.] GAS PRICES: HOW ARE THEY REALLY SET? ---------- THURSDAY, MAY 2, 2002 U.S. Senate, Permanent Subcommittee on Investigations, of the Committee on Governmental Affairs, Washington, DC. The Subcommittee met, pursuant to notice, at 9:36 a.m., in room SD-342, Dirksen Senate Office Building, Hon. Carl Levin, Chairman of the Subcommittee, presiding. Present: Senators Levin, Lieberman, and Collins. Staff Present: Linda J. Gustitus, Chief of Staff for Senator Levin, Senator Levin; Mary D. Robertson, Chief Clerk; Laura Stuber, Counsel; Dan Berkovitz, Counsel; Edna Falk Curtin, Detailee/General Accounting Office; Cliff Tomaszewski, Detailee/Department of Energy; Kathleen Long (Senator Levin); Kim Corthell, Minority Staff Director; Eileen Fisher, Investigator to the Minority; David Mount, Detailee/Secret Service; Hilary Keilp (Intern); Joyce Rechtschaffen, Staff Director, Government Affairs Committee; Laurie Rubenstein and David Berick (Senator Lieberman). OPENING STATEMENT OF SENATOR LEVIN Senator Levin. Good morning, everybody. Today the Permanent Subcommittee on Investigations will hold its second of two hearings on the reasons for dramatic fluctuations and recent increases in the price of gasoline. On Monday of this week, the Subcommittee released the report of the Majority staff following a 10-month investigation. One of the basic conclusions of the report deals with the effects of increased concentration in the oil industry on the wholesale supply market. Due to a series of refinery closures and mergers within the oil industry, the wholesale supply market is now more concentrated than ever. According to information provided by the Department of Energy's Energy Information Administration, the wholesale supply market is moderately to highly concentrated in a total of 37 States. By another accepted measure of concentration, 28 States are considered tight oligopolies. In general, more competition means lower prices for consumers, and lack of competition leads to higher prices. The oil industry is no exception to these general rules. In areas of high concentration, where a few refiners control most of the retail sales, by keeping supplies tight refiners can raise the price of gasoline without great fear of competition. One way to maintain a tight supply is by keeping only a minimal amount of gasoline in inventory. One effect of doing that is that any supply disruption will cause a shortage of gasoline because there is no reserve capacity to bring to market. This invariably leads to price increases, and because gasoline is such an essential commodity in our lives today, most Americans have no choice but to pay more and more when prices rise. Keeping supplies tight and inventories low in highly concentrated areas makes it possible for companies to spike prices without great fear of competition. Since all the companies maintain minimal inventories, no company need fear a competitor will gain market share by keeping their prices low because they would quickly run out of gas. James Carter, Regional Director, U.S., for ExxonMobil, testified to that on Tuesday. He said, ``If our price is extraordinarily low, we are going to run out before the next amount of gasoline gets here.'' So the few companies in these areas raise and lower prices together and in the same price relationship to each other, a practice called ``parallel pricing.'' One of the key findings in the staff report is that in a number of highly concentrated markets, oil companies are not just passive actors who respond to whatever the supply and demand situation is at a given moment; but, rather, they are active players, seeking to shape and structure the market in such a way so as to make the refining business more profitable. The investigation found a number of documents, which we discussed Tuesday, indicating that oil companies seek to tighten supply in highly concentrated markets to increase prices. While the oil company executives who testified on Tuesday said either that their companies didn't adopt the options set forth in their memo to limit supply, or that they didn't have any knowledge of the activities discussed in another memo, or that actions described in a third memo were against corporate policy, the evidence presented in the Majority staff report demonstrated many instances when refiners acted to limit supply to raise prices. Most of the oil companies that testified on Tuesday do not believe we need additional refineries in the United States. These companies believe that a shortage of refineries has not been a cause of any of the recent price spikes. Now, although the price of crude and government regulatory actions obviously have a large effect on wholesale and retail prices in this country, or in the case of regulatory actions, surely contribute to the cost of gasoline, the staff investigation looked at actions taken by the oil companies, within their control, downstream from the crude oil production process. Today we will hear from a number of distinguished public officials and economists about this subject. First we will hear testimony from Senator Ron Wyden. Senator Wyden has been working on the issue of gasoline prices and industry concentration for many years. Following Senator Wyden, we will hear from a panel of Attorneys General. Attorney General Jennifer Granholm is here today from my home State of Michigan. Attorney General Granholm has been very active on a number of consumer issues, including gasoline pricing in Michigan. She successfully forced gasoline stations that gouged the public after the tragic events of September 11 of last year to return some of their ill-gotten gains. Attorney General Richard Blumenthal from Connecticut is also on our panel today. Attorney General Blumenthal has been very active in gasoline pricing issues. Over a number of years, he has aggressively advocated for a competitive gasoline marketplace on behalf of Connecticut motorists. I am also pleased that Thomas Greene, Assistant Attorney General from California, will be here to represent the California Attorney General's views. As our Majority staff report shows, the effects of high concentration and vertical integration in the refining and marketing industries are acutely seen and felt by consumers in the State of California. A few years ago, the California Attorney General issued a report on gasoline pricing in that State. That report addressed many of the issues that we have been looking at. We are looking forward to Mr. Greene's testimony. On the third panel today, we will hear from four economists. All four of these panelists have studied one aspect or another of the petroleum industry. We are grateful for their presence, and we look forward to hearing from them as well. Senator Collins. OPENING STATEMENT OF SENATOR COLLINS Senator Collins. Thank you, Mr. Chairman. First, let me commend you and your staff for your in-depth investigation into this very important issue of how gasoline prices are set and the causes of high gasoline prices and price spikes. Volatile prices are a major source of concern to Americans, particularly lower-income families and small businesses. Given how vital oil and gasoline are to every aspect of our economy, gasoline prices play an important role in our country's ability to recover from the recession. On Tuesday, we heard testimony from executives of several of the Nation's largest oil companies who explained the industry's practices in distributing and establishing prices for gasoline. I was particularly interested to hear what the witnesses had to say about the impact on supply of the seasonal transition between winter and summer gasoline, a time of year when price spikes are common. The perennial glitches that occur during this seasonal transition are contributing factors to price spikes in some areas of the country. The oil industry argues that the stringent transition calendar that the EPA has put in place is at fault. I must say, based on my review, I do not understand why, after years of experience in the oil business and several years of dealing with the various Federal and State environmental regulations on gasoline, the industry has not been able to plan more effectively for these transitions to avoid price spikes. After all, summer always is going to follow spring, and the summer driving season is going to begin every year around Memorial Day. In addition, I remain concerned that the oil companies have not made the necessary investments in infrastructure and to maintain U.S. refineries. Refinery breakdowns were a major cause of gasoline price spikes in the Midwest, especially in the spring of 2000. While the oil companies clearly are profitable, they testified that they had made investments in refineries of only a few million dollars, mainly so that they could stay in compliance with environmental regulations. With refineries operating at near 100 percent capacity, any glitches usually lead to limited supplies and higher costs to consumers--costs to the tune of $1 billion in revenue annually for the industry for every penny increase at the pump. I also share Senator Levin's concern about the impact that industry mergers in recent years have had on competition. That has led to greatly increased concentration in the industry, and a basic rule of economics is more competition produces more choice for consumers and lower prices. We seem to be going in the opposite direction in the oil industry. For that reason, I am particularly interested in hearing the testimonies from the three States' Attorneys General. They will discuss their investigations into competition within the gasoline industry in their home States. I also look forward to hearing the statements from several economists and oil industry analysts who have studied the effects of mergers and the resulting increased concentration levels in the industry. This raises questions about the effectiveness of the FTC's review of mergers during the Clinton Administration. I also look forward to hearing their opinion on the industry's contention that U.S. refinery capacity is sufficient for our needs. I just don't see how that can be with the refineries operating at nearly 100 percent capacity. It seems to me that leaves no room for error. Consumers in Maine and across the Nation are justifiably confused and frustrated by the recent high gas prices and price fluctuations. I again want to thank Senator Levin for shining a spotlight on this important issue and for exploring what can be done to protect American consumers. Senator Levin. Thank you again, Senator Collins, and thank you again for your support and the support and assistance of your staff in this matter. Now the Chairman of our full Committee, Senator Lieberman. OPENING STATEMENT OF SENATOR LIEBERMAN Senator Lieberman. Thank you, Senator Levin. I am glad to be here for this second hearing on gas prices, and once again I would like to, in my capacity as Chairman of the Senate Governmental Affairs Committee, thank you and Senator Collins and your staffs for the extraordinary work that you have all done that led to a very substantive and informative hearing a few days ago. And I am sure the same will be true today. I want to thank our colleague, Senator Wyden, who has been a real leader on behalf of consumers in this and so many other areas over the years and to welcome particularly a couple of generals who are here today, I say as a former Attorney General, General Granholm of Michigan and my own Attorney General, Dick Blumenthal, from Connecticut, along with the senior Assistant Attorney General Greene from California. I know that they have very important testimony to offer. This Permanent Subcommittee on Investigations report on gasoline pricing raises some very serious questions. Is the oil industry as competitive as it ought to be? And is government doing everything it can, we can, to safeguard consumers? I want to go back in history a bit. The government broke up Standard Oil 91 years ago, ending one of the most egregious distortions of free and fair markets in our history. There is a wonderful quote from a book by Thomas Lawson called ``Frenzied Finance,'' which was published in 1905. I believe that it may have been given as a present to Senator Thurmond's parents on his birth. Anyway, I quote from it: ``Standard Oil has, from its birth to present writing, been responsible for more hell than any other trust or financial thing since the world began. Because of it, the people have sustained incalculable losses and have suffered untold miseries.'' Well, obviously, the oil market is much more free and more fair today than it was back then. But today, as this Subcommittee's investigation has shown, we are still faced with mergers and marketing practices that may well be constraining the marketplace rather than lubricating the gears of competition. The possibility of market manipulation in oil and gas is particularly troubling because, as we know, higher gas prices hit middle- and low-income workers and families the hardest. They are regressive. For the American who earns $30,000 per year, for instance, and has to drive 30 miles back and forth to work each day, the price at the pump can mean the difference between making ends meet and being unable to pay all the bills. That is why we should be disturbed by the PSI investigation's finding that gas prices in America are so volatile not because of a responsive market, but because of a market that is unhealthy. And its illness can be seen through two sets of symptoms: Concentration in the wholesale markets on the one hand and restrictive practices in the retail markets, such as zone pricing and redlining, on the other. In testimony to the House Judiciary Committee 2 years ago, Attorney General Blumenthal called zone pricing ``invisible and insidious.'' In fact, there are big signs outside every station with the price of gas, but consumers are actually kept completely in the dark when it comes to the workings of zone- pricing schemes. One major oil company operating in Connecticut, our geographically small State--we have just eight counties--had 46 different zones just in our State. That is astonishing. How can the market work as effectively as possible when wholesalers offer different distributors, who have no choice but to accept them, dozens of different prices for the very same product? I did some work on this when I was Attorney General during the 1980's. General Blumenthal has done very strong and effective work. And I must say I agree with his assessment that zone pricing is both invisible and insidious. Based on the Permanent Subcommittee's investigation, it does appear that oil companies could be charging more in some areas to squeeze as much as they possibly can out of retailers and consumers wherever and whenever they think they can get away with it. If gasoline dealers had more freedom to shop around, we would probably be seeing a much fairer and more fluid market in which prices were kept down by the natural pressures of supply and demand and not artificially inflated. To date, the Federal Government has not sent a clear signal on the legality of either zone pricing or redlining. Last year, the Federal Trade Commission closed an investigation into Western States' gasoline pricing after determining that there was insufficient evidence to show that any of the Western States refiners' practices caused higher wholesale or retail prices for gas. But in a concurring statement, Commissioner Mozelle Thompson expressed his concern about some of the redlining practices being employed, and he concluded, ``The Commission has vigilantly protected the competitiveness of the Nation's energy sector for years through its enforcement actions. I, therefore, am confident that should the Commission find evidence in any future investigation that site-specific redlining results in anti-competitive effects without generating countervailing consumer benefits, it''--the Commission--``would challenge the practice.'' With all respect, I am not confident that such effects could be discovered because of the lack of information revealed by big oil companies about their pricing policies. And government cannot challenge what it doesn't know. Fair and competitive markets are the foundation of a strong free economy, but the current level of information about how the oil industry really operates isn't enough for oversight agencies to ensure that these markets are fair and competitive. That needs to change, and quickly. And Attorney General Blumenthal has, I think, a very constructive proposal to bring that about. So, Mr. Chairman, I thank you again. I look forward to hearing this morning's testimony, and I am eager to make sense of these practices, and maybe even to figure out how we can save consumers a few cents a gallon at the same time. Thank you very much. Senator Levin. Thank you very much, Senator Lieberman. With respect to your zone-pricing point, one of the witnesses on Tuesday said that every single gas station is a separate zone. Senator Lieberman. That is quite a statement. Senator Levin. Quite a bit of testimony. Let me now introduce our first witness this morning, our friend and colleague, the senior Senator from Oregon, Ron Wyden. Senator Wyden, as I mentioned, has worked for years on the issue of gas prices and their volatility in Oregon and on the West Coast. We are pleased to have you before our Subcommittee this morning for your views on the subject. As you know, pursuant to Rule VI, all of the witnesses before this Subcommittee are required to be sworn, and so I would ask you to stand and be sworn in at this time. Do you swear that the testimony you will give before the Subcommittee will be the truth, the whole truth, and nothing but the truth, so help you, God? Senator Wyden. I do, Mr. Chairman. Senator Levin. Thank you. Please proceed. TESTIMONY OF HON. RON WYDEN,\1\ A U.S. SENATOR FROM THE STATE OF OREGON Senator Wyden. Thank you, Mr. Chairman, and let me begin by saying, watching you, Mr. Chairman, and your colleagues question the oil company executives a couple of days ago was like watching a teach-in on how to do oversight right. And I just want to commend you and the staff for a superb job both with the report and with the hearing that was held several days ago. --------------------------------------------------------------------------- \1\ The prepared statement of Senator Wyden appears in the Appendix on page 175. --------------------------------------------------------------------------- Senator Levin. Thank you very much. Senator Wyden. As you know, I have been investigating the oil price issue for several years, and I have brought with me this morning just a portion of the pile of government reports, including my own, that have detailed oil company anti- competitive practices over the years. The findings of the Subcommittee closely track what each of those investigations have shown, and that is, anti-competitive practices are rampant in the gasoline markets. Now, essentially in these reports is everything: That oil companies redlined; they sought to keep independent wholesalers from competing in markets by refusing to let independent dealers buy better-priced gas from the local jobber; they zone- priced; they charged different prices for the same gas at their own branded stores and adjacent neighborhoods, pricing it as high as the market would bear. They kept the market for themselves. They kept down refineries that could have increased supply and introduced competition. And they stuck it to the consumer on the export issue. The big oil companies, BP specifically in their internal E-mail, called it a no-brainer to export gas and oil to Asia at rock-bottom prices and just make up the difference by sticking it to people on the West Coast of the United States. It seems to me that cumulatively these practices just strip the competitive gears out of the gasoline market and hammer the consumer. And what is especially ominous is when you look at these reports and study the controlling law in this area, there isn't a whole lot that can be done right now to turn this situation around. So I wanted to come this morning and say I think there is really one question for the Congress at this point: Is it going to be business as usual with these reports just becoming an annual dust-collecting exercise? Or is the Congress going to move to rein in market manipulation and require meaningful consumer protection reforms? And I think--and this is what I am going to outline this morning, Mr. Chairman--moving to these reforms is critical now. I was in a small town in Oregon Saturday last, a small town on the Oregon coast called Brookings. The situation there is so bad that they are trying to form a nonprofit organization so that they can buy gas at a wholesale price because they are getting killed with retail prices. You have senior citizens, in my view, in Maine and Oregon and in small towns across this country basically trying to figure out how to do this kind of thing because the competition is being drained out of the gasoline markets. So here is my sense of what would constitute real reform, Mr. Chairman. First, I think the controlling statute in this area needs to be changed and broadened. The current law states that there must be one of three kinds of outright collusion taking place to stop these anti-competitive practices. One, there has got to be a contract or an agreement between companies to fix prices. Two, there has got to be a combination or a formal alliance of companies fixing prices. Or, three, there has got to be a conspiracy, which is basically like a bunch of people getting together for dinner and saying, Well, Bob, what do you think the price of unleaded should be? Now, we all know the old saw that the certainties in life are death and taxes. There is another one. You're not going to find smart oil companies holing up in a room colluding in that kind of way to set prices. They are just too savvy and the problem is subtle. Supplies are being manipulated and competition is being restricted in broad daylight. For example, the FTC found that redlining was used to discourage competition and raise prices while providing no benefit to the consumer. But because the Commission found no evidence that the refiners met either of those three tests for collusion, redlining could just go forward unabated. I believe it's time to make these anti-competitive practices illegal once and for all. So I would propose that, in addition to collusion, the statute be broadened to bar anti- competitive practices by a single company where the market is concentrated, where you have four or fewer players controlling a significant majority of the market. This would raise the bar to expect better business practices from the oil companies. When a company tries to squeeze an independent jobber out of a market by telling branded stores what gas they can and can't buy, the law wouldn't have a loophole anymore. So I think that would be change No. 1, making a change in the controlling statute to broaden out beyond that three-part test with respect to collusion. But I would propose changes in a second area, specifically changes to the law that authorizes the Federal Trade Commission and governs its oversight of markets. Under the FTC Act, I believe the Federal Government should consider establishing consumer watch zones in these concentrated markets. At Tuesday's hearing, ChevronTexaco's North American President David Reeves admitted that the West Coast gasoline market is dominated by a limited number of refinery marketers who, acting alone, can evade the laws of supply and demand. There's no need for oil company executives to get together in a smoke-filled room to collude on price when they've got the individual power to manipulate markets in that kind of fashion. And I believe that when you have a market that is highly concentrated, you ought to go beyond the question of whether there's collusion between competitors. And in these consumer watch zones, when oil companies employ anti-competitive practices like redlining or zone pricing, I believe the burden of proof should shift onto them to prove that those practices are not harming consumers. So that would be the second change that I would advocate, Mr. Chairman, as to the FTC statute in these concentrated markets, when you find practices like redlining and zone pricing, the burden of proof should shift to the companies to demonstrate that it is not harming the consumer. My sense was, Mr. Chairman, you were suggesting almost the same sort of thing with respect to parallel pricing, and I support those kinds of efforts as well. In the same way, the whole litany of anti-competitive practices should be considered an area that is substantively questionable until proven otherwise. That would include redlining, exporting at a discount, pressuring independents, all of the practices that manipulate supply or limit competition. The second set of changes I believe would go a long way towards helping American consumers. I would also empower the Federal Trade Commission to take more immediate action when you have those problems in a concentrated market. Under the FTC Act, I would like to see the agency have the ability to issue cease and desist orders to companies that participate in the anti-competitive practices so as to provide the consumers protection. It seems to me the Federal Government should not be powerless to regulate anti- competitive practices that can raise gas prices for the consumer. In addition, I would use this watch zone concept, this question of how you proceed in concentrated markets to serve as an early warning signal with respect to the antitrust statutes. If a proposed merger of oil companies would create a consumer watch zone, again, with four or fewer players controlling 70 percent of the market, I would say that kind of merger should require a closer level of scrutiny. A higher standard of evidence--of review would demand evidence before the merger would be allowed to proceed, again, to protect the consumer. Americans shouldn't have to wait for what amounts to an oil oligopoly to start gouging the consumer to get some protection from high prices. The Federal Trade Commission has already said that Americans shouldn't have to suffer because of bad decisions made by regulators years ago. The agency recently instituted a new policy of looking back at previously approved oil company mergers to see if there are any lingering anti-competitive problems. If the agency finds such problems, they're going back in to fix them. Why not make a change so as to do the appropriate amount of investigating on the front end before you let another anti-consumer merger kick in and, in my view, stop the anti-competitive practices before they start? Let me be clear on this point, Mr. Chairman and colleagues. When I suggest changes to the laws that govern oil companies and oil markets, I want to propose that those changes only be made in the case of concentrated markets where a predisposition to consumer abuse has been documented. Legislation along those lines would ultimately take the country in a more constructive direction. I don't think the country would be taken in a more constructive direction by some of the proposals that we heard in the last few days, such as weakening the Clean Air Act. We even heard Tuesday that the Clean Air permitting process, known as New Source Review, needs to be streamlined; it's been a deterrent, according to the companies, to increase capacity in the country. But I think there is something wrong with that picture when Mr. Reeves from ChevronTexaco testifies they have made significant expansions at their Mississippi refinery. He also states it'll be one of the first refineries in the Nation capable of producing both low-sulfur gas and highway diesel fuel outside of California. The project will be completed in advance of national deadlines for these requirements. So it seems to me by their own words, the words that you heard Tuesday, Mr. Chairman, the oil industry's claim that the Clean Air Act requirements are deterring refineries from increasing their output doesn't exactly match up with what's happening in the real world at ChevronTexaco's refinery. There's also something wrong with this picture when we hear repeatedly that no new refineries have been built in decades and that the Clean Air Act is at fault. Yet when asked whether the United States needs additional refineries, all of the executives at Tuesday's hearing said no. The real reason has more to do with return on investment, in my view, than anything to do with the Clean Air Act. There isn't going to be any more competition under the industry's proposals to streamline the Clean Air permitting. What I tried to offer today was a proposal to open up the free enterprise system in the gasoline business, and I think that ought to be a base by which the Congress proceeds rather than an approach that would advocate dirtier air and reward the same oil companies who perpetuated the gasoline supply crunch in the first place. These are the companies that deliberately worked to keep down refineries. You and I have talked specifically about Powerine in California, but these are the kinds of examples that are in these reports, Mr. Chairman. I want to commend you and your staff again on a very thorough report. It documents a litany of anti-competitive practices the oil companies use to manipulate supply and price in gasoline markets, and close by coming back to that question that I think is central to this debate. Mr. Chairman, we could pile these reports over the next 10 years up to the ceiling, and yours is superb and the work that you've done and Senator Collins and Senator Lieberman is excellent. I think the question now is: Are we going to do more than stack up the reports? I think that it is time now to get beyond the statute today that makes it virtually impossible to protect the consumer. These companies are not going to go into a back room, have a big supper, and say, ``Joe, what do you want the price of gas to be?'' They're just not going to do it. But that's virtually what you have to prove in order to bring an action to protect the consumer. I think we can do better on a bipartisan basis. In my State, Senator Smith shares many of the same views that I do. Senator Collins has a long record of consumer advocacy in this area. There is not going to be anything partisan about doing this job right, in my view, and I thank you and your staff, Mr. Chairman. You have given me a lot of time in recent months to work on an area I feel strongly about, and I'm very appreciative. Senator Levin. Well, thank you, Senator Wyden, for your testimony and for your long, energetic, persistent effort to protect consumers in this area. As we have discussed, a number of reforms are needed in the law to tighten up the law. I would only add to that very general point that the Federal Trade Commission does have power under existing law which it has not exercised to try to prevent some of the mega-mergers which have occurred and some of the lack of competition which has resulted. But I very much appreciate your very specific testimony. That is very helpful to this Subcommittee, and I would ask my colleagues if they have any questions. Senator Collins. Senator Collins. No, thank you, Mr. Chairman. Senator Levin. Senator Lieberman. Senator Lieberman. No, Mr. Chairman. Senator Levin. Thank you again. Senator Wyden. Thank you. Senator Levin. I would now like to introduce our second panel of witnesses. Welcome to this Subcommittee. Richard Blumenthal, Attorney General for the State of Connecticut; Jennifer Granholm, Attorney General from my home State of Michigan; and Tom Greene, the senior Assistant Attorney General for the State of California. This is a very distinguished, a very knowledgeable panel. We look forward to hearing your views on gasoline volatility and your experiences in your respective States and what we can do about it. Pursuant to Rule VI, as I have indicated, all witnesses who testify before the Subcommittee are required to be sworn, and so I would ask each of you to stand at this time and raise your right hand. Do you swear that the testimony that you will give this morning before this Subcommittee will be the truth, the whole truth, and nothing but the truth, so help you, God? Mr. Blumenthal. I do. Ms. Granholm. I do. Mr. Greene. I do. Senator Levin. Thank you. I think we will start with Attorney General Blumenthal. TESTIMONY OF RICHARD BLUMENTHAL,\1\ ATTORNEY GENERAL, STATE OF CONNECTICUT, HARTFORD, CONNECTICUT Mr. Blumenthal. Thank you, Mr. Chairman, and I would like to second a number of the remarks that have been made about the quality of the staff report that has been done. I know that very frequently we compliment the staff on the work they do, but this report really is extraordinarily insightful, penetrating, and revealing about the practices of this industry, and I think it will provide real ammunition for effective reform, and I want to thank you, Senator, and Senator Lieberman and Senator Collins for your excellent work in this area and for making sure that this report will be as useful and productive as I hope it will be. --------------------------------------------------------------------------- \1\ The prepared statement of Mr. Blumenthal appears in the Appendix on page 179. --------------------------------------------------------------------------- Price spikes have become almost a national norm at this point in gasoline pricing, and, unfortunately, they affect very deeply not only American consumers, particularly those of low and moderate means, but also our economy. And as you have remarked, Mr. Chairman, they have probably stifled our recovery and perhaps precipitated the recession that we are now seeking to undo. So there are implications to these kinds of price abuses beyond the simple consumer protection issues. They affect all of us, and their effects are tremendously far- reaching and fundamental. Market concentration has enabled the industry to manipulate prices, to take advantage of low supplies and even disruptions that may be the result of temperature, refinery fires, pipeline problems, and so forth. The industry has exploited those problems for its own benefit, and the Subcommittee report very dramatically documents that conduct. It also indicates that there has been conduct verging on the illegal, if not an outright violation of the antitrust laws. A number of the discussions and memos that are evidenced in the report show that there is a need for further investigation and enforcement. And one of the reasons that we have such high degrees of concentration is indeed the lack of effective enforcement. It has been a bipartisan failure on the part of the FTC, on the part of Federal enforcers, and the proposal that I am making today really is the result of that lack of effective enforcement that has brought us to such high degrees of market concentration. I am proposing a moratorium on all major mergers and acquisitions within this industry, whether at the wholesale or retail or other levels, a moratorium that would enable the Congress to fashion more effective remedies, and not only to empower but also to require Federal enforcers to do a better job. And I believe that a moratorium of this kind may be regarded as a kind of last resort. It ought to be for at least 1 year. It would affect only major mergers and acquisitions and so provide an exception, for example, if there were failing companies or if their market share were less than a certain HHI degree or number. But I believe that the record now more than justifies that kind of halt to any further major mergers and acquisitions in this industry. The second proposal that I believe is well merited would involve the kind of change that Senator Wyden and you have mentioned, Senator Levin, that would make admissible evidence of parallel pricing, the kind of conscious parallelism that in a market so highly concentrated as this one certainly ought to be regarded as evidence of an antitrust violation. I believe that the proposal that he has just made would also apply to concentrated markets that have a predilection or a predisposition toward abuse, those changes in the standard itself are worth consideration as well. But I think at a minimum there ought to be admissibility for common pricing patterns or conscious parallelism under our antitrust laws where there are highly concentrated markets, and that would certainly apply to this industry. And perhaps in some instances, with a sufficient threshold showing, it ought to be a per se violation. Obviously there are arguments pro and con to that kind of proposal, but I believe it's worthy of consideration. And then to promote more effective enforcement at the State as well as Federal level, I think there needs to be better information. Quite simply, there should be under the Energy Information Administration a central data bank that is accessible and more complete in real time so that it is truly useful to Federal antitrust enforcers and to State enforcement officials, such as those before you today and our colleagues around the country who have our own antitrust and consumer protection responsibilities. Right now, we have to spend tens and sometimes hundreds of thousands of dollars doing the kind of work that California did in its study, that Connecticut has sought to do over the last 10 years while I have been Attorney General simply to make a case, wholly apart from the use of subpoenas and other investigatory tools. Basic information is simply not as available and accessible as it should be. Finally, I propose again and urge very strongly a ban on zone pricing. I recognize that you have heard testimony from the industry that would seek to justify it on a competitive basis. In my view, zone pricing really is not a competitive measure. In fact, it is anti-competitive. And I have cited in my testimony pricing conduct that has been documented in our local media. The Stamford Advocate, for example, has reported price differentials in a very close proximity of 7 to 12 cents. It now happens that a truck can be delivering the same gasoline that is exactly the same product to the same city, indeed sometimes the same street, out of the same truck, and often to the same owner of two different stations located within blocks of each other; and simply because of these artificial, geographic, discriminatory means and distinctions, the prices will be different substantially to the consumer. The industry relies on computer programs and secret calculations as to how much profit the consumer will bear, not what competition will enable or provide. And so I believe that the Robinson-Patman Act and the Petroleum Marketing Practices Act ought to be amended to specifically prohibit the single-source requirement, which is at the root of this abuse, or specifically, discrimination based on location of stations, discrimination in pricing, and close the loopholes that now exist in those two statutes. I recognize, finally, that conservation has a role to play. All of the members of this panel have commented very eloquently on the importance of conservation, fuel efficiency, and mass transportation, other measures that can help us to save and conserve as well as to eliminate the abuses that artificial shortages and low inventories have created. I again thank this Subcommittee for this opportunity to comment on an area that I think has come of age. It certainly is an issue whose time has come. These practices for the most part are invidious and insidious. They are often invisible to consumers, but their effects are real and dire. And I offer my continuing help in addressing them. Thank you. Senator Levin. Thank you very much, Mr. Blumenthal. Attorney General Granholm. TESTIMONY OF JENNIFER M. GRANHOLM,\1\ ATTORNEY GENERAL, STATE OF MICHIGAN, LANSING, MICHIGAN Ms. Granholm. Thank you very much, Mr. Chairman. It's great to be invited here to talk about such an important subject. I very much appreciate the opportunity. --------------------------------------------------------------------------- \1\ The prepared statement of Ms. Granholm appears in the Appendix on page 187. --------------------------------------------------------------------------- I'm the Attorney General of Michigan, and for nearly 3 years, my office has been involved in the review of gas pricing, as well as in independent actions from our office to curb excesses. We joined with the FTC in looking at their investigation following the spikes in the year 2000. In the wake of the terrorist attacks, of course, many of us saw prices go through the roof, and in Michigan, it was between $2 and $5 per gallon, and our office filed notices of intended action against 46 gas stations who jacked up those prices and did get refunds. Thank you for mentioning that. In my role as legal counsel for our Michigan Public Service Commission, which is the body that regulates utilities, my office intervened in a FERC matter regarding the Wolverine pipeline and its lack of competition with respect to access to the pipeline and with respect to rates, which was so well documented in your report. So I would like to propose a couple of things. First of all, I think that General Blumenthal has made some excellent points. I agree on the issue of a moratorium--a moratorium particularly with respect to wholesale mergers. I was interested to hear Senator Wyden's comments about four suppliers controlling 70 percent of the market as being sort of a threshold. If you look at the HHI index, in Michigan we approached that almost tipping point. We are almost at 1,800 on that tipping point. And one more merger would push us over the top. Now, if you use that index as a means sort of across the board of saying when do we apply a moratorium, when do we believe there's too much concentration--and that's, of course, the threshold that the FTC and the DOJ use, anyway--I think that is a great way to start, at least where we might be able to apply the existing criteria and know that we've got to take another look before there's any more concentration of a market. So I agree fully with the moratorium idea. A couple of other things that I think are relevant, and I know that they were discussed before. First of all, I know Senator Collins was speaking particularly about the industry capacity levels being at almost 100 percent. And, of course, when that is the case, before, when they were much more fluid and you could shoot gas to an area where there was a disruption, there was an ability for the market to self-correct in a much more ready fashion. The inventory levels, the reformulated gas problems--and in Michigan, we don't have a reformulated gas requirement, but certainly the availability of supply from other States is more limited when other States have got different requirements. And when you combine that with this inventory level problem, that's, of course, exacerbating the spike problems. And in Michigan, we've had the Wolverine pipeline, which is our main pipeline, break down, huge gas spikes as a result of inability to access quick supplies. Now, the notion about that, though, that the market could self-correct and that the industry can take advantage of the arbitrage possibilities that previously existed when the prices were high in one area, and the other area with lower prices could shoot gas over and see the sort of equilibrium arise, they are much more limited, of course, when there is a concentration of market power in one area. And so in Michigan, I just want to address this issue of--because we have seen amazing price differentials from one adjacent area to the next, where you would think that the ability to take advantage of the arbitrage capability would really create a much more level pricing scenario, and they have not. We've seen as much of a 10-cent difference from the Chicago market to the West Michigan market, and the reason is--I mean, even a 2-cent differential would cause gas to shoot from one place to another. But a 10-cent difference, you'd really have to say: What is going on here? Who's taking advantage of something? And it's because in West Michigan--because we have had a merger, first of all, of Marathon and Ashland Petroleum. That occurred in 1998. And then the two of them merged with Ultramar Diamond Shamrock. Now, the resulting merger means that five companies in Michigan control 80 percent of the market, and in West Michigan, this concentration is particularly egregious because really the Marathon Wolverine pipeline--the Wolverine pipeline is owned by a number of these very same companies, and they control access to the tanks at the pipeline. So not only do you have a concentration of supply, but you have a concentration of the means of distribution and the tank--access to the tanks as well. As a result, we have seen--and the reason for this big disparity that I mentioned between Chicago and West Michigan is because people have difficulty accessing the terminals when the terminals are owned by one entity, which in this case is Marathon Ashland Petroleum. They were not allowing others to have access, which is why our office intervened with FERC to allow an independent wholesaler to have access to the terminals. But the result of these mergers was to limit access, and that is another area that I think this Subcommittee can look at. So it's not just the concentration and the ability to control capacity, but it's also the ability to control distribution and access to these terminals that we have seen the increases--where the increases have been so disturbing. Merger mania within the industry, in the last 5 years--I know you have documented this. This wave of mergers has obviously reduced competition enormously. But because Marathon Ashland Petroleum in our State alone has 28 percent of the terminal capacity market, and the next one down is British Petroleum Amoco, which merged, which has 14 percent, so the No. 1 person has more than twice what the next one has. And there's five who control the market. Exxon is the next one. Equilon and Citgo, and they have nearly 80 percent of the petroleum terminal capacity in Michigan. So I know that when you've got that concentration and you have an inability of independent jobbers to access the terminals or to access the pipeline or to access capacity, you have these independents having an inability to compete, and often they are not just competing with the retail establishments like Speedway, which is owned by Marathon, but they are also competing because they are purchasing their supply from the owners of Speedway. So their supplier is competing with the other retailers. You've got no ability for greater independence in the market when the entity from whom the independents are buying from is the same entity that's supplying their competition, the retailers, the other retailers. It's all coming from one place and, therefore, the competition is just not there. Consequently, in your report, which was very interesting, on the graph that you showed on page 361 and 362,\1\ has, of course, all of these spike fluctuations in Michigan. But this one down here shows who leads the fluctuation. And in this case, it is Speedway stations that are always leading the price up or down, it's Speedway that is doing it. Speedway, of course, is the one that is owned and controlled by the largest capacity operator. --------------------------------------------------------------------------- \1\ See Permanent Subcommittee on Investigations' Majority Staff Report, Gas Prices: How Are They Really Set, which is reprinted in the Appendix on page 322. --------------------------------------------------------------------------- So the concern, of course, that one entity is being able to not just control the market but control the prices is of great significance, and the independent folks have to compete and often lose money when the big players are lowering their prices. I think you have Justine Hastings who's testifying later today, and she will tell you, I'm sure--because she's written this--that the independent station is the only type of station that can purchase gasoline from any refiner and independently set its retail markup and, thus, increase competition at the wholesale and retail level. But if you reduce their ability to compete, obviously, then you have much higher prices. My suggestion, respectfully, to the Subcommittee in the wake of the great report that you have done, is to dovetail on General Blumenthal's request for a moratorium. Again, in Michigan, I would suggest that it would go to wholesale suppliers because there may be some very small retailers that are being acquired that may be independent gas stations, that may not affect the market as much, but wholesale, absolutely, terminal owners, etc. I would like to see also that there be adequate resources for merger review at the FTC and the DOJ so that they can really focus in on this. I'm not sure that they've got the ability to assess in the way they ought every merger that is being proposed, and I'd like to see that occur as well. Not every merger, of course, is a bad thing, but with the resource constraints and the overwhelming number of mergers in the past few years, I think that there are a number of anti-competitive mergers slipping through the cracks. And then I also believe that there should be a review of whether the transportation and the access to terminals' bottlenecks preclude normal market forces from responding to the higher prices as well. I dovetail, too, as well on what General Blumenthal said with respect to having access to information from the Energy Information Administration. It would be very good, particularly for States that don't have their fingers in the pie as much, to be able to have access to that information to know whether they can bring an action. So, again, I want to thank you very much for the opportunity to testify and talk a little bit about what has happened in Michigan because of the concentration of market power. And I truly do hope you're able to achieve some great results, too. Senator Levin. Thank you, General--``Jennifer,'' I almost said. Ms. Granholm. That's OK. Senator Levin. General Granholm, thank you so much for the testimony. Mr. Greene. TESTIMONY OF TOM GREENE,\1\ SENIOR ASSISTANT ATTORNEY GENERAL FOR ANTITRUST, CALIFORNIA DEPARTMENT OF JUSTICE, SACRAMENTO, CALIFORNIA Mr. Greene. Thank you, Mr. Chairman and Members, and certainly thank you on behalf of Attorney General Bill Lockyer of California, who could not be here this morning. --------------------------------------------------------------------------- \1\ The prepared statement of Mr. Greene appears in the Appendix on page 198. --------------------------------------------------------------------------- I think that the panel has already spoken eloquently to the key problems here. Let me just tick off the major points from my perspective. The first is that inventories, that key safety margin between enough supplies and shortage, have razor-thin margins. We are now at a point in which inventories are measured in days rather than weeks or months. The implication of that is that even a minor refinery outage, a minor fire, can throw markets into complete disarray. Our experience in 1999 in California, and more recently consumer experience in the Midwest, is that a 5- to 10-percent reduction in supply can kick the spot price up 50 to 100 percent. So this is a market in which volatility is increasingly a normal aspect of the marketplace. I think this has a number of critical implications. The first from my perspective is the necessity for aggressive, affirmative antitrust enforcement. That's what I do on a day- to-day basis. I would certainly echo Attorney General Granholm's perspective that resources are critical to this process. I was personally involved in the ExxonMobil transaction in which, at least from a California perspective, a major refinery was spun off. So we did what we refer to in the business as a zero delta deal, which is--from the perspective of our markets, the competitive situation did not change. But in that particular transaction, we received and analyzed over 10,000 boxes of material. When you deal with these kinds of transactions, you're talking about huge amounts of material that must be analyzed and reviewed. So I think both State resources and Federal resources must be adequate. We are increasingly familiar with the importance of retail in the competitive picture for this industry. We think of the oil industry as going from Kuwait to Kansas to California. They are enormously large corporations, among the largest in the world. But one of the things that has happened, largely because of the existence of new computer technology, the ability to communicate by satellite link on a daily basis between individual retail stations to the home office and to a very small group of consultants, actually, that help set the retail price, what is increasingly happening is a process which is called ``retail-back pricing''--that is, prices are set based on what's happening in the marketplace at the local corner. It's not a question of prices being set by the price of crude with a markup. It is what the market makes possible in a local situation. That is affected in a very dramatic way by what's already been spoken to, and that is, zone pricing. In a situation in which we have retail-back pricing, the lack of independence in those zones means that prices will not fall. There will be much less competition than we would otherwise expect. One of the implications of that, at least one of the things that we believe we've observed in California markets, is what we refer to as ``a rockets and feathers pricing pattern''--that is, when there is a refinery outage, prices rocket up, but they do not fall at a similar speed. They rocket up and then feather back down. We believe one of the reasons for that, indeed perhaps the major reason, is a limited amount of retail competition. There aren't effective competitive forces at retail at the local level to push those prices down as quickly as they rose. As a professional prosecutor in this area, let me speak to what I think may be important limits to current antitrust jurisprudence in this arena, and this has been touched on earlier. Largely unbeknownst to the public at large, there has been a major sea change--starting with the Federal courts which is now working its way into the State courts as well-- increasing substantially the burden of proof for prosecutors in showing that there has been an agreement within the meaning of the antitrust laws. A generation ago, actually, 10 years ago, approximately, the Ninth Circuit decided, In Re Petroleum Products Antitrust Litigation, that allowed us to use substantially circumstantial evidence to prove up the existence of a conspiracy. Far more recently, actually, last year, the California Supreme Court in its Aguilar decision looked at facts that were very similar, frankly, when you really examined the two cases, and determined that there was insufficient evidence to determine the existence of a conspiracy. When you are dealing with highly concentrated, oligopolized industries, communications of a very limited sort can have enormous implications in terms of providing and facilitating coordination between ever more concentrated players in this marketplace. There may be some other implications which I would certainly like to surface for the Subcommittee. Because of California's insularity due to its physical location and its unique fuel blend, we are beginning to look seriously at the possibility of creating a State physical hedge, a strategic inventory of fuel which would allow us to begin to move fuels into the marketplace if there are small perturbations in the supplies from the refineries as a way of addressing these very volatile price spikes. Whether that makes sense on a national basis, we would certainly leave it to the Subcommittee and its expert consultants. However, I would certainly commend to the Subcommittee the consultant reports that I've supplied with my testimony. There is another competitive issue which you need to be aware of. This affects us very directly in California, but insofar as reformulated gasoline becomes much more a part of the national picture, the existence of certain key patents, may become critical. Unocal sat in on the regulatory meetings, knew what was the arc of development of our fuel blend. At the end of the process, it was discovered both by the other major oil companies and by regulators, to the chagrin of all, that Unocal had patented the key blending technology. So our clean fuels are now possibly subject to patent challenge. This has gone through a whole series of pieces of litigation, and the usual patent is itself being specifically re-examined by the U.S. Patent Office. As gasoline becomes much more technical in terms of meeting specific clean air goals, patent policy may become very important here. In California, as I said, one of the reasons that we think people are more reluctant than not to come into our market is because of ambiguities created by the Unocal patent and whether people will be exposed to patent litigation, licensing litigation, in the event that they bring fuels into our market. Let me mention two other supply points. There is in our market a key oxygenate, methyl tertiary butyl ether, MTBE. This constitutes roughly 11 percent of our supplies. We are in the process, because of clean water problems associated with MTBE, of removing MTBE from our gasoline blends while still meeting our clean air obligations. Indeed, as the Subcommittee is presumably aware, California sets the most stringent clean air requirements in the United States. We believe that there is no fundamental chemical or environmental reason why we need to include oxygenates in our fuel. Governor Davis has written to President Bush seeking a waiver so that we can meet clean air requirements. We're willing to meet any of the air standards, but we would like to meet that without the necessity of oxygenates. This could very well give us more flexibility to create a blend which would both meet clean air standards and not result in an extraordinary reduction in supplies. In this regard, the 11 percent portion of our fuel stocks that MTBE represents would also be the equivalent of one major refinery in California. And, again, if we're in a situation in which a 5 or more percent perturbation in supplies could have a very outsized effect on price, this is a very big deal for us. Finally, I would certainly echo the points made earlier about conservation. California consumers are among the thriftiest in the Nation. We rank 44th in per capita gasoline consumption. That said, we think there are still enormous opportunities for reducing the need for gasoline both by increased support for rapid transit, and we think, without re- arguing all the questions about fuel economy standards, that there are still enormous opportunities in the transportation sector itself. And with those points made, I'd certainly be prepared to answer questions from the Subcommittee. Thank you. Senator Levin. Thank you very much, Mr. Greene. Thank you all. One of our key findings is that in areas of high concentration, where fewer refiners control most of the retail sales, by keeping supplies tight refiners can raise the price of gasoline without great fear of competition. And since all the companies maintain minimal inventories, no company need fear that a competitor would gain market share by keeping their prices low, because that competitor would quickly run out of gas. We walked through with the industry representatives on Tuesday a number of documents that we believe demonstrated that effort to tighten supply. And I want to go through a few of those with you. One of the most troubling was a 1999 memo from BP which went through a laundry list of truly outrageous methods for keeping supplies of gas tight in the Midwest. The witness agreed that the proposals were outrageous, said BP rejected them, and, ``counseled'' the persons who prepared them. But that doesn't take away from a very key fact that the goal of the BP effort was to increase prices in the Midwest by 1 to 3 cents by restricting supply. The top executives in BP were working to achieve that goal. Whether they rejected the particular methods or not is one issue but the goal they did not reject. Their goal was to increase prices by restricting supply, and they felt they could increase prices just by those means by 1 to 3 cents a gallon. And, again, 1 penny a gallon is $1 billion a year for the industry. Another memo from Marathon talked about OPEC's efforts, and here reading the words in this memo, OPEC's efforts to rein in output as ``bearing fruit.'' For our consumers in America, it is bitter fruit. But listen to what this Marathon memo says. ``As OPEC and other exporters' efforts to rein in output began bearing fruit, nature stepped in to lend the oil producers a helping hand in the form of Hurricane Georges, which caused some major refinery closures, threatened offshore oil production and imports, and generally lent some bullishness to the oil futures market.'' And they acknowledge that was an incredibly awful way to describe a result of a hurricane. But that's the way it was viewed. And then we had a memo from a Texaco official talking about how Shell had told him that everyone was nervous because Texaco wasn't saying what it was going to do about importing CARB into California. The memo says that Shell threatened Texaco that if they did import CARB fuel into California, then Shell would lobby for a tax on that import. So now the Shell official--who now owns that portion of Texaco, by the way--disavowed that conduct, said it would not be tolerated in the company today. But that was the conduct: You do this, we're going to go and try to get a tax on your import. A Chevron memo, one the oil company did not disavow, said the following: ``Market is dominated by limited number of large committed refiner/marketers whose individual actions can have significant market impact.'' So this is just some of a lot of evidence of showing that they are aware of the fact that by limiting supply in a highly concentrated market, that they can basically succeed to raise prices. Now, I have two questions. One, does that surprise you, what I just read? And, second, would you forward to this Subcommittee any material that is not in that report, if you have had a chance to read it, which also shows in your States the evidence of the oil companies' restricting supply because of the ability in that situation, particularly in concentrated markets, to have a direct impact on price? So let me start with you, if I could, General Blumenthal. Mr. Blumenthal. Thank you, Senator. To answer your second question first, I would be happy to forward any documents now in our possession or that we acquire in the future that show, as these very powerfully do, an intent or a desire to exploit tight supplies for purposes of raising prices and ultimately raising profits, and prices, as Senator Collins and the report indicated, have a very direct and immediate impact on profits because every 10-cent increase in prices produces on an annual basis $10 billion in additional revenues. Of course, all of these documents were merely for the purposes of brainstorming, I'm sure, as the industry has indicated. I am actually, to be very serious, not so sure that they were simply to consider illegal action and then reject them, as the industry has also said. I think they are very solid evidence that call for changes in the burden of proof, in evidentiary standards, that make these kinds of cases easier to detect, investigate, and prove. There are two areas that need improvement: One, as Attorney General Granholm has very well said, more resources so that prosecutors have the wherewithal to prosecute these cases; and the other is the standards of proof and evidence that enable them to deal with the much more sophisticated, technologically advanced means of communication. We don't have the smoke-filled rooms. We don't have the handwritten notes. We often lack cooperating witnesses in these cases. But the kinds of evidence that should and would be admissible under the proposals made this morning I think would enable more effective prosecution. And, finally, I would say that these documents show also that this industry as a whole needs to move in the direction of more independence, more independent owners and operators and refiners. It needs more unintegrated patterns of dealing, and it needs more unbranded products. Independence, unintegrated patterns of dealing, and unbranded products all will help to open this industry to more competition. Senator Levin. Thank you, General Blumenthal. General Granholm. Ms. Granholm. Yes, the euphemism of ``bearing fruit'' you were lucky to find in a document, but I think this speaks exactly why we do have to change the burden of proof. This is basic economics. It's supply and demand--wink, wink. You know, we tighten the supply, the price goes up. I don't even know you need a document to tell you that. Anybody who's in this industry knows that. It was just interesting that you were able to find smoking guns that revealed their knowledge of what they were doing. But we've got cases that have been tossed out because--on this notion of tacit collusion, where you've had a lot more--you've had joint price communications between firms, including meetings. You've had price verification calls, price changes between competitors, and the Eighth Circuit threw that out. So it wasn't enough. Some courts are requiring too many factors to be able to determine that this kind of collusion is going on. But, the reality is I don't even think you need to have evidence of-- it's almost a basic textbook on economics that would demonstrate that they know very well when you turn off the spigot, the price is going to go up. So, yes, if we have any documents that would reflect this, I would be thrilled to forward them on to you. But I think that this does call for a shifting of the burden of proof or of the standards that courts might look at in order to determine whether collusion has occurred. Senator Levin. Thank you. Mr. Greene. Mr. Greene. Senator, I would certainly agree. The documents that relate to CARB certainly are part of the Aguilar litigation, which was the case that I was referring to earlier that was decided against the plaintiffs because they had insufficient evidence. I think these documents are really quite remarkable. But currently, with the Federal courts leading the way, the burden of proof has gone up quite dramatically. They also illustrate, I think, really a key point of your hearing today as well. In a fully competitive market, if this were a grain market or this were some other more ordinary market, if somebody were to withhold supply from the marketplace, they would be unable to sustain that and sustain an increase in price because other marketers would come into that gap and fill it. We are in a situation now in which concentration has reached the point where it's both in the interest of an individual company to withhold supplies from the marketplace and others will not step in. Now, that may be a consequence of oligopolistic coordination. It's sort of the classic sort of perspective here, but we have reached the point where that certainly is theoretically possible, and we now have direct evidence that 's exactly what's going on. Senator Levin. Let me ask you about exchange agreements. I know you have had experience in California with that, and I don't know if other States have or not. But we have several oil company documents. Here is one from BP-ARCO. It reads: ``Exchange in trade selectively to preserve market discipline.'' That is a direction from a BP-ARCO executive. Then it says at another point in that document, ``From time to time, ARCO may need to endure brush fires to discipline the market.'' The particular witness did not know what was meant by that. He said it occurred before his time, so that was his answer. One way to discipline the market, I guess, would be to buy up a competitor's product--in the case of a product that was being sold in California--that is selling at a price lower than yours, and then reselling it at a higher price. Mobil apparently did that in California with respect to the Powerine refinery. There is an internal memo from Mobil, which you probably have, or you may have had, that is talking about the Powerine refinery and the threat that it poses to Mobil, and here is what it suggests: ``One other thought. If they do start up''--that is, if Powerine does start up--``depending on circumstances, might be worth buying out their production and marketing it ourselves, especially if they start to market below our incremental cost of production.'' And then it goes on to say that Mobil already did that. ``Last year,'' it said, ``they were dumping RFG at below cost of MTBE, we purchased all their avails, marketed it ourselves, which I believe was a major reason that the RFG premium last year went from 1 cent per gallon in January to 3 to 5 cents per gallon through to their shutdown.'' In other words, Mobil accomplished--at least the year before what it wanted to--by buying out the Powerine product, selling it at a higher price, and then increased the premium for all of the RFG several cents a gallon by doing that. Is that a document which you are familiar with, by the way? Mr. Greene. Yes, certainly. Senator Levin. OK. Now, apparently--was that one of the issues that was debated or litigated? Mr. Greene. These documents came to public light through the discovery process in the Aguilar case. We were actually amicus curiae, the Attorney General was amicus curiae in that case. But just from the analytics from an antitrust perspective, if an individual company does things on its own, that is, buys fuel and then resells it, that's an individual activity. Senator Levin. Sure. Mr. Greene. So we don't have that key agreement or conspiracy that Senator Wyden was speaking to. And it is also the case that doctrinally the monopolization statutes typically now require a very large market share, for example, 75-plus percent of a relevant market. But it may be the case that we need to look back at actual market power. One of the real implications of these documents is that everybody in these marketplaces has market power. They all have the ability to increase the price in the marketplace based on the individual steps that they take. Senator Levin. Right. Well, I want to get to that point, though. When you say we should look at it, a problem is that even though this is the activity that they engaged in and were able to raise prices 3 to 5 cents, acting on their own, without collusion, as it is currently defined, that may not be or apparently isn't illegal under the current definition in the statute of collusion. The question I would like to ask you, and perhaps the others, if they want, is: Shouldn't that be illegal? You said ``considered.'' I mean, it is pretty glaring here what went on, to be able to say I am going to buy up my competitor's product, and as a result raise the price 3 to 5 cents. If you have that kind of market power, if it is that kind of concentrated oligopoly that you have got in that market, should we not say, as Senator Wyden was suggesting, in terms of change the definition of collusion or broaden it, shouldn't that be one area where we ought to look seriously at broadening the definition of an anti-competitive practice? General Granholm. Ms. Granholm. To me, this goes to the question of using an objective standard rather than having to rely on documents like this. If you could make this judgment based upon the HHI index as sort of just a pure objective factor, then you could determine whether or not that is legal or not. Do you stop a merger when somebody arrives at a tipping point in the industry based upon objective factors? Because, otherwise, if you are relying on the subjective stuff, what is very sophisticated language--I mean, this is a little more obvious than what we would normally find. But, they wouldn't put it in writing. They would have it in a verbal meeting or something. Everybody knows what's going on. To have to rely on that is a little more difficult proof-wise, which is why I think an objective standard would be easier. Senator Levin. What you are then saying is that we should make it a presumption that---- Ms. Granholm. Yes. Senator Levin [continuing]. You will not approve mergers in markets that are highly concentrated by some objective measures, and I guess there are objective measures---- Ms. Granholm. The Herfindahl--what is it? Senator Levin. The HHI measure, right. Ms. Granholm. The Herfindahl-Hirschman Index would---- Senator Levin. We call it ``HHI'' around here because we can't pronounce it. Ms. Granholm. HHI is much easier, yes. That 1,800 threshold I think is a very basic and fair way of looking at it. Senator Levin. OK. Mr. Blumenthal. I would add on the issue of merger approval, not only suggesting a moratorium but also that consumer benefit ought to be an essential ingredient or element of showing to justify a merger to the FTC or to the Department of Justice as a part of the standard for approval. I think this kind of practice, and from what I know about it, clearly an anti-competitive practice, a practice with an anti-competitive effect, ought to be at the very least admissible as evidence of an antitrust violation. And that goes to the suggestion that you and Senator Wyden have made as to what kind of facts and documents and practices ought to be admissible, especially in a highly concentrated market, and in a highly concentrated market ought to be perhaps regarded as proof of an antitrust violation if otherwise substantiated. But I would add that part of the perspective in the courtroom and in the court of public opinion ought to be what the effects as well as the purposes are, because the effects of many of these industry practices have been simply to maintain market share, not to compete, not even to gain market share. The Subcommittee report is very pointed and persuasive on this point, that this industry is very unusual insofar as a lot of its motive is to maintain market share, which perhaps is typical of an oligopoly, but especially so in this one--and, again, also maintaining shortages of supply. Ordinarily, higher sales produce more revenue and more profits. In this industry, the goal is to keep supplies tight and squeeze inventory so as to retain control and increase profit. So I think that this kind of document and this kind of practice are very pertinent to the laws that exist now, but ought to be made part of proof in court. Senator Levin. I want to talk about parallel pricing because it really fits in exactly with what we have been talking about and what you just testified to. In Michigan, we have a phenomenon that I think exists in a few other States, and it is what I call ``Speedway bumps.'' Not speed bumps but Speedway bumps. And as you can see from the chart \1\ and as has been referred to already, prices spike up on Wednesday or Thursday. You can see those spikes in greater detail on the chart on the right, and in smaller bumps going up on the chart on the left. The smaller peaks going up to the big spike on the left are what I refer to as ``Speedway bumps.'' --------------------------------------------------------------------------- \1\ See Exhibit No. 11 and 12 which appear in the Appendix on pages 260 and 261. --------------------------------------------------------------------------- They drift back down at the end of the weekend, and when you look at it more closely, 1 month at a time, Speedway is running up the price and then it is followed by other brands. And then the next Wednesday and Thursday, the same thing happens. So Speedway is the price leader in Michigan. It has this pattern of weekly mini-spikes. And I am just wondering here--General Granholm, let me ask you about that. We asked Marathon about this, and here is what their reaction was a couple days ago: ``Our pricing policy is every day. We look at our costs. We look at our sales. We look at how competitors are pricing, and we elect to always match the lowest price on the street. And then there comes a time when our costs have increased that we elect to raise''--``when our costs increase''--like every Wednesday and Thursday, I guess, our costs increase--``we elect to raise the retail price to try to recover some of our costs. Every day''--and he repeats the ``every day'' part. ``I hope it's not predictable,'' he says, ``because we look at our prices every day.'' What is your reaction to that? Ms. Granholm. I tell you, you ask any person in Michigan and you know very well what happens. Everywhere I go, people say, how about that? Everybody fills up on Wednesday because you know on Thursday the price is going up. They hold off on filling up until Monday so that they can get a better deal. It is like clockwork. I cannot believe he would say, I hope it is not predictable, because it certainly is. They are the leader because they are the ones that have the most market share and they are the ones from whom the independents are buying the gas. So they can lead the rise of the gas to perhaps a place where they are comfortably able to make a profit, and then on Monday, they shoot it right back down and the independents have difficulty even meeting that because sometimes they are below even the price that they would be charging the independents. So the independents are finding it very difficult to compete because they have to compete with their main competitor on the wholesale level buying from them. That is the difficulty of this vertical integration. Senator Levin. Now a question for each of you. There is another pricing practice that is discussed in our report where lessee branded dealers enter the long-term contracts with oil companies, and under those contracts, the oil companies set what is called a dealer tank wagon price, or DTW price, and there is not much that the lessee dealer can do about it. As a matter of fact, I think under those leases, they are required to pay the price that is set by the oil company. Under the antitrust law, the oil company, though, cannot set the retail price that dealer can charge. Several oil companies, however, acknowledged when we talked to them that they do provide lessee dealers with a recommended price for the retail price. What they charge the dealer is unilateral. They do not admit that, but there is a lot of evidence that even the leases themselves say you must pay the price, if you are a lessee, the price that we charge you. But when it comes to what you, the dealer, charge, we recommend a price to you, but by law, you have the right to set that price. We have heard now from several dealers the following. They believe the oil companies enforce recommended prices through their dealer tank wagon prices. They do that, these dealers say, as follows. If the dealer charges a price that is higher than the recommended price, the oil company will capture that increase with a commensurate increase in the next dealer tank wagon price. Have any of you heard those kind of allegations from dealers, that, yes, in theory, I set the price, but because I have to pay that wholesale price by my lease--I have no option on that--heck, if I change the price, raise it, for instance, 2 cents, the company will capture that 2 cents in the next DTW price that they charge me? Is that something familiar to you? General Blumenthal. Mr. Blumenthal. Yes, it is, Senator. That practice is one of a slew of practices that the big oil companies use, in effect, to control and manipulate the prices and markets in the zones they establish. It complements the zone pricing practices that are imposed in States across the country. Those practices are documented in this report and so are the motives for them in the MPSI study that is referenced. But one problem here is, and I will be very blunt to you, Senator, what we find, at least what I find is that many of the owners, the franchisees, that is, are very reluctant to come forward because they are very fearful of retaliation, again, another reason for making these cases easier to prove. The degree of fear, that is, the fear factor simply cannot be overemphasized, and so, no doubt, your staff and you have heard about many of these kinds of abuses, but proving them in court through witnesses who are willing and sufficiently courageous and brave to help us is another challenge. Senator Levin. Do either of the two of you have a comment on that? Mr. Greene. I think you are describing, Senator, a very common practice in the industry. One of the sad realities, I think, for lessee dealers is they are increasingly in a form of indentured servitude. It is a problem that they are squeezed by their leases, they are squeezed by the DTW. Much of their historic independence has been lost. This DTW-lease combination is the way the zone pricing system is actually enforced and works. It is through these DTW price sets that you get differences between down the block, down the street. So these are absolutely key mechanisms for controlling price at the retail level. That is certainly true. Senator Levin. Thank you. I have just a couple more questions for you. One has to do with parallel pricing, which we have talked about, where companies stay in the same fixed price relationship with each other, going up and down. Currently, that is not a violation of the antitrust laws unless you can prove that there is an agreement or conspiracy, some kind of explicit collusion between the two. This is one example. Where prices are in a fixed relationship with each other and go up and down these peaks together, the question is whether or not we should amend the antitrust laws to make that at least either presumptively anti- competitive or, at a minimum, evidence of an anti-competitive practice, which can go to the jury. Now, I believe that one of you has testified already on that, and I think it was you, General Blumenthal. Mr. Blumenthal. Yes, sir. Senator Levin. That you have already said that should be enough evidence to get you to a jury. Mr. Blumenthal. In a highly concentrated market, certainly, it should go to a jury and it should enable the case to go to a jury. Senator Levin. And I think that is a very important point that I should restate, that we are talking about in the highly concentrated markets when we talk about changing the antitrust laws or making mergers presumptively not going to be approved by the FTC in highly concentrated markets. General Granholm, do you have a comment on the parallel pricing question? Ms. Granholm. Just so that we are very clear about what the court has done, as we currently speak, the quote from the most recent court who decided this said tacit collusion, sometimes called oligopolistic price coordination or conscious parallelism, describes the process, not in itself unlawful, by which firms in a concentrated market might, in effect, share monopoly power, setting their prices at profit maximizing supra-competitive levels by recognizing their shared economic interests and their interdependence with respect to price and output decisions. It is well established that where a market is dominated by a few major players, parallel pricing is not uncommon and is generally insufficient to prove an antitrust conspiracy. So that mindset has got to be changed. Senator Levin. OK, thank you. Did you want to add anything, Mr. Greene? Mr. Greene. I think you do need to look at this very closely. If you were to take a look at the In Re Petroleum Products Litigation decision in the Ninth Circuit of 1990, one of the key points there was the existence of a sawtooth pattern, much like the first one you saw with the retail station. That was a key piece of evidence. Under current law, that might not even survive summary judgment. So I think, at the end of the day, I personally would feel more comfortable with evidence of parallel pricing plus, but at this point, that combination is probably not enough to get you to a jury and I think that is a wholly appropriate result, and insofar as the Subcommittee could suggest legislation that would get us there, that would be very helpful. Senator Levin. And the position that you favor would be that evidence of parallel pricing would be either enough to get to the jury, get you past summary judgment, or precisely what is your position? Mr. Greene. I think that it should be parallel pricing plus. Senator Levin. Plus what? Mr. Greene. Plus communication patterns. There is a whole body of law that existed circa 1990, 1989, in which, basically, parallel pricing plus not a whole lot more would get you to the jury. I think that is, at the very least, where we should be in this concentrated industry. Senator Levin. But short of the explicit concerted agreement? When you say plus---- Mr. Greene. It is a way of inferring the existence of an agreement. Senator Levin. I have got you. Ms. Granholm. The only problem with having an agreement is you do not need one. It is out there on the corner. I mean, who needs to talk to anybody when the price is up posted per gallon on every street corner? So the plus part of it is what is hard to get at when it is open and notorious. Mr. Blumenthal. And I would simply add that a jury should be permitted to infer an agreement, in this case an illegal agreement, from those factors, including conscious parallelism and parallel pricing, and these kinds of patterns are so dramatic, to use the old expression, a picture is worth a thousand words, this kind of picture should go to a jury and evidence of signaling or the opportunity to communicate and other kinds of implicit or tacit communication should be part of that case, as well. Senator Levin. I am just trying to get the exhibit number there so we can put in the record what the picture is that you are referring to. That is Exhibit 10.\1\ --------------------------------------------------------------------------- \1\ See Exhibit No. 10 which appears in the Appendix on page 259. --------------------------------------------------------------------------- This is the response of the representative who was here from ChevronTexaco when the parallel pricing issue was put to him. ``I happen to think that the reflection of a reasonably stable relationship of prices is actually an indication that the market is working exactly as it should.'' He was shown the same picture. ``The fact that market prices are going up and going down and that individual companies are in relative position not changing quite often, is, in fact, an indication to me that the market is working.'' Do you have any comment on that comment? Let me start with you, perhaps, Mr. Greene. Mr. Greene. Generally, the economics of this are that if it was an unconcentrated market, again, think of a grain market, prices will converge on a particular price. But it is not the case, typically, that each of the players stays in an individual position vis-a-vis the other players. I think that is a pattern much more closely associated with a concentrated market, which is what you are dealing with here. Senator Levin. Thank you. Ms. Granholm. I think, in general, players do see what the others are doing and they respond accordingly. That is the market. But I do think this issue of concentration is really the best place to start to prevent that, because I think that is really much easier to get at than this issue of parallel pricing, because that is a symptom. Mr. Blumenthal. I agree, to emphasize the importance here of market concentration in this industry, and also to, just as a footnote, to say that zone pricing, as the Subcommittee report shows, actually produces disparities, in my view, artificial disparities, in very closely located areas with no competitive or economic rationale. Senator Levin. I just have one more question, but on this particular subject, let me just say this, that where you already have a concentrated market, it seems to me the question of parallel pricing becomes more than a symptom. It becomes something which may be one of the problems that you can get at if you make it presumptively an anti-competitive act, because you already have the concentration. Your alternatives, then, are, I guess, either to break up the concentration, which is mighty complicated, or to go at some of those symptoms and to try to address the symptoms. I happen to agree with you. It is better to try to avoid the problem by preventing the mergers and the concentrated market, or that would create a concentrated market to begin with, but that is not the situation that we have now in half our States. We are already there, so we have to deal, I am afraid, with symptoms, and one of the issues we will face as to whether or not the parallel pricing symptom should be one that is addressed, even though it does not get to the underlying problem. One other symptom, and then we are going to let you go, and you have addressed this, I believe, Mr. Greene, and that is the question of whether we should mandate or let States mandate increased inventories. I believe you said that you are considering in California mandating a higher inventory level, which really is a critical part of this problem. If I heard you correctly--is that right, that you are thinking about doing that? Mr. Greene. That is certainly correct. The Attorney General recommended that we look, that the legislature and our expert energy agencies look very closely at this as a possibility. Our inventories are now so low that, literally, if a refinery coughs, we are in a price spike situation. So in my prepared materials, there is a very substantial report from one of our consultants explaining how that might work. Now, we are, as I mentioned, a very isolated market, so this may or may not be something that the Nation as a whole may want to look at. I would note, though, that our European partners, all of whom have these kinds of structures to deal with pricing problems. So I think it is something that may not be right for the Nation, but we are certainly looking at it in our market in California. Senator Levin. General Granholm, do you have any comment on that? Ms. Granholm. I think it is something worth looking at. Senator Levin. OK. Thank you. Mr. Blumenthal. I think it is worth considering, Senator. It has potential disadvantages in costs and difficulty to manage. That is, a regional or, in California's case, a State reserve might be very expensive and very problematic as a management challenge. But I do think at the Federal level, there should be much stronger oversight and perhaps inventories that are mandated, and I think there are other ways, even at the State level, to intervene in these situations. We had just a week ago the announcement from one of our major companies, Motiva, that it is closing a 200,000 barrel terminal facility, and it is not closing it and selling it, it is mothballing it. So that storage capacity is removed from our State inventory and, presumably, from the supply available to consumers at a time when, obviously, in the summer months, demand is going to increase. I think providing the legal means for some kind of intervention in that situation would be very welcome in a lot of States, but I do think that inventories perhaps are a Federal task. Senator Levin. Thank you. You have been a terrific panel. We thank you all and appreciate your testimony. Ms. Granholm. Thank you very much. Mr. Blumenthal. Thank you, Mr. Chairman. Mr. Greene. Thank you. Senator Levin. Let me now introduce our third panel of witnesses. First, Peter Ashton, who is President of Innovation and Information Consultants; next, Dr. Justine Hastings, Assistant Professor of Economics at Dartmouth; Dr. R. Preston McAfee, who is the Murray Johnson Professor of Economics at the University of Texas; and then Dr. Philip Verleger, President of PK Verleger, LLC. Let me first swear you all in, as is required by our rules. I would ask you just to stand and raise your right hands. Do you swear that the testimony that you will give before this Subcommittee this morning will be the truth, the whole truth, and nothing but the truth, so help you, God? Mr. Ashton. I do. Ms. Hastings. I do. Mr. McAfee. I do. Mr. Verleger. I do. Senator Levin. We have a panel of academics, experts this morning to discuss price volatility, to discuss mergers approved by the FTC, and a number of other topics that we have discussed both Tuesday and this morning. We would ask you, given the hour, if you could keep your oral remarks to 10 minutes or less and we will make sure your printed testimony is entirely in the record. Let me just go alphabetically here. Mr. Ashton. TESTIMONY OF PETER K. ASHTON,\1\ PRESIDENT, INNOVATION AND INFORMATION CONSULTANTS, CONCORD, MASSACHUSETTS Mr. Ashton. Good morning, Mr. Chairman, and thank you. It is certainly a pleasure to be here to discuss issues related to gasoline pricing. --------------------------------------------------------------------------- \1\ The prepared statement of Mr. Ashton with attachments appear in the Appendix on page 204. --------------------------------------------------------------------------- As you indicated, my name is Peter Ashton. I am the President of Innovation and Information Consultants, an economic and financial consulting firm, and over the last 20 years, I have had the opportunity to act as a consultant to various States, the Federal Government, and also different firms in the industry with regard to gasoline and oil pricing issues. My comments, very briefly this morning, will relate to four issues. First, I will talk about trends in market concentration due to mergers in the refining and marketing industry. Second, I will address recent episodes of price spikes, particularly in the Midwestern region of the country. Third, I have a couple of brief comments to make about your staff's excellent report. I guess I am telegraphing what I am going to say. And fourth, I have a few suggestions and a couple of additional thoughts based on what I have heard this morning in terms of potential policy recommendations. Let me first start by talking about recent trends in terms of merger activity. As you are aware, in the last 5 years, the domestic refining and marketing industry has witnessed a wave of mergers not unlike what was observed during the early 1980's. During that time frame, several larger mergers in the industry were approved by the Federal Trade Commission, and in a report it issued in 1989, the Federal Trade Commission commented at that time that those mergers had led only to modest increases in concentration and that such increases stemmed as much from closure of independent, inefficient refineries as it had from the mergers themselves. The recent wave of mergers, however, has led to, I think, a fairly different conclusion in terms of having a much more significant impact on market concentration. I do not need to go into and belabor what an HHI is. You have certainly used that term and understand it. I have looked at HHIs for both refining capacity as a whole and also just for gasoline manufacturing capacity and there have been fairly significant increases, really throughout the country, but particularly in certain markets, such as the East Coast, what I have termed and what the FTC has defined as a relevant market as the Upper Midwest, which includes Indiana, Illinois, Kentucky, Ohio, and Michigan. There, for example, the HHI in both refining capacity and particularly gasoline manufacturing capacity is now over 1,800, which signifies a highly concentrated market. And in California, which I have also spent time looking at, due in part to its unique gasoline specifications and its location, is a relatively isolated market. Here, the HHI for gasoline production has risen from about 1,300 5 years ago now to close to 1,800. Concentration has also increased at the wholesale level. This level of the market, in my opinion, is critical to understanding pricing and supply, as it is the link between refinery production and the consumer. In my experience, this is often the point at which the greatest control over supply may be exerted, where significant interdependence exists, and also often where regulatory authorities fail to adequately examine competitive impacts. Finally, at the retail level, today, over 65 percent of all retail sales now occur through branded stations, whereas only 5 years ago, that number was less than 45 percent, according to DOE statistics. In some areas of the country, such as California, independent marketers have virtually disappeared. I would note that considerable research over the years, including by my colleague next to me, has demonstrated the competitive importance of maintaining a viable independent segment of the retail market. Let me turn now to the reasons that I see for the increased gas price volatility over the last 2 years, particularly in the Midwest. One naturally thinks of the cost of crude oil as having a significant impact when the price at the pump goes up. Indeed, crude oil represents about 75 percent of the cost of making a barrel of gasoline. However, in my opinion, crude oil price increases were not the cause of the price spikes in the late spring of 2000 or during the spring and summer of 2001, and that is shown in two of the figures that I have presented as part of my testimony, Figures 1 and 2.\1\ --------------------------------------------------------------------------- \1\ Figures 1 and 2 which is attached to Mr. Ashton's prepared statement appears in the Appendix on page 213. --------------------------------------------------------------------------- Other possible explanations for the increase in gasoline prices could include supply curtailments, either caused by a reduction in inventories or production, or surges in demand. Data on consumption reveal no unexpected surges in demand that could explain either of the first two price increases. However, demand did increase fairly significantly in the summer months preceding the so-called Labor Day price spike of 2001 and may have been partially responsible for the price increase. Production did not decline in any meaningful way in the periods leading up to and including the first two price spikes. Supply disruptions due to refinery outages do not appear to be a plausible explanation for the magnitude of the price spikes that we observed. During the third price spike, there was a nationwide decline in production, although not in the Midwest, but this does appear to have had some impact on prices. Inventories, however, present a more interesting picture. First, it is important to understand that the absolute level of gasoline inventories relative to consumption has fallen significantly in recent years. Refining and marketing companies made a conscious decision in the mid-1990's to carry lower inventories of refined products, including gasoline. Such just- in-time inventories were rationalized as a cost cutting measure, but they appear to have led to greater price volatility, as well. The reduction in inventory levels is illustrated in Figure 3 \2\ to my written testimony, where the average carrying level has now been reduced from about 30 days' supply to less than 24 days' supply. --------------------------------------------------------------------------- \1\ Figure 3 which is attached to Mr. Ashton's prepared statement appears in the Appendix on page 214. --------------------------------------------------------------------------- As a result, the difference between the average level of inventories maintained and the minimum operating inventory level has shrunk, so that now even brief supply disruptions can cause major problems. This reduction in inventories means that small changes in gasoline supply can result in very large changes in prices, and is in my opinion the most likely reason for the increase in price volatility in recent years. Examination, for example, of inventories immediately preceding the first two price spikes in the Midwest indicates lower than normal levels, although not necessarily of the magnitude to cause such a huge spike in prices. And it is important to note that in each case, inventories return to relatively normal seasonal levels within about 2 weeks after the start of the price spike, and this is shown in Figure 4 \1\ to my written testimony. --------------------------------------------------------------------------- \2\ Figure 4 which is attached to Mr. Ashton's prepared statement appears in the Appendix on page 214. --------------------------------------------------------------------------- During the June 2000 price spike, for example, the surge in wholesale and retail prices began the last week in May, when inventories were at abnormally low levels. Within 2 weeks, however, inventory levels were back to normal, yet gasoline prices continued to rise for the next 2 to 3 weeks, on the order of 15 cents per gallon in the Midwest. With each of the two succeeding price spikes in the Midwest in the spring of 2000 and late summer 2001, much of the same story played out. The August 2000 price increase, as I already alluded to, is somewhat more puzzling as there appears to have been not the reduction in inventory as much as a nationwide increase in demand, as well as reduction in production. This does not, however, explain the fact that Midwest prices appeared to rise considerably more than in other parts of the country. I have also done some statistical analysis of the relationship between changes in gasoline prices over the years and various other economic factors that could explain those prices, such as changes in crude oil prices, inventory levels, production, capacity utilization, and the like. I have found that in normal, relatively stable times, crude oil price changes, along with changes in inventory and production levels, do explain a significant portion of the change in gasoline prices. But changes in crude oil prices and these other factors do not explain the price spikes observed in the Midwest, and also to a large extent on the West Coast, in the last 2 years, even accounting for possible lags. I have also found in my statistical analysis that beginning in approximately 1998, a measure of market concentration has become a more significant statistically explanatory variable for those changes in gasoline prices, not necessarily a large magnitude of the change, but it has become a statistically significant factor. Let me turn briefly to comments on the staff's report. I have had the opportunity to review the Majority staff's report and I share many of the same conclusions as contained in that report. It is a highly professional piece of analysis and points quite correctly, I believe, to the tightening of the supply-demand balance, as well as increases in concentration, as ways in which supply can be affected and which, given inelastic product demand, has allowed gas prices to rise significantly at certain times. Staff's conclusions, importantly, are based on a 10-month investigation that included interviews with industry officials, trade associations, and others, as well as review of internal company documents. It is, in my experience, rare when one is able to catch a glimpse of the workings of an industry in this way, and staff's analysis is more compelling to me as a result. In light of these findings, let me talk just briefly about possible measures to deter future price volatility. First, I do believe that the FTC must be more vigilant in its merger review, focusing more closely on competitive impacts, particularly at the wholesale level, and encouraging, where possible, the competitiveness of independent marketers and refiners. Second, due to the fact that many markets are already highly or moderately concentrated, the FTC, as well as other regulatory authorities, including FERC, should take a tougher stand on various practices and behavior that might be conducive to price fixing or price signaling. Third, and I think we heard this recommendation earlier, I think resources should be added to the enforcement agencies, particularly the FTC in terms of its merger oversight, and it should tend to view these mergers not in isolation but together with other changes going on in various markets. Fourth, I would recommend investigation of measures to encourage greater supply flexibility. This would include, among other things, increasing the role of unbranded competition, greater consistency in regulatory policies, especially as it relates to gasoline specifications, and other ways to increase the general absolute levels of product inventories. And in that vein, and I heard the suggestion from Mr. Greene of California, I am intrigued and would at least suggest that a study of some kind of maintenance of minimum inventory levels, or perhaps even a reserve. I think that might be a very interesting option. Finally, I have also heard this morning, I think, some interesting suggestions about changes to both the antitrust laws as well as potentially enforcement. A couple of those cases that I have heard mentioned in the discussion earlier this morning were ones that I was involved with and I certainly think that some of those moves should be considered. That concludes my remarks, Mr. Chairman. I certainly appreciate being here and I would be happy to try to answer any questions. Senator Levin. Thank you very much, Mr. Ashton. Dr. Hastings. TESTIMONY OF JUSTINE S. HASTINGS,\1\ ASSISTANT PROFESSOR OF ECONOMICS, DARTMOUTH COLLEGE, HANOVER, NEW HAMPSHIRE Ms. Hastings. Thank you. Mr. Chairman, my name is Justine Hastings and I am an Assistant Professor of Economics at Dartmouth. I received my Ph.D. in economics from UC-Berkeley. --------------------------------------------------------------------------- \1\ The prepared statement of Ms. Hastings appears in the Appendix on page 215. --------------------------------------------------------------------------- My research focuses on the effects of vertical relationships between refiners and retailers on retail and wholesale gasoline prices. I have analyzed extensive data on gasoline market structure for a diverse group of U.S. metropolitan areas covering the 1990's. I have used this data to conduct independent academic research into the relationships between vertical market structure and competition in gasoline refining and marketing. My independent research and my acquired knowledge of the industry form the basis of my testimony before the Subcommittee today. I will now summarize the results of two of my research papers and discuss their possible implications for government policy. Both analyses use changes in vertical integration generated by mergers to identify their main results. The first study, entitled ``Vertical Relationships and Competition in Retail Gasoline Markets,'' finds that independent retailers are uniquely important for retail price competition. This paper uses detailed station-level data for Southern California, coupled with the 1997 purchase of the independent retail chain Thrifty by ARCO to show that the loss of independence contributes to higher retail prices. Specifically, the analysis concludes that retail prices in markets affected by the acquisition increased, on average, 5 cents a gallon relative to unaffected markets. When independents exit and are replaced by integrated branded competitors, competition in the market is softened and prices increase. What matters for competition is whether there are independent, unbranded retailers, not what types of contracts integrated refiners have with their stations. The second paper is entitled, ``Vertical Integration in Gasoline Supply: An Empirical Test of Raising Rivals' Costs.'' This work is done with Dr. Richard Gilbert. This paper asked the following question: Does vertical integration affect wholesale gasoline prices? Using Tosco Corporation's acquisition of Unocal's West Coast refining and marketing assets, we find that integrated refiners raise wholesale prices to independent retailers. This allows them to increase prices at their own retail stations, thus increasing their own retail profits. These results are consistent with the strategic incentive to raise competitors' input costs and show that the extent of a wholesaler's vertical integration into downstream markets can have a significant impact on wholesale competition and prices. We then look at a broad panel of 26 metropolitan areas over the 1990's, including ones in the West Coast, Rocky Mountain, and Gulf Coast States. We find a positive correlation between the extent of vertical integration and unbranded wholesale price, consistent with the effect we identified in the Tosco- Unocal event study. Our main result concludes that vertically integrated refiners have an incentive to increase wholesale prices to independent marketers in order to increase retail profits. This implies that it is very important to consider such interactions between vertical integration and competition in antitrust and merger policy. The main conclusions from my research are that independent refiners and independent retailers are important contributors to competition in retail and wholesale gasoline markets. Independent retailers are uniquely important for competition because they are incredibly price competitive and increase competition at the retail level. In addition, they are the only type of station that can purchase from the lowest price wholesaler, thus introducing and forcing competition at the wholesale level. Furthermore, they allow outside entry of other refiners into concentrated markets when prices in those markets are excessively high. Independent refiners are also uniquely important for competition, and this is because independent refiners do not have the incentive to raise rivals' costs that integrated refiners have. Independent refiners compete intensely on wholesale price, unlike branded wholesalers, and because of these two factors, unintegrated refiners are important to ensure sufficient wholesale gasoline supply at competitive prices. This is necessary for the entry and survival of independent retailers, including new chains such as RaceTrac, Wawa, Costco, or Wal-Mart. What are the positive policy implications of my research? First is that antitrust and merger policy should more carefully consider the impacts of vertical integration on competition, both in merger analysis and in divestiture requirements. Mergers that result in a significant increase in the degree of vertical concentration should be scrutinized more carefully. In addition, competition may best be served by designing divestiture requirements to increase the retail market share of independent retailers and decrease the degree of vertical concentration in the market. For example, divestitures required from recent mergers consistently require the divestiture of a refinery and retail stations to a single new integrated competitor. Take, for example, the divestiture requirements for ExxonMobil merger on the West Coast and the Ultramar Diamond Shamrock-Valero merger on the West Coast. In both cases, the refinery and stations were divested to a single integrated competitor. Why not divest the retail stations and the refinery to separate companies? The results from my research imply that divesting the refinery and station separately would do more to increase competition in California's gasoline markets. I encourage the current efforts of the Federal Trade Commission to incorporate vertical integration issues into merger and antitrust regulation. For example, in Michigan, mergers between Marathon and Ashland and Ultramar Diamond Shamrock's, or UDS's, total assets resulted in a significant decrease in the number of competitors supplying unbranded gasoline at wholesale racks. A traditional measure of HHI would not have picked this up. It seems to me that we should adapt the HHI to include specifically components of vertical integration when looking at mergers. My colleague, Dr. McAfee, has proposed such an alternative to the HHI. Furthermore, the Environmental Protection Agency needs to incorporate secondary impacts on market structure and competition when designing environmental regulations. The current system of boutique fuels further segments markets and leads to market power for local refiners. It creates barriers to entry and, thus, increases price levels and volatility. In addition, price volatility caused by market segmentation drives out independent retailers in the long run, further lessening competition. The EPA should attempt to minimize the number of fuels required while still protecting the environment in order to minimize segregation of gasoline markets and increase price volatility. I would now like to comment on a couple of legislative ideas that have been proposed and are aimed at increasing competition in gasoline markets. The first of these falls under wholesale price regulation and this legislation has the following title. It comes under fair wholesale pricing, branded open supply, or zone price elimination legislation. These types of legislation are most likely regressive policies that will lead to price increases in low-income neighborhoods. Furthermore, they may lead to further vertical concentration, lessening competition in the long run. What would zone price elimination do? Currently, as has been noted here, refiners price discriminate, charging higher wholesale prices in less price sensitive markets and lower prices in highly competitive markets. Zone price elimination would require refiners to charge one wholesale price. In order for this policy to lead to lower retail prices, two things have to happen. First, zone price elimination must lead to lower wholesale prices. Second, that lower wholesale price must be passed on to the pump by the dealers who set the retail price. If refiners are forced to charge one wholesale price, it actually could be the case that average wholesale prices would rise. In addition, they would certainly rise in low-income neighborhoods, currently the most price sensitive neighborhoods. Zone price elimination could be a very regressive policy. In addition, if zone price elimination leads to higher average wholesale prices, this may lead to the closure of independent marketing stations. Independent dealer-owned stations may go out of business in the long run, further increasing vertical concentration and lessening competition. I would also like to point out one more fact. Branded open dealers pay one rack price and it is not the case that we see less price discrimination at those stations than we do at lessee dealer stations where the oil companies price discriminate. I would like to sum up my comments by stating that members of your staff have worked incredibly hard to produce an extensive and excellent report, and I am certain that, by now, they are deeply aware of the following two facts. First, there is a pressing need for more independent academic research into the factors that affect petroleum pricing at all levels of production. Second, it is incredibly difficult to acquire data to conduct such research. I would like to propose creating a program at the Energy Information Administration modeled after the excellent program that the U.S. Census Bureau has to disseminate and make available to highly screened researchers proprietary data that would allow for excellent studies needed to inform public policy debates. This concludes my comments, and I look forward to answering your questions. Senator Levin. Thank you so much, Doctor. Dr. McAfee. TESTIMONY OF R. PRESTON McAFEE,\1\ MURRAY S. JOHNSON PROFESSOR OF ECONOMICS, UNIVERSITY OF TEXAS, AUSTIN, TEXAS Mr. McAfee. Mr. Chairman and Members of the Subcommittee, my name is Preston McAfee. I am a professor at the University of Texas and I have worked extensively with the Federal Trade Commission in evaluating mergers. This includes the ExxonMobil, BP-ARCO mergers, and others. I also assisted the Commission with the summer 2000 Midwest gas price spike investigation. --------------------------------------------------------------------------- \1\ The prepared statement of Mr. McAfee appears in the Appendix on page 227. --------------------------------------------------------------------------- As part of my studies of these mergers, I have had access to and studied a substantial amount of information, including the documents that the FTC had gathered in the course of its investigation. Much of this information is confidential. In the case of ExxonMobil, it is more than 100 million pages of documents. I am pleased to be here today to discuss the economic issues I have researched as they pertain to your examination of gasoline prices in the United States. I will concentrate on volatility and antitrust. Let me start by saying I appreciate the effort and thought that went into the Subcommittee's report. I want to compliment the Chairman, the Subcommittee, and the staff on this report and I am going to highlight a few issues considered in the report and disagree with a few. First, on volatility, a basic fact of the gasoline market is that the combination of inelastic demand and inelastic supply magnifies the effects of supply disruptions. Short-run price changes can easily be three to five times the quantity changes. So a 10 percent change in quantity can result in 30 to 50 percent price increases. This is a feature of consumer values and production costs that cannot be changed by policy. That is, unless you can change the way consumers value gasoline, you cannot change this demand response. Consequently, there is only a limited role for government in reducing price volatility. Some level of fluctuations in price is unavoidable and are caused by large-scale phenomena like demand increases and short-term phenomena like pipeline breaks. I want to emphasize that price controls are not a fix for volatility. We have lived through the gasoline lines of the 1970's, which were created by price controls, and I hope never to see these again. Preventing the establishment of market prices through price controls does not change underlying conditions, but instead creates severe shortages and eliminates investment. Price volatility is increased by the proliferation of boutique fuels, which certainly contributed to the Midwest price spikes. As a Nation, we should be aware that every time an area is assigned its own fuel specifications, the rest of us lose a little bit of insurance. We should attempt to reduce the total number of distinct types of gasoline in use. Currently, there appear to be 19 different regular unleaded specifications, and that means you need 19 distinct storage units for those fuels. The greater the extent to which the Nation is interconnected, the less will be the overall volatility of gasoline prices. Easing the construction of pipelines may reduce volatility by linking geographic areas more tightly. This is certainly relevant to Michigan. Price volatility is not unambiguously bad. Gasoline prices are volatile because the value of gasoline varies over time. Stabilizing prices at a high level, which is essentially the Canadian policy, is much worse than allowing fluctuation where sometimes we get the benefit of low prices. The tendency to reduce taxes when supply is temporarily disrupted is a very bad policy. This was used by Illinois. The price must rise to ration demand to the available supply. Removing the taxes does not change this fact. It does not change the fact that consumers must pay a higher price to reduce their demands. A tax holiday during a price spike does not decrease the prices but, in fact, creates a windfall gain to the oil companies by transferring the taxes from the government to the oil companies. In terms of the response to price spikes, long-distance transportation typically takes about 4 weeks. Refining adds another 4 weeks. So a 2-month response to an unexpected shortage is a normal competitive response. In the case of the Midwest price spike, the possibility of EPA waivers actually contributed to the problem. There were several companies that expected EPA waivers that never came. Because they were expecting waivers to the reformulated gasoline specifications, they waited, hoping to be able to supply regular unleaded. It would be very useful for the EPA to clearly delineate the criteria under which waivers are issued. In the case of the Midwest, the need to clean storage tanks between summer and winter creates a window of severe vulnerability to supply disruptions. Essentially, all companies have their storage units empty at the same time, and that contributed to the Midwest gas price spike. This problem is easily cured by staggering the imposition of fuel requirements across the companies. And so just a matter of a few weeks' difference would actually ease this burden and reduce our vulnerability. Let me now turn to antitrust. Parallel pricing is a feature of both perfect competition and collusion. That is, firms that are aggressively competing will display parallel pricing. Firms with similar costs engage in parallel pricing. It is not possible to conclude from parallel pricing alone anything about collusion. As a result, parallel pricing should not be made illegal, in my opinion. It is equally evidence of competition as it is evidence of collusion. Something else is needed. As the report noted, the West Coast gasoline market is controlled by an oligopoly of seven firms, ChevronTexaco, Shell, BP, Tosco, Valero, ExxonMobil, and probably Tesoro, depending on a spin-off. It is hard to keep up with this without a scorecard. I want to note that is actually still seven firms, just as it was before the ExxonMobil merger. That is, the wave of mergers has not resulted in a significantly more concentrated market in this very inter-dependent market. I agree with the Subcommittee's finding that these firms are inter-dependent and aware of each other's behavior and that significantly reduces the likelihood of competitive behavior. As Dr. Hastings emphasizes, vertical integration exacerbates the risk of noncompetitive behavior. The Federal Trade Commission is quite aware of the threat created by increasing vertical integration and the interdependence of the firms and it actively blocks it by requiring divestitures. Unfortunately, while we would like to actually improve the situation, the law dictates that you can prevent a lessening of competition, so we cannot force the firms to increase the competition. So we cannot break up the vertical integration when divestitures are required. I am sure the FTC would greatly appreciate more resources for its investigations. My bottom line is that the FTC does a thorough job investigating large oil company mergers and that extensive divestitures to preserve competition have been required. Elimination of zone pricing by statute will not tend to reduce average gasoline prices. Instead, as Dr. Hastings emphasized, it will tend to increase prices in the most competitive and also the poorest areas. Zone pricing is essentially the same phenomenon as the senior citizen discount at the movie theater. That is, the companies give a lower price to the more price sensitive consumers, like students and senior citizens. My 84-year-old mother very much appreciates the senior citizen discount at the movie theater and would not like to see it made illegal. Finally, let me turn to conclusions. Industry executives are justifiably pessimistic about the ability of this Nation to produce new refineries, especially on the West Coast. Even in their private documents, they say there will never be a new West Coast refinery built. There is a role for the government to moderate the ``not in my backyard'' mentality that makes it more difficult for us to build adequate refineries, adequate electric power generation facilities, pipelines, electric transmission lines, and even cellular phone towers. And finally, for the big picture, over the past 30 years, this country has deregulated or partially deregulated trucking, airlines, rail, gasoline, oil, natural gas, and long-distance telephony. We are in the process of deregulating electricity and local telephony. Overall, economic studies indicate that the deregulation of the U.S. economy has produced enormous gains for the American consumer. We should not let a few problems, and price spikes are a problem and also the California electricity crisis is a problem, but we should not let a few problems deflect us from our market economy or send us back to the miserable regulated environment of the 1970's. In almost all instances, competitive industries deliver more, higher quality goods to consumers than regulated industries do. Gasoline lines, which are the archetypal outcome of regulation, are worse in the long run than volatile prices. Finally, on the presumption of guilt, let me end with this. My understanding of the American system is innocent until proven guilty. We should not be presuming guilt for what could be competitive behavior. Thank you very much. Senator Levin. Thank you very much, Dr. McAfee. Dr. Verleger. TESTIMONY OF PHILIP K. VERLEGER, JR.,\1\ PRESIDENT, PK VERLEGER, LLC, NEWPORT BEACH, CALIFORNIA Mr. Verleger. Thank you very much, Senator Levin. It is a pleasure to be here. --------------------------------------------------------------------------- \1\ The prepared statement of Mr. Verleger appears in the Appendix on page 239. --------------------------------------------------------------------------- Let me start by saying I am the BP Senior Fellow in International Economics at the Council of Foreign Relations and I also have my own consulting firm. What I am saying here today are my own opinions and not those of the council. I have studied energy now for more than 30 years. I have written extensively on commodity markets and on the linkage between commodity prices and stocks. I am a member of the National Petroleum Council. I was a member of Attorney General Lockyer's task force to look at California gasoline, testified in the Aguilar matter, testified to the Senate Monopolies Committee on the announcement of the BP-Amoco merger at the request of the Chairman, consulted on ExxonMobil, BP-Amoco, and on the Shell-Texaco joint venture. I also testified and consulted extensively on the Unocal patent. I am an energy person much more than an antitrust person. Let me break the order of my testimony and start, by saying that something has gone unmentioned here, that is the role of the new competitors. Wawa, Sheetz, and most importantly, Wal- Mart have entered the gasoline marketing business in many parts of the country. Where local regulations permit them and where State regulations do not prevent them from charging low prices, they are bringing to the consumer the same benefit that they have brought the consumer of every other commodity. That is, they achieve economies of scope and scale and we see much lower prices. I think your Subcommittee report noted this. It is a little hard to get information on this, but the Federal Trade Commission has just recently issued a letter to Virginia essentially trying to stop legislation which would impose minimum cost selling prices. This entry is an important change and it will progress. In Europe, it has brought much lower prices. The officials at DG-9, which is the antitrust group at the European Community, say that in France and in England, where these competitors have been permitted to enter, consumer prices have dropped sharply--I do not have a percentage number--as compared to Spain and Portugal and other countries where they are not permitted to market. The second point is we have a fundamental inconsistency in our national energy policy and our competition policy. In the debate on the energy bill, the Senate and the House both decided that nothing would be done, really, to limit CAFE standards. This means that gasoline demand will probably increase by around 2 percent per year for the next several years. Unfortunately, supply will not. Unless imports are available, that means each summer, we have to expect to see higher prices than the summer before to balance supply and demand. The very large sports utility vehicles that are being sold create a demand for gasoline that we just cannot meet. My third point is that refinery capacity in this country has increased. The Federal Trade Commission will hold hearings next week asking what has changed between 1985 and 2000, and in preparation for this, I examined the refineries that were in existence in 1985 and the refineries that exist today. What we find is the number of refineries has declined, but total refining capacity has increased by about 10 percent, to 16 million barrels a day. That is, the average refinery that remained in operation increased in size roughly by 40,000 barrels a day. One of the ways this occurred was by merging inefficient older units with newer units. One of the major constraints on building a refinery, I am told, is land. That is, if you do not have enough land, you cannot expand capacity due to the problems associated with fire and explosion. I regret that at least in the case of two mergers, one in the case of Shell and Texaco, there was an opportunity to achieve some real gains in the State of Washington, where two refineries that were next door to each other could have been combined. Unfortunately, the FTC interpretation--correct interpretation--of antitrust laws made that impossible. The fourth point is that the sisters are diminishing in importance. Senator Hart from Michigan held an excellent hearing on the role of the seven sisters in the oil industry years ago. Today, you are dealing with four sisters. The Gulf has vanished, Texaco has vanished, Mobil has vanished. Between 1985 and 2000, the four sisters disposed of 26 percent of their U.S. refining capacity. That is, they sold over two million barrels a day of refining capacity, and they have gone from firms that had surplus gasoline supplies to be essentially short, and what we see is a set of firms that really want to supply their own needs, their own branded dealers, and leave the other unbranded dealers to the mercy of other firms. There is nothing wrong with this. There is no parallel decisionmaking in this. This is just something where we see them moving back. It also seems to be the case, although I have studied it less, in the case of Marathon, Ashland, and others. Fifth, the big firms have been replaced by smaller firms, fringe suppliers, that now provide 35 percent of the refining capacity in the United States. I have been afraid for years that these firms, one, cannot afford to make the upgrades needed to produce the very clean gasoline that EPA is demanding, and two, would face problems holding sufficient inventories. I note that in the last 48 hours, we have seen one of those firms, Valero, cut its capital budget by 25 percent and another of those firms, Tesoro, announce that it may not be able to proceed with the purchase of a refinery in San Francisco due to financial constraints. The question, then, is what to do. What can be done? I applaud the hearings and I applaud the report. First, one of the reasons the gasoline market does not work very well is there are no forward buyers. This is an arcane subject that comes out of commodity markets, but the jet fuel markets and the heating markets and the natural gas markets work very well because buyers are willing to make purchases 6 months, a year ahead of time. I work with one major airline which regularly will cover half to two-thirds of its supply ahead of time to control its costs, and it actually reported a profit in the fourth quarter of 2001 because of its fuel management procedures offset some of their losses. Home heating consumers in New England regularly buy their winter heating oil by the end of October. It is not possible to do this in gasoline for the average consumer because any program you put together would conflict with the Petroleum Marketing Practices Act. It is possible, however, for State Governments and the Federal Government to enter into forward contracted fixed prices to essentially create that forward market. That is, the State of California could buy its gasoline in the future. Such purchases, we know, would cause inventories to be increased. We teach it when we teach commodity market economics. You see it in grain markets. If there is a forward market, the buying causes inventories to rise and you get a net gain in inventories. So that one of the elements is to convince State Governments, county governments, city governments, to enter contracts to buy in the forward market. Now, many bureaucrats will not do this for fear of what we call adverse publicity. That is, they buy forward, prices go down, and everybody looks at them and says, that was a stupid decision. We are going to find somebody else to manage the job. So there needs to be some sort of suggestion that, perhaps even a requirement, that governments buy forward at fixed prices. One of the largest buyers could be DFSC, the Defense Fuel Supply Agency. A corollary to this rule is that attempts to require stockpiles or to build strategic stockpiles by government are a mistake. We know from extensive studies of commodity markets that when the Federal Government or the government builds inventories, private inventories go down. In my conversations last week in Brussels, I find that there are many problems associated with the Europeans. The third point is to echo the comments made by the Attorney General from Michigan that one needs to focus very closely on bottlenecks such as pipelines. The Wolverine Pipeline example in your report is excellent. In California, I think we have a problem with the SFPP Pipeline, particularly in the way they establish tariffs at their terminal facilities, which are not regulated. These tarriffs could raise the cost of entry for smaller independent firms. Fourth, going to what Professor McAfee was saying on regulations on fuel, Professor Bornstein of Berkeley has proposed that instead of prohibitions, environmental agencies impose fees. That is, require a supplier that wants to sell unleaded gasoline in an area that requires reformulated gasoline to pay a fee to the government agency and introduce that gasoline into the market. Set a fee of 5 cents or 7 cents a gallon, for example. That would allow conventional gasoline into the market and would cap the price spikes. It is a very clever solution. It goes back to what we have learned over the last 30 years, that prohibitions and controls are a much inferior method to some sort of fee-based system or taxation. Finally, I will note that gasoline prices are affected by winter weather. The reason gasoline prices rose in the spring of 2000 was that January 2000 was very cold and the price spike associated with heating oil forced refiners to make heating oil for a longer period of time, preventing the normal conversion to producing gasoline. Thank you very much, sir. Senator Levin. Thank you, Dr. Verleger, very much for your testimony. Your reference to strategic purchasing by government raises a question which I would like any of you who feel qualified to address to comment on. It is my understanding that some companies are using crude oil that is produced in the North Sea called Brent to help fill up our Strategic Petroleum Reserve in Louisiana, to replace oil which had been removed from it. So they are using that particular kind of crude oil to fill the reserve in response to the Department of Energy's program to now replenish that reserve. The problem apparently is this, and it is sort of raised in an interesting way, Dr. Verleger, by your testimony. Brent is in short supply, as I understand it. That particular kind of crude is in short supply. What we have been told is that some companies that produce or trade in Brent, not exclusively, but who produce and trade in Brent, are putting Brent into the reserve in order to create, or at least with the effect of creating a shortage of Brent, which then drives up the worldwide price of Brent. Now, many other crude oils produced in Europe and Africa are priced in relation to Brent, so that as the price of Brent increases, the price of these other crude oils increase, also. Approximately 20 percent of our imported crude oil is from Europe and Africa, so we may be paying more for crude oil in this country as a result of companies putting Brent oil into the Strategic Petroleum Reserve, even though other oil would be acceptable to replenish that reserve. It is kind of triggered by your testimony about buying strategically, but this is a little different question and I am wondering whether this resonates with any of you. Dr. Verleger. Mr. Verleger. We could spend all day talking about Brent. Brent is the benchmark of the world crude market. It is produced in the North Sea by several companies. There are something like 25 to 30--I think, I may be wrong--500,000- barrel cargoes a month. Over the years, the Brent system has been expanded to include certain other crudes, similar characteristics, as that production has gone down. But it is really the reference to the world market. Brent has been subject to a large number of manipulations over the years. About a year and a half ago, a firm named Arcadia, which is owned by a Japanese firm, managed to buy in the paper market associated with this control of all the cargoes, which they then took to South Africa or other places, and they made, evidently, a very large profit because of purchases of other crudes that were linked to this, and they took the position secretly. Tosco Corporation sued under the antitrust laws and it was a unique antitrust suit. It was settled in 3 weeks. There was no discovery. There was nothing else, and evidently, a large sum of money was paid. I do not know about the existing rules. I have had any number of problems with the Strategic Petroleum Reserve management people. Two years ago September, I wrote an article on the op-ed page of the New York Times calling for use of the Strategic Petroleum Reserve when crude prices were $35, forward crude was at $22, that the government should lease it out, that is, ask firms to take 100 barrels today and get back 105 barrels in a year. The commodity rate of interest was a high commodity rate of interest. The government finally did it, but if you will recall, the Department of Energy managed to bollux the auction up so that, in one case, about a third of the oil they auctioned was purchased by somebody who had an apartment in Harlem. It was not purchased by any major oil company. I have a question of why we are putting light oil into the Strategic Petroleum Reserve. If we ever need to use the Strategic Petroleum Reserve, presumably, refinery operating rates will be reduced because we will be in a shortage situation on the world market and there will be some surplus refining capacity and most good refining capacity can take heavier crude oils. This may be a request of some of the smaller independent refiners that have not made the investment to upgrade it. There are many ways that DOE could write the specifications so that Brent would not be the crude but, say, a Bonnie light out of Nigeria, which is the same. I just do not know the facts on this one. I have read in the petroleum trade press that cargoes are being purchased. I will say that if the government imposes a requirement, say, to deliver 10 million barrels of oil of a consistent specification, there are very few places other than the Salom Voe terminal in Scotland where you can go to arrange that. The companies that happen to be equity producers have the crude, so the government may have given them an opportunity. Senator Levin. OK. Does anybody else have a comment on that? Dr. Hastings. Ms. Hastings. Sure. I understood your comment to be analogous to what could happen in gasoline markets were the government to engage in storage and long-term purchasing on the market and reselling on the market in order to smooth supply disruptions. I would like to point out one thing. Reformulated fuel has a much shorter shelf life than does crude oil, so if you are putting out this one case where we once in a while have to dip into the Strategic Reserve and then repurchase oil or produce oil and bring it back in to replenish it, actually, for gasoline, in order for it to meet EPA specs, this would have to happen on a very frequent basis, i.e., the government would have to go into the business of purchasing gasoline and reselling it as quickly as that fuel goes off spec. Now, it is an open debate as to how quickly the fuel goes off spec. It depends on what additive and stabilizers you might put in, something about mixing the gasoline. I am not an expert on this, but I know that it is some time between about 3 and 6 months. So if you are worried that firms could actually use this to manipulate prices, i.e., get the government to be purchasing up gasoline and further creating a shortage, that problem is going to be exacerbated by the short shelf life of reformulated gasoline. The second question is, how do you sell the gasoline? If there is a shortage, do you sell it to the major refiners? Well, if they have an incentive, as was brought out in many of the documents that your staff put together, if they have an incentive to create shortages, what is to say that they have an incentive, then, to purchase the gasoline from the government and supply it through if they benefit from the shortage of the gasoline or from restricting supply? One of the documents said that Marathon-Ashland, for example--correct me if I am wrong--actually had reformulated gasoline. I know there was some debate about this between the executive for Marathon-Ashland and the Subcommittee on Tuesday, but they had supply available during one of the price spikes and they did not release it onto the market because they would make more money, right? So why would they buy gasoline from the government and then release it onto the market? So there is this second factor to take into account. I think what really needs to be done is that we need to encourage the integration between markets by decreasing boutique fuels. We also need to de-bottleneck systems, specifically in relationship to vertical integration. So we need to make sure that independent wholesalers, such as Quality Oil in Michigan, have access to pipelines and to tankage, that those barriers of entry have not been erected through vertical integration, that would enable tight oligopolies to prevent outside entry when there is a large price increase. We need to facilitate arbitrage. The only ones, obviously, from this case study in Michigan that have the incentive to arbitrage are independents, like Quality Oil. So it is not clear to me how the government reserve would actually facilitate that or not. Second, you have this problem that the gasoline goes off spec at a fairly rapid rate. Senator Levin. Thank you. Ms. Hastings. Thank you. Senator Levin. Did you have a comment on my question, Dr. McAfee? Mr. McAfee. I did. I have two comments. One is the purpose of the Strategic Oil Reserve itself is, I think, subject to a lot of confusion. If the purpose is military, then we probably should not be buying Brent because for preparedness for a war, if we have actually run out of imported oil or imported oil is being blocked, as Dr. Verleger said, we have excess refinery capacity and we can probably crack heavier oils. So we should, in fact, be using the cheapest oil we can put in there. If, instead, the purpose is economic, that is, we are going to try to stabilize world oil prices, for one thing, I think we need a much larger team of people figuring out, trying to out think the commodities market than we are, in fact, employing. In fact, my impression is we are employing none. The ability of government analysts to beat the commodities market at their game strikes me as unlikely. But that would actually dictate a very different thinking than is currently being used about the Strategic Oil Reserve. The second point I wanted to make was the ability to manipulate world oil prices is limited by the fact that there is a pretty large pool of oil out there and there is pretty inexpensive transportation. Now, transportation across the Pacific runs 75 cents per barrel, maybe $1 per barrel. Transportation from the Middle East to California runs about $1.50 a barrel at tops. So your ability to manipulate oil prices is relatively limited. A barrel has 42 gallons, and so even at the extreme of Middle East to California, we are looking at on the order of 2.5 cents per gallon, which is roughly one-for-one for gasoline. So while this could be important and something that should be studied, it is not an explanation for high gasoline prices. Senator Levin. Thank you. Mr. Ashton. Mr. Ashton. Senator, I have two comments which have, I think, a common theme. First, with regard to the Strategic Petroleum Reserve, unfortunately or fortunately, a lot of the decisions that are made that come out of SPRO are politically motivated or politically driven as opposed to economically driven, and I have seen that over a number of years, and to the extent to which perhaps purchasing a light sweet crude like Brent is being done in a market which we know has been manipulated in the past, it is probably not a very good decision but may, in fact, be driven by something other than economic motives. The other part of your question, which I thought you were also getting at, which is also where the political motivation comes in, is this whole idea of trying to foster and encourage large buyers to buy forward, such as State and local governments and those types of entities. I have had some experience trying to convince those types of entities to do exactly that, and I will tell you that because of their incredible risk averseness, which is in part driven, I think, by their short-term political position, they are not likely to do that type of activity or engage in that activity, although it might well make some sense. Senator Levin. I see that a roll call has begun in the Senate, so I am just going to be able to ask a few additional questions, but I do want to get to the role of regulation and boutique fuels in terms of whether they are one of the major causes of price spikes. A couple of you have commented about the importance of trying to reduce the amount of regulation, the number of different fuels that are required, but my question relates to the role of boutique fuels in the price spike, the large, sudden increases in prices. Mr. Ashton, in your testimony, you said that none of the factors which some people sometimes point to, which is the fluctuation in crude prices or inventories, provide a rationale for these price spikes. Mr. Ashton. That is correct, Senator, yes. Senator Levin. What about the role of boutique fuels? Mr. Ashton. The role of boutique fuels, again, unfortunately, the type of data that we would like to look at with regard to inventories simply does not exist to be able to extract out for each individual type of fuel exactly what was going on in the period prior to and during the price spikes. But looking just more generally at, for example, RFG inventories, in the price spike in the spring of 2000, for example, the RFG inventory hit its bottom actually in late April, before the price spike even started, and started to build again. Now, to the extent to which boutique fuels and specific types of formulas or specifications are required in specific areas, such as Chicago or elsewhere, that does cause some market dislocation and does, to some extent, exacerbate the problem in terms of creating sort of mini-markets that cannot be served by all producers. There is no question about that. But you have to remember that the price spike that we observed generally, although it was different in different areas, certainly transcended throughout most of the Midwest during this period of time. So it is being driven, certainly, by factors other than just boutique fuels. Senator Levin. Does anyone want to comment further on that? Yes, Dr. McAfee? Mr. McAfee. Where the prices were highest was Chicago and Milwaukee, which shared a unique blend of ethanol-based RFG-2, and those are the only places that we are using that fuel. So the effect of the break in the Explorer Pipeline, which affected the entire Upper Midwest, was that it would hit hardest in the places that had the unique fuels because they could not, in essence, share with St. Louis and other places. Senator Levin. Yes? Mr. Verleger. I think it should be added that one of the problems that Wisconsin and Chicago had was that the EPA rules prohibited commingling of RFG-2 that has MTBE in it with RFG with the ethanol in the tanks, and so there was just a--the product was around the corner, but it could not be used. Senator Levin. When you say the worst price spikes occurred in those areas, however, price spikes occurred in other areas, as well, but not just to the same degree. Would you agree with that? Mr. McAfee. Yes, absolutely. Senator Levin. OK. Just on inventory issues, this has been referenced by a number of you, about the effects of inventory changes in the market on these price spike situations that really triggered this investigation. A number of our witnesses have talked about the importance of trying to have greater inventories, that would help in terms of prices. I am wondering whether or not you believe that increased gasoline storage in these areas of high concentration, at least, would lessen the severity and the occasion of the price spikes. Would greater storage have that effect, Mr. Ashland? Mr. Ashton. Yes, Senator. I would certainly believe that greater storage, investment in that type of infrastructure, pipelines as well as storage capacity, would certainly help. Senator Levin. OK. Do you have a comment on that? I think you perhaps have already, but let me call on you anyway, Dr. Hastings. Ms. Hastings. Sure. I have two comments. Greater storage would alleviate price spikes, but as I pointed out, it is not clear that if there is gasoline, it would actually be released onto the market during a price spike. And second, I also think that--I forget what I was going to say second, so---- Senator Levin. OK. We will come back to you. Dr. McAfee. Mr. McAfee. Let me emphasize that it is greater total storage that reduces volatility and agree with a comment made earlier that government's own storage will tend to crowd out private storage, and so that you may not get much, if any, net benefit. Ms. Hastings. That was my second point. Thanks. [Laughter.] Senator Levin. Thank you. Dr. Verleger. Mr. Verleger. I have made a career, and many economists have in the agricultural economic business, inventories are the whole story. If inventory levels are higher, the prices will be lower and you do not get the price spikes. The question is, how do you get the inventory to be higher? Senator Levin. And I take it that you would not be particularly supportive of mandates, but you would be supportive of either incentives or perhaps advance purchases as the way to do that, is that an accurate summation? Mr. Verleger. I have made a career of testifying before the Senate on Strategic Petroleum Reserves when that was an issue 10 years ago. Mandates do not work. One way or another, what will happen is if you mandate it, we have seen the majors leave. They will sell more refining capacity and we will be left with more firms that do not have the capital and they will come and they will ask for exemptions and the system will just become more volatile. I think that is not the solution. Senator Levin. But additional storage is a solution? Mr. Verleger. That is---- Senator Levin. You agree with that, it is just how you get there. Dr. McAfee, do you have any comment about the importance of additional--you have already commented on the importance of additional storage--as to how you get there? Would it be worth doing even if you had to have some kind of a mandate coming out of the Department of Energy? Mr. McAfee. I think mandates are hard to make workable. It is too easy to have storage that does not actually have any practical use but satisfies the requirements, or lobby for exemptions, so that mandates are generally not such a great idea because they are hard to enforce. Plus, you create this problem that Dr. Hastings referred to of you store it and it goes bad, and then you cannot actually sell it, and then what do you do with it? It is just sitting there being a fire hazard. So how do you get there? Well, there are things like tax incentives. The thing that I would most emphasize is where the ``not in my backyard'' mentality is preventing the building of new facilities, those companies would like to but they are just being blocked, the permits are too great, any ease of that regulation may facilitate storage increases. The more concentrated is the market, the less effective that is going to be. Senator Levin. Thank you. Did you want to comment on how we get to the increased storage capacity any further, Dr. Hastings? Ms. Hastings. No. Senator Levin. Thank you so much. Mr. Ashton, we are going to wind up with you. If we needed mandates to get there, is it worth considering? Mr. Ashton. I think it is worth considering, although I think the crowding out effect is potentially a problem. I think you also have to evaluate sort of the trade-off of the costs and benefits of doing that versus potentially other measures that might increase supply or increase inventories. Senator Levin. You heard the five buzzers go off, which means you are going to see me run a little faster than usual, so we will end right there, but let me just summarize as follows. This testimony today has been very helpful in a lot of ways, and I want to thank this panel, as I have our earlier panels, for your coming today to join us and to share with us your experiences, your testimony, your studies, and to help us take a look at some possible solutions, particularly in areas of high concentration because that is what we are really focusing on, where there are very few companies that have a large market share in a particular area. One of the possible solutions or options would be to have a moratorium on mergers, or at least a presumption against mergers in those areas of high concentration. We have heard pros and cons about that. We have heard about the possibility of beefing up the FTC staff in order to have a better understanding of the effects of the mergers. We have not really had a good FTC study about the impacts of previous mergers. We have had some suggestions about modifying antitrust laws to allow anti-competitive cases to get to a jury based on less evidence than is currently required, in other words, less than explicit evidence of agreement, cooperation, or collusion, but something more circumstantial than that in areas in highly concentrated markets. While I surely believe in the presumption of innocence and could never change that, as an American who believes in the Constitution, I do believe, also, that there are presumptions that are used all the time in court. That does not lead to criminal convictions, but they do apply in civil cases. It will at least allow you to change a burden of proof or to get to a jury based on evidence, but it does not require a particular conclusion. We also talked about inventory, increasing inventories as something which is important and how that might be achieved. We need to have greater access to important industry data in order to understand what is going on in industry. The reference to eliminating logistical bottlenecks was referred to both by Attorney General Granholm and by a number of other witnesses, including two of you, I believe, on this panel, so that we can move supplies more readily from market to market. We do have a serious concentration problem in the oil industry in many States and it clearly is hurting consumers where it exists. Competition will lower prices. We know that, and we should take appropriate steps, and I emphasize the word ``appropriate,'' but I also emphasize the word ``take,'' to reinvigorate competition in highly concentrated areas. More aggressive antitrust enforcement, I believe, is part of that, but a number of the other solutions, I believe should also be considered. We would welcome additional comments from this panel or others as we develop a response to what we learned in this investigation, and let me conclude just by saying this. There is not agreement among all of you as to each of the issues that we discussed, but there was common agreement on something which is very clear to me, which is that this staff report is extraordinary, and each of you were kind enough to point that out. I want to just simply conclude by saying I have been around here a long time and I have seen a lot of staff reports. I have never seen one that was taking on a more complex issue and doing a better job of dealing with it than this staff report of mine is and I am very proud of them. I thank them. I think the Nation is better off because we have this kind of an effort to look at facts, see what might be appropriate to deal with those facts, and if that happens as a result of this report, we will all be better off, and I am going to do everything that I can to make sure that it does, indeed, happen that way. Thank you again for coming, and we stand adjourned. [Whereupon, at 12:34 p.m., the Subcommittee was adjourned.] A P P E N D I X ---------- OPENING PREPARED STATEMENT OF SENATOR BUNNING May 2, 2002 Thank you, Mr. Chairman. This is the second hearing this Subcommittee has held on gas pricing, and I appreciate the time our witnesses have taken today to testify. I think that we can all agree that pricing gas is a complex undertaking. It is not only affected by the price of crude oil on the world market, but by a careful balance between supply and demand, the amount of gas we have stockpiled, and our ability to transport the fuel to certain areas of the country. Every American notices when gas prices spike, and it always seems that prices never fall as fast as they rise. Like all companies, the gas industry has a responsibility to consumers, and any acts of gouging or collusion should be investigated thoroughly. The solutions to fixing this problem are not easy, and I think that the last thing anyone would want is for the Federal Government to get into the game of pricing gas. However, every summer it seems that consumers end up paying more at the pump as prices fluctuate widely. I hope the gasoline industry can take steps to help alleviate some of the causes to this problem. Also, if we are serious about helping stabilize prices, State, local and Federal leaders have to recognize that the sheer number of special formulated fuels on the market can isolate communities or even whole States for that matter. We also need to make sure that our regulations and red tape for getting infrastructure built--like a new pipeline or some new storage tanks--doesn't discourage companies from making these types of investments. Thank you. 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