Gasoline prices have been extremely volatile for nearly two years, with three significant pricespikes focusing the attention of consumers and policy makers on the gas pump. With 2004 nationalaverage gasoline prices setting a record of $2.05 per gallon (/gal) in mid-May -- breaking the oldsummer 2003 record of $1.74/gal -- gasoline market developments have been viewed with concern,even with a year-end decline to $1.80/gal. Crude oil prices also rose sharply during 2004, brieflyexceeding $55 per barrel on the spot market. Despite a pullback, crude prices for 2004 remainedabove levels last seen when Kuwait was invaded during the 1990-1991 Gulf Crisis. By mid-May, the crude oil price increase to almost $42 per barrel accounted for as much as20 cents per gallon of a total increase at the pump of 43 cents since the end of 2003. Simply stated,pump prices are essentially determined by the supply of and demand for gasoline, although the costof crude figures into the equation. Other supply-side factors leading to high prices relate to the abilityof domestic refineries to meet growing gasoline demand. With no new domestic refinery built fora quarter century, the nation relies on imports for roughly 11% -- 1 million barrels per day (mbd) --of its 9 mbd gasoline needs. As U.S. gasoline specifications to meet clean air standards becometougher for all refiners to meet, the supply of foreign fuel available to U.S. importers is not alwaysimmediately available. In addition to meeting U.S. specifications, foreign supply difficulties includelong in-transit time, and the cost and availability of vessels suitable for refined product transporthave become tight. These factors have contributed to gasoline prices exceeding the observed increasein crude oil cost during much of 2004. As a consequence, while the increase in crude prices standsout, increased gasoline prices have a greater profile, drawing attention to the nation's energysituation. According to the American Automobile Association (AAA) daily survey of retail gasolineprices around the country, gasoline prices at the pump nationwide have exceeded previous records.Since the start of 2003, prices at the gas pump have fluctuated by as much as 55 cents per gallon, andreached peaks above $1.70 three times. Figure 1 shows pump prices for the United States as a wholeand California, where both price levels and peaks exceed the national averages -- a result of variouslocal conditions. California pump prices peaked in October at $2.45 for regular. Figure 1. Daily Prices per Gallon for California and Nationwide Retail Gasolineand for Crude Oil, Jan. 2003 - Dec. 2004 Sources: Retail gasoline prices: Oil Price Information Service, Daily Fuel Gauge Report online,sponsored by the American Automobile Association, http://www.fuelgaugereport.com . Spot oil prices: EIA, Weekly Petroleum Status Report , Table 14. http://www.eia.doe.gov/oil_gas/petroleum/data_publications/weekly_petroleum_status_report/wpsr.html Also shown on Figure 1 are crude oil prices for the benchmark NYMEX traded crude oil,West Texas Intermediate (WTI, for delivery at Cushing, OK). This is often referred to as the "spotmarket" price; the weighted average cost of different types of crude used by refiners tracks theNYMEX price, although it generally averages less than this benchmark. Gasoline is manufacturedfrom crude oil, and this price series provides a baseline comparison between retail prices, wholesaleprices (excluding tax), and raw material cost. When gasoline prices peaked in May, crude oilaveraged more than $40 per barrel on the NYMEX, the equivalent of 95 cents per gallon, an increaseof about 19 cents from the December 2003 average of $32 per barrel. Crude oil prices fluctuatemarkedly on a daily basis, posing a difficulty in updating the figures cited here. While an oversimplification, every gallon of gasoline requires a gallon of crude added torefinery input. For much of the Figure 1 time frame, crude oil prices track national average pumpprices reasonably closely. But the peaks in gasoline prices -- spring, late summer 2003, and morerecently in May 2004 -- exceeded what could be attributed to increased crude costs. While crude oilprice increases are generally passed through to the gas pump on a penny-for-penny basis, and helpexplain much of the change in gasoline prices, the divergence between gasoline at the pump andcrude points toward changed gross margins in refining and marketing. This is due to the fundamentalsupply and demand situation for gasoline, relating specifically to an imbalance between the two thatis resolved by a change in price. The most recent price spike seen in Figure 1 -- taking place in fall2004 -- appears to coincide with an increase in crude prices. The coincidence here suggests that highgasoline prices seen in September and October 2004 may have been driven by crude cost push, ratherthan demand pull at the pump. Rising gasoline prices often elicit questions about the federal government's ability tointervene in the market and roll back price hikes. It must be kept in mind that gasoline prices are notcurrently regulated, and there is no statutory authority to do so. A period of price controls,accompanied by supply allocation requirements, was in effect from August 15, 1971, until January20, 1981. Those controls were often associated with shortages, resulting in episodes of long lines atgas pumps. In retrospect, it is not clear that the price controls resulted in retail prices that were lowerthan they might otherwise have been. As a result, the concept of government-mandated price controlsduring periods of rapid price increases has seen little support as a policy option since the 1970s. Figure 2 shows U.S. gasoline inventories during the past two years. The gray area highlightsthe normal operating range -- including seasonal fluctuations -- for gasoline stocks. The horizontalline across the bottom of the figure shows the "lower operational inventory," which the Departmentof Energy (DOE) places at 185 million barrels, the equivalent of about 20 days of nominal supply.That is the level at which sporadic physical shortages begin to appear around the nation. The 185million barrel figure can be thought of as the "fill" needed to keep the distribution system in normaloperation; it cannot be drawn upon to meet a demand increment at the pump. When there is virtuallyno extra supply to act as a price cushion, price spikes, spot shortages, and localized "run-outs" area possibility. Figure 2. U.S. Gasoline Inventories, January 2003 to Present Source: EIA, Weekly Petroleum Status Report , Figure 4. The most recent peak gasoline demand -- recorded in mid-summer 2003 -- was a four-weekaverage of about 9.4 mbd: gasoline demand consistently averaged about 9.0 mbd during 2004. Thedifference between stocks -- which have run between 200 and 215 million barrels during 2004 --and DOE's "minimum operating level" is between 15 and 30 million barrels, the equivalent ofroughly two or three days of supply available from refiners' stocks. Gasoline inventories have bounced between the upper and lower ranges of "normal" during2004. They were below the normal range when gasoline prices peaked in May. And, at the end of2004, they were above the normal range for this time of year, a factor likely contributing to theyear-end decline in pump prices. Generally, when crude oil stocks were below the seasonal norm, pump prices rose. Andwhen stocks were above the seasonal norm, prices fell. The ebb and flow of gasoline stocks during2004 -- a period of noteworthy gasoline price volatility -- reflects a balance between gasolineinventories, seasonal driving demand, and the crude available to make more at U.S. refineries as wellas the supply of imports. U.S. refineries cannot currently manufacture all the gasoline called for by the nation'smotorists. (1) About 11%is imported either as finished, ready-to-market gasoline or as blending components that can be mixedinto the gasoline pool. Thus, two sets of gasoline supply figures should be watched; the "productssupplied" series compiled by EIA, and "new gasoline supply," the combination of imports of finishedgasoline, gasoline blending components, and net U.S. refinery production of gasoline. The "productssupplied" data show gasoline flowing to consumers from inventory. "New supply" data show theamount of newly available gasoline -- be it produced or imported -- that may flow into inventoriesor directly to the pump. Figure 3 shows gasoline supplied to U.S. markets since the start of 2003. These data consistof domestic refinery production, (2) imports of finished gasoline that meets U.S. specifications, as wellas a significant amount -- between 300,000 and 500,000 barrels per day -- of blending componentsfrom refineries abroad. Figure 3. Gasoline Production and Imports, Jan. 2002 - Dec. 2004 Source: Finished Imported Gasoline: EIA, Petroleum Supply Monthly , Table 54. BlendComponents: EIA, Weekly Petroleum Status Report , Table 9. U.S. Net Refinery Production:see text of report. These imported blending components lend a complexity to tabulating the data on gasolineproduction. EIA includes the blending components in its series on refinery production, even thoughthey are not produced in U.S. refineries. Blending components are added to gasoline supplies atrefineries and terminals. They appear in the EIA data collected from refiners and terminal operatorsas if they were the same as output from U.S. refineries' manufacturing process, whereas they areactually imported. EIA does this in order to avoid counting the components twice -- as imports andas refinery output. Without these imports of blending components, gasoline supplied by U.S. refinersand terminal operators would be less on a barrel-for-barrel basis. Once they are blended into the poolof U.S. refinery output and meet marketability standards they become part of U.S. gasoline supply,although they are not identified by EIA as imports per se. Imports of gasoline and components peaked at 1.1 mbd -- including 426,000 barrels per dayof components -- in April 2003. Venezuela has historically been a supplier of refined gasoline to theUnited States, but petroleum sector labor unrest has hindered refining operations. U.S. gasolinesupplies from Venezuela have suffered since late 2002, when a two month oil workers strike crippledproduction and refining. Reformulated gasoline (RFG) supplies in particular have suffered, with thefirst post-strike cargo shipped to the United States in June 2003. (3) Subsequently, supplies fromVenezuela -- whose refineries have operated as if they were a part of the U.S. supply system -- havebeen sporadic, as operational and labor problems have limited the output of difficult-to-producegasoline that meets U.S. specifications. (4) U.S. refineries maintained gasoline production of about 8.4 mbd through most of 2003, withtotal output of all products reflecting operating rates of between 92% and 96% of capacity. Butrefiner utilization typically falls in the month of January, as refiners "turn around" production toemphasize gasoline output instead of heating fuels and perform scheduled maintenance. Consistentwith this pattern, capacity utilization in February and March of 2004 ran in the 89% area. April andMay saw utilization rates as high as 96%, a figure which has historically represented maximumpractical operating capability. It is noteworthy that these early-2004 months represented a period ofrising pump prices, a development likely linked to high refinery runs. Total gasoline production and imports made available to commercial inventories and endmarkets (illustrated by the top line in Figure 3) peaked in August 2003 and declined through thewinter. Refinery production and imports increased as the 2004 driving season approached; in earlyMay over 9.1 mbd was made available. Gasoline supplied, including inventory withdrawals, peakedat 9.4 mbd in August 2003, as Figure 4 shows. This is significantly more than levels of 8.6 to 8.7mbd in winter 2003-2004, and allowed inventories to stabilize above 200 million barrels, exceedingminimum levels. Above-minimum gasoline inventory levels and increased gasoline availability maywell be a price stabilizing factor, having contributed to the decline of pump prices from theirall-time highs during the last part of 2004. But to maintain such an inventory expansion, domesticrefiners would need to produce sufficient gasoline, and imports -- which have not been robust --would need to increase for the bulk of the driving season just ahead. For U.S. refiners to run moregasoline, their own supplies of crude must exceed minimum operating levels so that they haveenough crude for expanded operations. Depending on how events unfold, the softening in retailgasoline prices seen during the final weeks of 2004 may be temporary. Figure 4. Gasoline Supplied, Jan. 2003 - Dec. 2004 Source: EIA, Weekly Petroleum Status Report , Table 10. Crude oil in refiner inventories is shown of Figure 5 . Note that crude stocks recently fellbelow the lower observed limit during early winter 2003-2004, but recovered, reflecting lowerrefinery runs during January 2004. For gasoline supplies to maintain levels sufficient to avoidrun-outs and price spikes, crude must be available at refineries. With domestic crude production atits maximum, imported crude oil will be called on to provide the needed incremental supply. In the recent past, crude oil imports peaked in September 2003 at 10.3 mbd, and they fell toa low of 9.3 mbd in early 2004. At the end of 2004, crude imports had peaked again at 10.3 mbd.This supply of imports has permitted crude stocks to rise to about 300 million barrels in early May,a level equivalent to two days of refinery operations above minimum operating levels. Crudeavailability may ultimately become a factor in meeting gasoline supply needs. Absent sufficientinventories -- and some assurance that they can be replaced at prices commensurate with sellingprices for gasoline and other refined products -- refiners may be reluctant to run barrels of whatmight be viewed as scarce crude. In other words, a refiner may be unwilling to refine high-pricedcrude, and sell the resulting gasoline at an effective price below crude cost. The current world crude situation is characterized by many cross-currents, notably OPECproduction policy and growing demand, chiefly from Asia. OPEC has pursued a supply and pricepolicy that has resulted in prices that -- exceeding $50 on the NYMEX briefly -- are well above itsrecently stated target band of $22 to $28 per barrel (measured at the point of export). This hasresulted in much higher prices in the United States. Asian demand appears to be growing at a much higher rate than previously expected. TheInternational Energy Agency (IEA) reports that surging demand in China and other non-OECD Asianeconomies has raised the assessment of global oil demand growth for 2004 to an average of 1.65mbd over 2003. (5) Growingdemand for the world's oil -- even U.S. demand grew by 500,000 barrels per day between 2003 and2004 (a 2.5% increase) -- has given OPEC some pricing power as it tries to manage markets. Figure 5. Crude Oil Refiner Inventories, January 2003 to Present Source: EIA, Weekly Petroleum Status Report , Figure 3. U.S. gasoline quality and composition regulations have created unusual fuel requirementsthat are not easily met by foreign refiners. In a nation where refinery capacity can only meet about90% of gasoline needs, calling for significant supplies from abroad, meeting U.S. product "specs"for imports can present a barrier to supplying market demand. In addition to U.S. requirements forreformulated gasoline, low sulfur requirements began in 2004. Further, the ban on use of the additiveMTBE now in effect in California, New York, and Connecticut has resulted in increased need forlow-volatility gasoline, because the MTBE ban necessitates the use of ethanol in the gasoline"cocktail." Since ethanol increases the vapor pressure (volatility, measured by the Reid VaporPressure Index or RVPI) of gasoline, low-cost, high vapor pressure components such as butane andpentanes must be removed from the RFG pool. The gasoline base stock suitable for blending withethanol such that an acceptable RVP is achieved is relatively difficult and costly to refine, and notavailable from every refiner. There is also a volumetric loss with ethanol blended gasoline. Because approximately twogallons of MTBE are being replaced by one gallon of ethanol, the net volume loss must be replacedwith some other high-octane blend component with low vapor pressure. In addition to the need formore gallons of gasoline in the blend, the availability of blending components of the needed quality,such as alkylate and iso-octane, is limited. In addition to manufacturing challenges at U.S. refineries, two purely economic factors haveoperated to raise the cost of importing gasoline. There is a shortage of smaller, clean tankers inwhich gasoline cargoes are transported, resulting in high tanker rates, which are passed on to thepump. (6) If the incrementalcost of imported product is high by virtue of this, it tends to erect a price umbrella, supporting higherprices for all gasoline sold in the nation. The other economic factor is the structure of gasoline price futures that took shape in 2003and prevailed for much of 2004, a situation traders call "backwardation." This refers to the hierarchyof prices for gasoline for delivery in future months, in which near months have higher prices thanout-months. A purchaser of current-market gasoline knows that, at the time it is scheduled to beshipped and delivered, the market price at that future point in time is expected to be lower than theprice paid when the deal was crafted. If this event comes to pass, the purchaser may not be able tosell the gasoline for what he paid for it. This phenomenon tends to discourage the immediatepurchase of gasoline for future sale, keeping inventories from growing. The recent increase in the prices of crude oil and gasoline have prompted calls for use of theStrategic Petroleum Reserve (SPR). While some have called for a drawdown, the first issue iswhether to cease the current fill program, which critics assert has aggravated a tight oil supplysituation and contributed to high gasoline prices. On November 13, 2001, the President ordered fillof the SPR to its current capacity of roughly 700 million barrels, principally through royalty-in-kind(RIK) acquisitions of the government's share of production from federal offshore leases. Historically, the Treasury has taken this royalty in the form of a cash equivalent. However, an RIKprogram was established for the purpose of adding crude to the SPR. Continued deliveries of RIKoil were scheduled through October 2004, and if left in place will average between roughly 65,000and 200,000 barrels per day (b/d), depending upon the month. Further deliveries will be scheduledwith the intention of filling the SPR to capacity sometime in 2005. (7) The SPR currently holdsroughly 650 million barrels. Some have argued that these RIK deliveries are contributing to currently high oil prices andshould be suspended so that the RIK oil can be offered in markets. Others have argued that thevolumes involved are too small to have a significant impact, and that fill should continue in theinterests of national security. On March 11, 2004, in its debate on the FY2005 budget resolution,the Senate called for a suspension of deliveries and a sale instead of 53 million barrels of RIK oil. Proceeds (pegged at $1.7 billion) would be used for deficit reduction and increased homelandsecurity funding for states. Some Members of the House have also voiced support for deferring fill. The Administration has argued that the volumes of RIK being added to the SPR are too small to putsignificant pressure on crude oil prices, and that it will continue its current fill policy. If there is to be any use of the SPR in the current situation, the deferral of oil deliveries -- andallowing this oil to enter into markets -- might be a logical first step. However, some supporters ofusing the SPR are also urging President Bush to also authorize a "swap" or exchange of SPR oil,comparable to one held in September 2000 when the Clinton Administration made 30 million barrelsavailable. (8) Under theterms of a swap, interested parties are invited to bid to borrow crude from the SPR, to be returnedat a later date. Awards are made on the basis of how much oil a bidder will return in exchange fora barrel now; in other words, for every barrel taken in a swap, the refiner or bidder will returnsomething more than one barrel at an agreed-upon future date. The bidding and award process wascompleted in two weeks in 2000, with oil picked up soon thereafter. Oil borrowed in the fall of 2000was returned to the SPR by early 2004. The swap had the effect of ultimately adding oil to the SPRat a time -- as is the case now -- when Congress was not authorizing funds for outright purchase ofoil for the reserve. While historically the use of the SPR (or simply announcement of its intended use) hasresulted in some decline in crude prices, nearly every occasion has been unique. Each situation hashad other external circumstances surrounding the event such that it is difficult to isolate the extentof any price moves that can be attributed solely to the use of the SPR. (9) More to the point in this particular report is whether the availability of SPR crude would havean effect on gasoline prices. As noted elsewhere in this report, gasoline supply -- in some regions-- is constrained by the refining capacity to produce fuel that meets local or seasonal requirements. While a release of SPR oil may soften crude prices to some extent, it may be little reflected in localgasoline prices if demand for fuel remains high where refining capacity is tight. (It may even bepossible that a release of SPR crude, to the extent that it benefitted supply in some regions of thecountry, might widen the observed disparity between gasoline prices on the West Coast andelsewhere.) Moreover, in the spring of 2004, prices appear especially sensitive to weekly reports oncrude and product stocks. While release of SPR might benefit crude stock levels, gasoline stockswill improve only if demand levels and refining capacity (plus imports) allow refiners to add tostocks. As suggested, this is likelier in some regions of the country than others. In sum, opinion appears divided on the effect that the Administration's current fill policy ishaving on crude price and product supply, as well as on the benefits that might be more thanshort-term if RIK oil is diverted to the markets, or a swap/exchange of SPR is held. The nation experienced its third gasoline price spike in little more than one year, with a newnationwide record for the average price for unleaded regular reaching $2.05 in mid-May 2004. Whileprices have fallen as supplies have increased, the supply-demand-price situation remains volatile.Several general gasoline supply issues have contributed to the recent episode: A shortage of refinery capacity -- resulting from a lack of new construction -- has led to increasing reliance on imports of blending components and finished gasoline. Increasinglychallenging fuel specifications -- including the MTBE ban in several states and the 2004 standardsfor reduced sulfur content -- have added to the complexities of refining anddistribution. Steadily growing gasoline demand, which has increased by 600,000 barrels perday since 1999, has risen from 8.4 mbd to 9.0 mbd for the whole of 2004. This has accounted forvirtually all the nation's increase in oil consumption. Gasoline inventories were low; in early April 2004, there was less than twodays of available supply in the system. Crude oil stocks were below normal seasonal levels for much of 2004, onlyrecently rebounding from below minimum operational levels. There is little U.S. refining capacityto make more gasoline; while crude availability might not be an immediate concern, this situationcould easily change. OPEC has gained power on crude supply and price. Members actually reducedoil exports by about 400,000 barrels per day during April 2004, and that contributed to prices risingover $41. (10) This setthe stage for crude prices surging over $50, despite what subsequently proved to be a steady flowfrom OPEC during the last half of 2004. OPEC output for November was the highest since1979. (11) This may haveled to crude declines to the $45 area, and on December 10, OPEC announced a 1 mbd productioncut. (12) The recent gasoline price surge was especially severe in California, where prices peaked at$2.45/gal, setting a new state record. California's situation is unique because of state requirementsfor especially clean gasoline and its ban on the use of MTBE. Fuel meeting California specificationsis not readily available from all refineries, especially those abroad. Additionally, California has noeast-to-west pipeline system through which gasoline can be shipped from Gulf Coast refineries. Evenhigh prices -- which would under other circumstances attract extra supply -- cannot easilyself-correct a supply shortfall. With insufficient West Coast refinery capacity to meet regional needsand a dependency on imports, California has generally seen gasoline prices trending above nationalaverages for the past several years. And because the state cannot quickly get make-up supply fromother domestic refineries, small operational difficulties in the refining and transport system can leadto out-sized price spikes. An important energy policy aspect of the gasoline price situation involves the potential useof the SPR. Various measures involving release of SPR crude -- by whatever mechanism -- tostabilize the market have been proposed, and it is likely that more will be forthcoming if pricesremain volatile at elevated levels. Options for using SPR oil must be evaluated in context of thecomplex nature of oil markets. By statute, the SPR is intended to be used to offset demonstrable supply shortages that arecontributing to high prices. As has been noted, factors other than crude supply have had a significantrole in fuel markets. Under some circumstances, adding crude to markets -- in the absence ofincremental refining capacity -- will not boost supply or reduce price in a timely fashion.

Summary:
Since late 2002, gasoline prices have been extremely volatile, with the national averagespiking above $1.70 three times. Most recently, the nationwide pump price for regular fuel set a newrecord as momentum carried it over $2.00 per gallon. Prices in some states -- reaching a high of$2.45 per gallon in California -- are much above the national average. In addition to the marketforces affecting pump prices in the United States, the Organization of Petroleum Exporting Countries(OPEC) announced a production cut effective in January 2005. At a minimum, this is likely tosupport crude prices; crude prices have significant impact on prices at the pump. Apart from higher crude oil prices, gasoline prices are strongly influenced by the supply anddemand situation at the pump. Since 1999, the only growth in U.S. oil consumption has beenincreased gasoline demand, which has risen by 600,000 barrels per day to a current annual averageof 9.0 million barrels per day. While this might seem to be a relatively small amount, it has directlyincreased demand for imports of foreign gasoline, since U.S. refineries have not added capacity asgasoline demand has grown. Demand for imported gasoline now exceeds one million barrels per day. In addition to the high demand for imported gasoline, the quality of gasoline sought fromforeign refiners has become a factor. As the specifications for environmentally acceptable fuel havebecome more stringent, the complexity of manufacturing "U.S. spec" gasoline has increased. Not allrefiners can economically make fuel that meets domestic requirements. U.S. gasoline marketersseeking imports must shop world markets for a scarce commodity; accordingly, prices are high.These high-priced incremental supplies play an important role in determining prices at the pump,because all gasoline tends to be priced by the market at the cost of the last units supplied. Other factors contributing to the pump price situation include the state of gasoline and crudeoil inventories at U.S. refineries. Both are recovering from low levels. Gasoline inventories availablefor consumption amount to less than two days of supply. Crude oil stocks -- from which gasolineconsumed is replaced -- are still at low levels, although rebounding somewhat from last winter'srecord lows. Petroleum inventories are low because global oil supplies are tight, in part due to strongdemand, especially in Asia. OPEC production policy is a consideration as well. As gasoline prices rise, so does interest in finding some sort of public policy remedy thatwould return lower and more stable prices. Among the options generally discussed are a release ofcrude from the Strategic Petroleum Reserve and the relaxation of Environmental Protection Agencyrules regarding gasoline composition. Both are controversial, with the wisdom and effectiveness ofeach challenged by some. This report will be updated to reflect significant changes in the factors impacting gasolinemarkets and prices.