Background

In 2004, the United States consumed about 20.5 million barrels per day of  crude oil accounting for roughly 25 percent of world oil production. A  great deal of the crude oil consumed in this country goes into production  of gasoline and, as a nation, we use about 45 percent of all gasoline  produced in the world. California alone presently consumes almost 44  million gallons of gasoline per day. To put this in perspective, in 1997 (the  last year for which we found available data for international comparisons),  only the rest of the United States and Japan consumed more gasoline than  California.
Products made from crude oil—petroleum products, including gasoline— have been instrumental in the development of our modern lifestyle. In  particular, gasoline, diesel, and jet fuel have provided the nation with  affordable fuel for automobiles, trucks, airplanes and other forms of  public and goods transportation. Together, these fuels account for over 98  percent of the U.S. transportation sector’s fuel consumption. In addition,  petroleum products are used as raw materials in manufacturing and  industry; for heating homes and businesses; and, in small amounts, for  generating electric power. Gasoline use alone constitutes about 44 percent  of our consumption of petroleum products in the United States, so when  gasoline prices rise, as they have in recent months, the effects are felt  throughout the country, increasing the costs of producing and delivering  basic retail goods and making it more expensive to commute to work. It is  often the case that prices of other petroleum products also increase at the  same time and for the same reasons that gasoline prices rise. For example,  today’s high gasoline prices are mirrored by high jet fuel prices, which  have put pressure on airline companies, some of which are currently in the  midst of financial difficulties.
Gasoline prices vary a great deal over time. For example, in the 10-year  period April 1995 through April 2005, the national average price for a  gallon of regular grade gasoline has been as low as $0.89 and as high as  $2.25 without adjusting for inflation. In addition, gasoline prices vary by  location and, in recent years, California has consistently had among the  highest prices in the nation.
The future path of gasoline prices is difficult to predict, but it is clear that  the use of petroleum products worldwide is going to increase for the near  term and maybe beyond. Some analysts have predicted much higher crude  oil prices—and as a result, higher prices of petroleum products—while  others expect prices to moderate as producers respond to high prices by  producing more crude oil and consumers respond by conserving more,  and investing in more energy-efficient cars and other products. In either  case, the price of gasoline will continue to be an important part of the  household budgets of Americans for the foreseeable future and therefore,  it is important to understand how prices are determined so that consumers  can make wise choices.

	Gasoline Prices Are Determined by the Price of Crude Oil and a Number of Other Factors

Crude oil prices feed directly into the price of gasoline, because crude oil  is the primary raw material from which gasoline is produced. For example,  according to our analysis of EIA data, crude oil accounted for about 48  percent of the price of a gallon of gasoline on average in 2004 in the United  States. When crude oil prices rise, as they have in recent months, refiners  find their cost of producing gasoline also rises, and in general, these higher  costs are passed on to consumers in the form of higher gasoline prices at  the pump. Figure 2 illustrates the importance of crude oil in the price of  gasoline. The figure also shows that taxes, refining, and distribution and  marketing also play important roles.
Because of the prominent role of crude oil as a raw material of gasoline  production, in order to understand what determines gasoline prices it is  necessary to examine how crude oil prices are set. Overall, the price of  crude oil is determined by the balance between world demand and supply.  A major cause of rising crude oil prices in recent months has been rapid  growth in world demand, without a similar growth in available supplies. In  particular, the economy of China has grown rapidly in recent years,  leading to increases in their demand for crude oil. In contrast, oil  production capacity has grown more slowly, leading to a reduction in the  surplus capacity—the amount of crude oil that is left in the ground, but  could be extracted on short notice in the event of a supply shortfall. EIA  has stated that the world’s surplus crude oil production capacity has fallen  to about one million barrels per day, or just over one percent of the  world’s current daily consumption, making the balance between world  demand and supply of crude oil very tight. This tight balance between  world crude oil demand and supply means that any significant supply  disruptions will likely cause prices to rise. For example, a workers’ strike  in Nigeria’s oil sector in October 2004 forced world crude oil prices to  record highs (Nigeria is the world’s seventh largest oil producer, supplying  an average 2.5 million barrels per day in 2004).
Another important factor affecting crude oil prices is the behavior of the  Organization of Petroleum Exporting Countries (OPEC)—members of  which include Algeria, Indonesia, Iran, Iraq, Kuwait, Libya, Nigeria, Qatar,  Saudi Arabia, United Arab Emirates, and Venezuela. OPEC members  produce almost 40 percent of the world’s crude oil and control almost 70  percent of the world’s proven oil reserves. In the recent past and on  numerous other occasions, OPEC members have collectively agreed to  restrict production of crude oil in order to increase world prices for that  commodity.
In addition to the cost of crude oil, gasoline prices are influenced by a  variety of other factors, including refining capacity constraints, low  inventories, unexpected refinery or pipeline outages, environmental and  other regulations, and mergers and market power in the oil industry.
First, domestic refining capacity, has not kept pace with growing demand  for gasoline. As demand has grown faster than domestic refining capacity,  the United States has imported larger and larger volumes of gasoline and  other petroleum products from refiners in Europe, Canada, and other  countries. EIA officials told us that, in general, this increase in imports has  reflected the availability of gasoline from foreign sources at lower cost  than building and operating additional refining capacity in the United  States would entail. However, the American Petroleum Institute (API) has  recently reported that capacity utilization has been high in the U.S.  refinery sector. Capacity has typically averaged over 90 percent, and has  recently increased to 92 percent—much higher than the rate in many other  industries, which API reports are more typically operating at around 80  percent of capacity. As a result, domestic refineries have little room to  expand production in the event of a temporary supply shortfall. Further,  the fact that imported gasoline comes from farther away than domestically  produced gasoline means that when supply disruptions occur in the  United States, it might take longer to get replacement gasoline than if we  had excess refining capacity in the United States, and this could cause  gasoline prices to rise and stay high until these new supplies can reach the  market.
Gasoline prices may also be affected by unexpected refinery outages or  accidents that significantly disrupt the delivery of gasoline supply. For  example, in a recent report, we found that unexpected refinery outages  had been a factor in a number of prices spikes in California in the 1990s.  More recently, the tragic explosion and subsequent fire at a BP refinery in  Houston, that killed 15 people, temporarily shut down about 3 percent of  the nation’s refining capacity. While we have not analyzed the potential  impact on gasoline prices of this specific event, similar events in the past  have caused temporary increases in prices until alternative sources of  supply can be brought to market. Pipeline disruptions can have a similar  effect, as was seen when Arizona’s Kinder Morgan pipeline broke in July  2003 and average gasoline prices jumped 56 cents in a month in Arizona. In  addition, tanker spills, and other similar events can all have an impact on  gasoline prices at various points in time because they cause interruption in  the supply of crude oil or petroleum products, such as gasoline.
The level of gasoline inventories can also play an important role in  determining gasoline prices over time because inventories represent the  most accessible and available source of supply in the event of a  production shortfall or increase in demand. Similar to trends in other  industries, the level of inventories of gasoline has been falling for a  number of years. In part, this reflects a trend in business to more closely  balance production with demand in order to reduce the cost of holding  large inventories. However, reduced inventories may contribute to  increased price volatility, because when unexpected supply disruptions or  increases in demand occur, there are lower stocks of readily available  gasoline to draw from. This puts upward pressure on gasoline prices until  new supplies can be refined and delivered domestically, or imported from  abroad.
Regulatory steps to reduce air pollution have also influenced gasoline  markets and consequently have influenced gasoline prices. For example,  since the 1990 amendments to the Clean Air Act, the use of various blends  of cleaner-burning gasoline—so-called “boutique fuels—has grown. A  number of reports by government agencies, academics, and private  entities have concluded that the proliferation of these special gasoline  blends has put stress on the gasoline supply infrastructure and may have  led to increased price volatility because areas that use special blends  cannot as easily find suitable replacement gasoline in the event of a local  supply disruption. However, these special gasoline blends provide  environmental and health benefits because they reduce emissions of a  number of pollutants. GAO is currently working on a report on special  gasoline blends that will look at these issues and discuss the effects of  these special blends on emissions and on the supply system.
Finally, we recently reported that industry mergers increased market  concentration and in some cases caused higher wholesale gasoline prices  in the United States from the mid-1990s through 2000. Overall, the report  found that the mergers led to price increases averaging about 2 cents per  gallon on average. For conventional gasoline, the predominant type used  in the country, the change in the wholesale price, due to specific mergers,  ranged from a decrease of about 1 cent per gallon—due to efficiency gains  associated with the merger—to an increase of about 5 cents per gallon— attributed to increased market power after the merger. For special blends  of gasoline, wholesale prices increased by from between 1 and 7 cents per  gallon, depending on location.

	California’s Unique Gasoline and Isolation from Other Markets Contribute to its Higher Gasoline Prices

California, and the West Coast states more generally, have consistently  had among the highest gasoline prices in the nation. For example,  California’s gasoline prices averaged about 21 cents more per gallon than  national gasoline prices over the last ten years. In addition, California has  at times had more volatile gasoline prices than the rest of the country. For  example, in an earlier report on California gasoline prices, we noted that,  while gasoline prices did not spike more frequently than in the rest of the  United States, California’s gasoline price spikes were generally higher.
Many of the factors influencing gasoline prices nationwide have had an  even more dramatic effect on California prices. For example, California’s  high gasoline prices have been attributed, in part, to its cleaner burning  gasoline. In response to air quality problems and in order to meet air  quality standards resulting from the Clean Air Act and amendments,  California adopted a unique blend of gasoline in 1996 that increased  refining costs and likely caused prices of gasoline in the state to rise.  California’s blend of gasoline is unique in the United States and, according  to EPA models, is the cleanest burning of all the widely used special  gasoline blends in the country. This gasoline blend is also very difficult to  make, and those refineries that chose to make it had to install expensive  new equipment and refining processes in order to meet the specifications  of the gasoline. Some studies have suggested that the current blend of  California gasoline costs between 5 and 15 cents more per gallon to make  than conventional gasoline. It is likely that these costs are passed on, at  least in part, to consumers.
In addition, in recent years, California has developed a tight balance  between supply and demand, which has at times led to sharper or longer  price spikes when supply disruptions have occurred. Expansion of the  gasoline supply infrastructure has not kept pace with growing demand,  and as a result, the California refinery system has run at near capacity. For  example, according to EIA testimony before the Congress, demand for  gasoline in California has grown at roughly two to four times production  capacity growth. California Energy Commission staff told us that the tight  supply and demand balance has led to large price movements in response  to even small supply disruptions, caused by refinery outages and other  events.
Moreover, supply disruptions may have a larger impact on California than  on other states. First of all, only a few refineries outside of the state can  produce California’s special blend of gasoline. In addition, there are no  major pipelines connecting the state with other major refining areas.  Therefore, if supply is disrupted in California, gasoline must be brought in  from the few refineries outside the state that make California’s blend of  gasoline—often from as far away as the Gulf Coast or beyond. And  because of the lack of pipeline access to the state, tankers and other  means must be used, and the process is slow. For example, we recently  reported that gasoline shipped into California by tanker from such places  as the Gulf Coast, the U.S. Virgin Islands, Europe, and Asia, can take  between 11 and 40 days and added 3 to 12 cents per gallon to the retail  price.
Another factor contributing to the prices Californians pay at the gasoline  pump is that residents of California pay comparatively higher gasoline  taxes than residents in many other states. For example, at about 57 cents  per gallon on average, California’s total gasoline tax rate is among the  highest, behind only New York and Hawaii, and is 30 percent higher than  the national average of 44 cents per gallon, according to a November 2004  survey by the American Petroleum Institute.
In our recent report on oil industry mergers discussed earlier in this  testimony, we found that the highest price impact of mergers—over 7  cents per gallon of gasoline—was in California. In addition, the California  Attorney General recently reported that California’s gasoline industry is  more concentrated than that of the rest of the United States, with  California’s six largest refiners controlling more than 90 percent of  refining capacity. The California Attorney General noted further, that these  six refiners in California control a majority of the terminal facilities and 85  percent of the retail locations in the state. To the extent that these factors  lead to greater market power on the part of refiners or gasoline marketers,  prices may be higher as a result. However, we have not analyzed this  directly.

	Future Oil and Gasoline Prices Will Reflect Supply/Demand Balance, but Technological Change and Conservation Will Also Play a Role

Looking into the future, daunting challenges lie ahead in finding,  developing, and providing sufficient quantities of oil to meet projected  global demand. For example, according to EIA, world oil demand is  expected to grow to nearly 103 million barrels per day in 2025 under low  growth assumptions, and may reach as high as 142 million barrels per day  in 2025 —increases of between 25 and 71 percent, from the 2004  consumption level of 83 million barrels per day. For the United States  alone, EIA estimates that oil consumption will increase by between 1.2 and  1.9 percent annually through 2025 depending on assumptions about  economic growth and other factors. Looking further ahead, the rapid pace  of economic growth in China and India, two of the world’s most populous  and fastest growing countries, may lead to a similarly rapid increase in  their demand for crude oil and petroleum products. While these countries  currently consume only a small fraction of world crude oil, the pace of  their demand growth could have far reaching implications if recent trends  continue. For example, consumption of oil by China and India is currently  far below that of the United States, but is projected to grow at a more  rapid rate. EIA’s medium-growth projections estimate that oil  consumption for China and India will each grow by about 4 percent  annually through 2025, while consumption in the U.S. is projected to grow  at an annual rate of 1.5 percent over the same period.
To meet the rising demand for gasoline and other petroleum products,  new oil deposits will likely be developed and new production facilities  built. Currently, many of the world’s known and easily accessible crude oil  deposits have already been developed, and many of these are experiencing  declining volumes as fields become depleted. For example, the existing oil  fields in California and Alaska have long since reached their peak  production, necessitating an increasing volume of imported crude oil to  West Coast refineries. Developing new oil deposits may be more costly  than in the past, which could put upward pressure on crude oil prices and  the prices of petroleum products derived from it. For example, some large  potential new sources, such as oil shales, tar sands, and deep-water oil  wells, require different and more costly extraction methods than are  typically needed to extract oil from existing fields. In addition, the  remaining oil in the ground may be heavier and more difficult to refine,  necessitating investment in additional refinery processes to make gasoline  and other petroleum products out of this oil. If developing, extracting, and  refining new sources of crude oil are more costly than extracting and  refining oil from existing fields, crude oil and petroleum product prices  will rise to make these activities economically feasible.
On the other hand, technological advances in oil exploration, extraction,  and refining could mitigate future price increases. In the past, advances in  seismic technology significantly improved the ability of oil exploration  companies to map oil deposits, which enabled them to ultimately extract  the oil more efficiently, thereby getting more out of a given oil field. In  addition, improvements in technology have enabled oil companies to drill  in multiple directions from a single platform, and also to pin-point specific  oil deposits more accurately, which has led to increases in the supply of  crude oil. Further, refining advances over the years have also enabled U.S.  refiners to increase the yield of gasoline from a given barrel of oil—while  the total volume of petroleum products has remained relatively constant,  refiners have been able to get more of the more valuable components,  such as gasoline, out of each barrel, thereby increasing the supply of these  components. Further technological improvements that lower costs or  increase supply of crude oil or refined products would likely lead to lower  prices for these commodities.
Similarly, innovations that reduce the costs of alternative sources of  energy could also reduce the demand for crude oil and petroleum  products, and thereby ease price pressures. For example, hydrogen is the  simplest element and most plentiful gas in the universe and its use in fuel  cells produces almost no pollution. In addition, hydrogen fuel cell cars are  expected to be roughly three times more fuel-efficient than cars powered  by typical internal combustion engines. Currently, enormous technical  problems stand in the way of converting America’s fleet of automobiles  from gasoline to hydrogen, including how to produce, store, and distribute  the flammable gas safely and efficiently, and how to build hydrogen cars  that people can afford and will want to buy. However, there are federal  and state initiatives under way as well as many private efforts to solve  these technical problems, and if they can be solved in an economical way  in the future, the implications for gasoline use could be profound.
Greater conservation or improved fuel efficiency could also reduce future  demand for crude oil and petroleum products, thereby leading to lower  prices. The amount of oil and petroleum products we will consume in the  future is, ultimately, a matter of choice. Reducing our consumption of  gasoline by driving smaller, more fuel-efficient cars—as occurred in the  1980s in response to high gasoline prices—would reduce future demand  for gasoline and put downward pressure on prices. For example, the  National Academies of Science recently reported that if fuel-efficiency  standards for cars and light trucks had been raised by an additional 15  percent in 2000, consumption of gasoline in the year 2015 would be 10  billion gallons lower than it is expected to be under current standards. The  Congress established fuel economy standards for passenger cars and light  trucks in 1975 with the passage of the Energy Policy and Conservation Act.  While these standards have led to increased fuel efficiency for cars and  light trucks, in recent years, the switch to light trucks has eroded gains in  the overall fuel efficiency of the passenger fleet. Future reductions in  demand for gasoline could be achieved if either by fuel efficiency  standards for cars and light trucks are increased, or consumers switch to  driving smaller or more fuel-efficient cars.
The effect of future environmental regulations and international initiatives  on oil and petroleum products prices is uncertain. On one hand,  regulations that increase the cost or otherwise limit the building of  refining and storage capacity may put pressure on prices in some  localities. For example, the California Energy Commission told us the lack  of storage capacity for imported crude oil and petroleum products may be  a severe problem in the future, potentially leading to supply disruptions  and price volatility. Alternatively, international efforts to reduce the  generation of green house gas emissions could cause reductions in the  demand for crude oil and petroleum products through the development  and use of more fuel-efficient processes and as cleaner, lower-emissions  fuels are developed and used.
Moreover, geopolitical factors will likely continue to have an impact on  crude oil and petroleum product prices in the future. Because crude oil is  a global commodity, the price we pay for it can be affected by any events  that affect world demand or supply. For example, Venezuela—which  produces around 2.6 million barrels of crude oil per day, and which  supplies about 12 percent of total U.S. imports for oil—is currently  experiencing considerable social, economic, and political difficulties that  have, in the past, impacted oil production. In April 2002, the oil flow from  Venezuela was stemmed during 3 consecutive days of general strikes,  affecting oil production, refining, and exports. Finally, instability in the  Middle East, and particularly the Persian Gulf, has in the past, caused  major disruptions in oil supplies, such as occurred toward the end of the  first Gulf War, when Kuwaiti oil wells were destroyed by Iraq.
Finally, the value of the U.S. dollar on open currency markets could also  affect crude oil prices in the future. For example, because crude oil is  typically denominated in U.S. dollars, the payments that oil-producing  countries receive for their oil are also denominated in U.S. dollars. As a  result, a weak U.S. dollar decreases the value of the oil sold at a given  price. Some analysts have recently reported in the popular press that this  devaluation can influence long-term prices in two ways. First, oil- producing countries may wish to increase prices for their crude oil in  order to maintain their purchasing power in the face of a weakening  dollar. Secondly, because the dollars that these countries have  accumulated, and that they use, in part, to finance additional oil  exploration and extraction, are worth less, the costs these countries pay to  purchase technology and equipment from other countries whose  currencies have gained relative to the dollar will increase. These higher  costs may deter further expansion of oil production, leading to even higher  oil prices.

	Conclusions

In closing, clearly none of the options for meeting the nation’s energy  needs are without tradeoffs. Current U.S. energy supplies remain highly  dependent on fossil energy sources that are costly, imported, potentially  harmful to the environment, or some combination of these three, while  many renewable energy options are currently more costly than traditional  options. Striking a balance between efforts to boost supplies from  alternative energy sources and policies and technologies focused on  improved efficiency of petroleum burning vehicles or on overall energy  conservation present challenges as well as opportunities. How we choose  to meet the challenges and seize the opportunities will help determine our  quality of life and economic prosperity in the future.
What is true for the nation as a whole is even more dramatically so in  California. California is one of the most populous and steadily growing  states in the nation, and its need for gasoline, as well as other energy  sources, will grow. However, California’s unique problems with respect to  developing the right amount and type of infrastructure necessary to ensure  a sufficient supply of gasoline, other petroleum products, or alternative  fuels must be resolved or viable alternatives developed if California is to  continue to enjoy the prosperity and high quality of life it is known for.
We are currently studying the gasoline prices in particular, and the  petroleum industry more generally, including a primer on gasoline prices,  a forthcoming report on special gasoline blends, an analysis of the viability  of the Strategic Petroleum Reserve, an evaluation of world oil reserves,  and an assessment of U.S. contingency plans should oil imports from a  major oil producing country, such as Venezuela, be disrupted. With this  body of work, we will continue to provide Congress and the American  people the information needed to make informed decisions on energy that  will have far-reaching effects on our economy and our way of life.
Mr. Chairman, this completes my prepared statement. I would be happy to  respond to any questions you or the other Members of the Subcommittee  may have at this time.

	GAO Contacts and Staff Acknowledgments

For further information about this testimony, please contact me at (202)  512-3841 (or at wellsj@gao.gov ). Godwin Agbara, Nancy Crothers, Randy  Jones, Mary Denigan-Macauley, Samantha Gross, Mark Metcalfe, Michelle  Munn, Melissa Arzaga Roye, and Frank Rusco made key contributions to  this testimony.

Appendix: Selected Charts and Figures

U.S. Retail Price of Gasoline (Not adjusted for inflation)
U.S. Gasoline Consumption (1970-2004)
Refining Capacity and Number of Refineries (1970-2004)
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Summary:
Why GAO Did This Study

Gasoline prices have increased dramatically in recent weeks and currently, California has the highest gasoline prices in the nation. Consequently, consumers are expected to spend significantly more on gasoline this year than last. Specifically, EIA recently projected that, because of higher expected gasoline prices, the average American household will spend about $350 more on gasoline in 2005 than they did in 2004. Understandably, the public and the press have focused on these higher gasoline prices and some have questioned why this is happening. Moreover, people are concerned about the future, with some analysts projecting prices of crude oil--the primary raw material from which gasoline is produced--to remain at current high levels or even increase. Other analysts expect prices to fall as new oil supplies are developed and as consumers adjust to the current high prices and adopt more energy-efficient practices. This testimony, as requested, address factors that help explain today's high gasoline prices in the nation as a whole and specifically in California. In addition, potential trends that may impact future prices of crude oil and gasoline are addressed.

What GAO Found

Crude oil prices and gasoline prices are linked, because gasoline is derived from the refining of crude oil. As a result, crude oil prices and gasoline prices generally follow a similar, albeit not identical, pattern over time. For example, from January 2004 to the present (April 25, 2005), the price of West Texas Intermediate crude oil rose by almost $20 per barrel, an increase of almost 60 percent, while over the same period, average gasoline prices rose nationally from $1.49 to $2.20 per gallon, an increase of 48 percent. Explanations for this large increase in crude oil and gasoline prices include rapid growth of world demand for crude oil and petroleum products, instability in the Persian Gulf region, and actions by the Organization of Petroleum Exporting Countries (OPEC) to restrict the production of crude oil and thereby increase its price on the world market. In addition to the cost of crude oil, gasoline prices are influenced by a variety of other factors, including refining capacity constraints, low inventories, unexpected refinery or pipeline outages, environmental and other regulations, and mergers and market power in the oil industry. Gasoline prices in California, and in other West Coast states, have consistently been among the highest in the nation and recent experience is no different. For the last week in April, the price of regular grade gasoline in California was $2.63 per gallon, about 43 cents above the national average. Explanations for California's higher than average gasoline prices include (1) California's unique gasoline blend, which is cleaner burning and more expensive to produce than any of the other commonly used gasoline blends; (2) a tight balance between supply and demand in the West Coast, and the long distance to any viable sources of replacement gasoline in the event of local supply disruptions; and (3) California's higher level of gasoline taxes--California currently taxes a gallon of gasoline at 30 cents per gallon more than the state with the lowest taxes, Alaska. Some sources have also attributed high gasoline prices, in part, to the fact that California's refining sector is more concentrated in the hands of fewer companies than in other refining areas, such as the Gulf Coast. Future gasoline prices will, in large part, be determined by the supply and demand for crude oil and its price on the world market. World crude oil demand is projected to rise, so new sources will have to be developed or prices will rise. Technological innovations that reduce the cost of finding or extracting crude oil could reduce prices, other things remaining constant. Greater conservation, or improvements in energy efficient technologies could also mitigate rising demand and reduce upward pressure on prices. In addition, alternative fuel sources may become more economical, thereby supplanting some of the demand for crude oil and gasoline in the future. America faces daunting challenges in meeting future energy demands, and policy makers must choose wisely to ensure that the country can meet these demands, while balancing environmental and quality of life concerns.