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Report to the Ranking Minority Member, Permanent Subcommittee on 
Investigations, Committee on Governmental Affairs, U.S. Senate: 

May 2004: 

ENERGY MARKETS: 

Effects of Mergers and Market Concentration in the U.S. Petroleum 
Industry: 

[Hyperlink, http://www.gao.gov/cgi-bin/getrpt?GAO-04-96]: 

GAO Highlights: 

Highlights of GAO-04-96, a report to the Ranking Minority Member, 
Permanent Subcommittee on Investigations, Committee on Governmental 
Affairs, U.S. Senate

Why GAO Did This Study: 

Starting in the mid-1990s, the U.S. petroleum industry experienced a 
wave of mergers, acquisitions, and joint ventures, several of them 
between large oil companies that had previously competed with each 
other. For example, as shown in the figure, Exxon, the largest U.S. oil 
company, acquired Mobil, the second largest, thus forming ExxonMobil. 
 
GAO was asked to examine the effects of the mergers on the U.S. 
petroleum industry since the 1990s. For this period, GAO examined (1) 
mergers in the U.S. petroleum industry and why they occurred, (2) the 
extent to which market concentration (the distribution of market shares 
among competing firms) and other aspects of market structure in the 
U.S. petroleum industry have changed as a result of mergers, (3) major 
changes that have occurred in U.S. gasoline marketing, and (4) how 
mergers and market concentration in the U.S. petroleum industry have 
affected U.S. gasoline prices at the wholesale level. Commenting on a 
draft of GAO’s report, FTC asserted that the models were flawed and the 
analyses unreliable. GAO used state-of-the-art econometric models to 
examine the effects of mergers and market concentration on wholesale 
gasoline prices. The models used in GAO’s analyses were peer reviewed 
by independent experts. Thus, GAO believes its analyses are sound.

What GAO Found: 

Over 2,600 mergers have occurred in the U.S. petroleum industry since 
the 1990s. The majority occurred later in the period, most frequently 
among firms involved in exploration and production. Industry officials 
cited various reasons for the mergers, particularly the need for 
increased efficiency and cost savings. Economic literature also 
suggests that firms sometimes merge to enhance their ability to control 
prices. 

Market concentration has increased substantially in the industry, 
partly because of these mergers. Concentrated markets can enable firms 
to raise prices above competitive levels but can also lead to cost 
savings and lower prices. Evidence suggests mergers also have changed 
other factors that affect competition, such as the ability of new firms 
to enter the market.

According to industry officials, two major changes have occurred in 
U.S. gasoline marketing related to these mergers. First, the 
availability of generic gasoline, which is generally priced lower than 
branded gasoline, has decreased substantially. Second, refiners now 
prefer to deal with large distributors and retailers, which has 
motivated further consolidation in distributor and retail markets.

GAO’s econometric analyses indicate that mergers and increased market 
concentration generally led to higher wholesale gasoline prices in the 
United States from the mid-1990s through 2000. Six of the eight mergers 
GAO modeled led to price increases, averaging about 1 cent to 2 cents 
per gallon. GAO found that increased market concentration, which 
reflects the cumulative effects of mergers and other competitive 
factors, also led to increased prices. For conventional gasoline, the 
predominant type used in the country, the change in wholesale price due 
to increased market concentration ranged from a decrease of about 1 
cent per gallon to an increase of about 5 cents per gallon. For 
boutique fuels sold in the East Coast and Gulf Coast regions, wholesale 
prices increased by about 1 cent per gallon, while prices for boutique 
fuels sold in California increased by over 7 cents per gallon. 

Selected Recent Major Petroleum Mergers: 

[See PDF for image]

[End of figure]

www.gao.gov/cgi-bin/getrpt?GAO-04-96

To view the full product, including the scope and methodology, click on 
the link above. For more information, contact Jim Wells at (202) 
512-3841 or wellsj@gao.gov.

[End of section]

Contents: 

Letter: 

Executive Summary: 

Purpose: 

Background: 

Results in Brief: 

Principal Findings: 

Recommendations for Executive Action: 

Agency Comments and GAO's Evaluation: 

Chapter 1: Introduction: 

The Petroleum Industry Consists of Three Main Segments: 

Different Entities Have Historically Exerted Influence over the World 
Petroleum Market: 

FTC and DOJ Review Proposed Mergers to Preserve Market Competition: 

Objectives, Scope, and Methodology: 

Chapter 2: All Segments of the Petroleum Industry Experienced Mergers 
for Several Reasons: 

Mergers Occurred in All Three Segments, but Most Frequently in the 
Upstream: 

Several Reasons Were Cited for Mergers in the Petroleum Industry: 

Chapter 3: Mergers Contributed to Increases in Market Concentration and 
Other Changes in Market Structure: 

Market Concentration Increased Mostly in the Downstream Segment of the 
Petroleum Industry During the 1990s: 

Mergers Have Caused Changes in Other Aspects of Market Structure, but 
the Extent of These Changes Is Not Easily Quantifiable: 

Chapter 4: Gasoline Marketing Has Changed in Two Major Ways: 

The Availability of Unbranded Gasoline Decreased: 

Refiners Prefer Dealing with Large Distributors and Retailers: 

Chapter 5: Mergers and Increased Market Concentration Generally Led to 
Higher Wholesale Gasoline Prices in the United States: 

Econometric Models Developed to Estimate the Effects of Mergers and 
Market Concentration on Wholesale Gasoline Prices: 

Mergers in the Second Half of the 1990s Mostly Led to Increases in 
Wholesale Gasoline Prices: 

Increased Market Concentration Generally Led to Higher Wholesale 
Gasoline Prices: 

Other Factors Also Resulted in Higher Wholesale Gasoline Prices: 

Our Findings Are Generally Consistent with Previous Studies' Empirical 
Results: 

Agency Comments and Our Evaluation: 

Appendixes: 

Appendix I: Companies, Agencies, and Organizations Contacted by GAO: 

Appendix II: Experts Who Reviewed GAO's Econometric Models: 

Appendix III: Correlation Analysis of Mergers and Market Concentration 
in the U.S. Petroleum Industry: 

Wholesale Gasoline Market Concentration by State: 

Correlation Analysis of Mergers and Market Concentration: 

Appendix IV: Econometric Analyses of the Effects of Specific Mergers 
and Market Concentration on U.S. Wholesale Gasoline Prices: 

GAO's Econometric Models of Wholesale Gasoline Prices Built on Previous 
Studies and Market Analysis: 

Data Sources and Sample Selection: 

Specification of Econometric Models and Estimation Methodology: 

Econometric Results: 

Our Econometric Methodology Had Some Limitations: 

Appendix V: Comments from the Federal Trade Commission's Commissioners: 

GAO's Comments: 

Appendix VI: Comments from the Federal Trade Commission's Bureau of 
Economics Staff: 

GAO's Comments: 

Appendix VII: GAO Contacts and Staff Acknowledgments: 

GAO Contacts: 

Acknowledgments: 

Bibliography: 

Tables: 

Table 1: FTC/DOJ Horizontal Merger Guidelines on the General Standards 
for Evaluating Postmerger Market Concentration: 

Table 2: Selected Vertical Mergers in the Petroleum Industry Since the 
1990s: 

Table 3: Types of Wholesale Prices Paid for Gasoline: 

Table 4: Selected Oil Industry Mergers Affecting Wholesale Gasoline 
Markets, 1994-2000: 

Table 5: Estimated Changes in Conventional Wholesale Gasoline Prices 
Associated with Individual Mergers (1994-2000): 

Table 6: Estimated Changes in Reformulated Wholesale Gasoline Prices 
Associated with Individual Mergers (1995-2000): 

Table 7: Estimated Changes in CARB Reformulated Wholesale Gasoline 
Prices Associated with Individual Mergers (1996-2000): 

Table 8: Estimated Changes in Conventional Wholesale Gasoline Prices 
Associated with Increased Market Concentration (1994-2000): 

Table 9: Estimated Changes in Boutique Fuels Wholesale Prices Associated 
with Increased Market Concentration (1995-2000): 

Table 10: State-level HHI for Wholesale Gasoline (1994-2002): 

Table 11: Correlation between the Average Transaction Value of Mergers 
and Market Concentration (HHI) for Petroleum Refining by PADD (1991-
2000): 

Table 12: Correlation between the Average Transaction Value of Mergers 
and Market Concentration (HHI) for Wholesale Gasoline (1994-2001): 

Table 13: Expected Effects of Key Explanatory Variables on Wholesale 
Gasoline Prices: 

Table 14: Variables in Our Econometric Analysis of Wholesale Gasoline 
Prices: 

Table 15: Effects of Mergers on Conventional Wholesale Gasoline Prices 
(1994-2000): 

Table 16: Effects of Mergers on Reformulated Wholesale Gasoline Prices 
(1995-2000): 

Table 17: Effects of Mergers on CARB Wholesale Gasoline Prices (1996-
2000): 

Table 18: Effects of Market Concentration on Conventional Wholesale 
Gasoline Prices (1994-2000): 

Table 19: Effects of Market Concentration on Wholesale Prices of 
Boutique Fuels (1995-2000): 

Table 20: Selected Summary Statistics for Conventional Wholesale 
Gasoline Markets: 

Table 21: Econometric Estimates of Mergers' Effects on Conventional 
Wholesale Gasoline Prices: 

Table 22: Econometric Estimates of Mergers' Effects on Reformulated 
Wholesale Gasoline Prices: 

Table 23: Econometric Estimates of Mergers' Effects on CARB Wholesale 
Gasoline Prices: 

Table 24: Econometric Estimates of Market Concentration on Conventional 
Wholesale Gasoline Prices: 

Table 25: Econometric Estimates of Market Concentration on Conventional 
Wholesale Gasoline Prices: Eastern Region (PADDs I-III): 

Table 26: Econometric Estimates of Market Concentration on Conventional 
Wholesale Gasoline Prices: Western Region (PADDs IV-V): 

Table 27: Econometric Estimates of Market Concentration on Reformulated 
Wholesale Gasoline Prices: 

Table 28: Econometric Estimates of Market Concentration on CARB 
Wholesale Gasoline Prices: 

Figures: 

Figure 1: U.S. Petroleum Industry Chain: 

Figure 2: Product Yield from a Barrel of Crude Oil, 2000: 

Figure 3: Major Events in the World Petroleum Market: 

Figure 4: Shares of the World's Conventional Crude Oil Reserves 
(February 2003): 

Figure 5: World's Estimated Excess Production Capacity (February 2003): 

Figure 6: Percentage of Mergers That Occurred in Each Segment of the 
Petroleum Industry (1991-2000): 

Figure 7: Petroleum Industry Merger Trends (1991-2000): 

Figure 8: Selected Major Petroleum Mergers (1996-2002): 

Figure 9: Percentage of Merger Transactions within the Downstream 
Segment by Type of Key Assets Acquired: 

Figure 10: Range of Reported Merger Transaction Values (1991-2000): 

Figure 11: Petroleum Administration for Defense Districts: 

Figure 12: Market Concentration for the Upstream Segment, as Measured 
by the HHI (1990-2000): 

Figure 13: Refining Market Concentration for PADD I Based on Crude Oil 
Distillation Capacity (1990-2000): 

Figure 14: Refining Market Concentration for PADD II Based on Crude Oil 
Distillation Capacity (1990-2000): 

Figure 15: Refining Market Concentration for PADD III Based on Crude 
Oil Distillation Capacity (1990-2000): 

Figure 16: Refining Market Concentration for PADD IV Based on Crude Oil 
Distillation Capacity (1990-2000): 

Figure 17: Refining Market Concentration for PADD V Based on Crude Oil 
Distillation Capacity (1990-2000): 

Figure 18: Percentage of U.S. States with Unconcentrated, Moderately 
Concentrated, and Highly Concentrated Wholesale Gasoline Markets (1994, 
2000, and 2002): 

Figure 19: Wholesale Gasoline Market Concentration by State in Each 
PADD (1994 and 2002): 

Figure 20: The Flow of Gasoline Marketing: 

Figure 21: Percentage Volume of Gasoline Sold through Different 
Marketing Channels: 

Figure 22: Normalized Inventories and Expected Demand for Wholesale 
Gasoline (1994-2000): 

Figure 23: Ratio of Inventories to Expected Demand for Wholesale 
Gasoline (1994-2000): 

Abbreviations: 

API: American Petroleum Institute: 

BP: British Petroleum: 

CARB: California Air Resources Board: 

cpg: cents per gallon: 

DOE: Department of Energy: 

DOJ: Department of Justice: 

DTW: Dealer-tankwagon: 

EAI: Energy Analysts International, Inc.

EIA: Energy Information Administration: 

FERC: Federal Energy Regulatory Commission: 

FRS: Financial Reporting System: 

FTC: Federal Trade Commission: 

HHI: Herfindahl-Hirschman Index: 

MAP: Marathon Ashland Petroleum: 

mmb/d: million barrels per day: 

MTBE: methyl tertiary butyl ether: 

OGJ: Oil and Gas Journal: 

OPEC: Organization of Petroleum Exporting Countries: 

OPIS: Oil Price Information Service: 

PADD: Petroleum Administration for Defense Districts: 

PMAA: Petroleum Marketers Association of America: 

RFG: reformulated gasoline: 

UDS: Ultramar Diamond Shamrock: 

WTI: West Texas Intermediate: 

Letter May 17, 2004: 

The Honorable Carl Levin: 
Ranking Minority Member:
Permanent Subcommittee on Investigations: 
Committee on Governmental Affairs:
United States Senate: 

Dear Senator Levin: 

This report responds to your request that we examine the effect of the 
wave of mergers that occurred in the U.S. petroleum industry in the 
1990s. The report examines the segments of the petroleum industry that 
were involved in mergers, the extent to which market concentration and 
other aspects of market structure that affect competition have changed 
in the U.S. petroleum industry because of mergers, and major changes 
that have occurred in U.S. gasoline marketing because of mergers. 
Finally, the report estimates the effects of mergers and market 
concentration on U.S. gasoline prices at the wholesale level.

As agreed with your office, unless you publicly announce its contents 
earlier, we plan no further distribution of this report until 30 days 
after the date of this letter. At that time, we will send copies to 
appropriate congressional committees, the Chairman of the Federal Trade 
Commission, the Secretary of Energy, the Attorney General, and other 
interested parties.

Please contact me at (202) 512-3841 if you or your staff have any 
questions. Major contributors to this report are listed in appendix 
VII.

Sincerely yours,

Signed by: 

Jim Wells: 
Director, Natural Resources and Environment: 

[End of section]

Executive Summary: 

Purpose: 

Since the 1990s, the U.S. petroleum industry has experienced a wave of 
mergers, acquisitions, and joint ventures (hereafter referred to as 
mergers), several of them between large oil companies that had 
previously competed with each other for the sale of petroleum products. 
For example, in 1998 British Petroleum (BP) and Amoco merged to form 
BP-Amoco, which later acquired ARCO in 2000. In 1999, Exxon, the 
largest U.S. oil company, acquired Mobil, the second largest, thus 
forming ExxonMobil. Increasing concerns about potential 
anticompetitive effects have caused some policy makers and consumer 
groups to suggest that these mergers may have reduced competition in 
the United States and ultimately led to higher gasoline prices.

In this context, the Ranking Minority Member, Permanent Subcommittee on 
Investigations, Senate Committee on Governmental Affairs, asked GAO to 
examine the effect of the mergers that have occurred in the U.S. 
petroleum industry since the 1990s. GAO examined (1) mergers in the 
U.S. petroleum industry from the 1990s through 2000 and why they 
occurred, (2) the extent to which market concentration (the 
distribution of market shares among competing firms within a market) 
and other aspects of market structure in the U.S. petroleum industry 
have changed as a result of mergers, (3) major changes that have 
occurred in U.S. gasoline marketing since the 1990s, and (4) how 
mergers and market concentration in the U.S. petroleum industry have 
affected U.S. gasoline prices at the wholesale level.

To address these issues, GAO purchased and analyzed a large body of 
data on mergers and wholesale gasoline prices, as well as data on other 
relevant economic factors. GAO also developed econometric models for 
examining the effects of eight specific mergers and increased market 
concentration on U.S. gasoline wholesale prices. In doing so, GAO 
isolated the effects of mergers and market concentration from several 
other factors that could influence wholesale gasoline prices, such as 
crude oil costs, gasoline inventories relative to demand, refinery 
capacity utilization rates, and gasoline supply disruptions. GAO also 
differentiated among fuel formulations in its analyses. Other factors-
-including taxes--can affect the retail gasoline prices that consumers 
ultimately pay, but GAO did not examine the effects of such factors 
because this study focuses on wholesale gasoline prices.

In the course of its work, GAO consulted with Dr. Severin 
Borenstein,[Footnote 1] a recognized expert in the modeling of gasoline 
markets; interviewed officials across the industry spectrum; and 
reviewed relevant economic literature and numerous related studies. 
Furthermore, GAO used an extensive peer review process to obtain 
comments from experts in academia and relevant government agencies.

Background: 

The U.S. petroleum industry consists of many firms of varying sizes 
that operate in one or more of three broad segments--the upstream, 
which consists of exploration for and production of crude oil and 
natural gas; the midstream, which consists of pipelines and other 
infrastructure used to transport these products; and the downstream, 
which consists of refining crude oil and marketing petroleum products 
such as gasoline and heating oil. While some firms engage in only one 
or two of these activities, fully vertically integrated oil companies 
participate in all of them. Before the 1970s, major oil companies that 
were fully vertically integrated controlled the global network for 
supplying, pricing, and marketing crude oil. However, the structure of 
the world crude oil market has dramatically changed as a result of such 
factors as the nationalization of oil fields by oil-producing 
countries, the emergence of independent oil companies, and the 
evolution of futures and spot markets in the 1970s and 1980s. Moreover, 
U.S. oil prices, controlled by the government since 1971, were 
deregulated in 1981. Consequently, the price of crude oil is now 
largely determined in the world oil market, which is mostly influenced 
by global factors, especially Organization of Petroleum Exporting 
Countries' (OPEC) supply decisions and world economic and political 
conditions.

The United States currently imports over 60 percent of its crude oil 
supply. In contrast, the bulk of the gasoline used in the United States 
is produced domestically. In 2001, for example, gasoline refined in the 
United States accounted for over 90 percent of the total domestic 
gasoline consumption. Companies that supply gasoline to U.S. markets 
also post the domestic gasoline prices. Historically, the domestic 
petroleum market has been divided into five regions, known as Petroleum 
Administration for Defense Districts (PADD)--PADD I is the East Coast 
region, PADD II is the Midwest region, PADD III is the Gulf Coast 
region, PADD IV is the Rocky Mountain region, and PADD V is the West 
Coast region.

Proposed mergers in all industries, including the petroleum industry, 
are generally reviewed by federal antitrust authorities--including the 
Federal Trade Commission (FTC) and the Department of Justice (DOJ)--to 
assess the potential impact on market competition. According to FTC 
officials, FTC generally reviews proposed mergers involving the 
petroleum industry because of the agency's expertise in that industry. 
FTC analyzes these mergers to determine if they would likely diminish 
competition in the relevant markets and result in harm, such as 
increased prices. To determine the potential effect of a merger on 
market competition, FTC evaluates, among other things, how the merger 
would change the level of market concentration. Conceptually, the 
higher the concentration, the less competitive the market is and the 
more likely that firms can exert control over prices. The ability to 
maintain prices above competitive levels for a significant period of 
time is known as market power.

Market concentration is commonly measured by the Herfindahl-Hirschman 
Index (HHI), calculated by summing the squares of the market shares of 
all the firms within a given market. According to the merger guidelines 
jointly issued by DOJ and FTC, market concentration is ranked into 
three separate categories based on the HHI: a market with an HHI under 
1,000 is considered to be unconcentrated; if the HHI is between 1,000 
and 1,800 the market is considered moderately concentrated; and if the 
HHI is above 1,800, the market is considered highly concentrated.

While concentration is an important aspect of market structure--the 
underlying economic and technical characteristics of an industry--other 
aspects of market structure that may be affected by mergers also play 
an important role in determining the level of competition in a market. 
These aspects include barriers to entry, which are market conditions 
that provide established sellers an advantage over potential new 
entrants in an industry, and vertical integration, which is the 
participation of firms in more than one successive stage of production 
or distribution in a market.

Results in Brief: 

GAO's analysis indicates that from 1991 through 2000 all three segments 
of the U.S. petroleum industry experienced mergers--over 2,600 
transactions in all. The majority of the mergers occurred during the 
second half of the decade, most frequently in the upstream (exploration 
and production) segment. Petroleum industry officials cited various 
reasons for this wave of mergers, particularly the need for increased 
efficiency and cost savings. Economic literature suggests that firms 
also sometimes use mergers to enhance their market power. However, the 
reasons cited by both sources generally relate to the merging 
companies' desire to ultimately maximize profit or shareholder wealth.

Market concentration, as measured by HHI, has increased substantially 
in the downstream segment of the U.S. petroleum industry since the 
1990s, partly as a result of merger activities, while changing very 
little in the upstream segment. Increased market concentration can 
result in greater market power, potentially increasing prices above 
competitive levels. On the other hand, it can lead to efficiency gains 
through cost savings, which may be passed on to consumers in the form 
of lower prices. The impact--either positive or negative--of increased 
market concentration on prices ultimately depends on whether market 
power or efficiency dominates. In the downstream (refining and 
marketing) segment, market concentration in refining increased from 
moderately to highly concentrated in the East Coast and from 
unconcentrated to moderately concentrated in the West Coast; it 
increased but remained moderately concentrated in the Rocky Mountain 
region. Concentration in the wholesale gasoline market increased 
substantially from the mid-1990s so that by 2002, most states had 
either moderately or highly concentrated wholesale gasoline markets. On 
the other hand, market concentration decreased somewhat in the upstream 
(exploration and production) segment and remained unconcentrated by the 
end of the 1990s. While mergers occurred in the midstream 
(transportation) segment, GAO could not determine the extent to which 
concentration changed in this segment because of a lack of relevant 
data and difficulties in defining markets. Anecdotal evidence and 
economic analysis by some industry experts suggest that mergers not 
only affected market concentration but also enhanced vertical 
integration and barriers to entry. GAO could not, however, determine 
the extent to which these other aspects of market structure changed in 
the petroleum industry because adequate data do not exist. Like 
increased market concentration, increased vertical integration can 
result in higher or lower consumer prices. Barriers to entry are 
important in a market because firms that operate in concentrated 
industries with high barriers to entry are more likely to have market 
power.

According to industry officials, two major changes have occurred in 
U.S. gasoline marketing since the 1990s, partly related to mergers. 
First, the availability of unbranded (generic) gasoline has decreased 
substantially. Unbranded gasoline is generally priced lower than 
branded gasoline, which is marketed under the refiner's trademark. 
Industry officials generally attributed the decreased availability of 
unbranded gasoline to, among other factors, a reduction in the number 
of independent refiners that typically supply unbranded gasoline. GAO 
could not, however, statistically quantify the extent to which the 
supply of unbranded gasoline has decreased because relevant data are 
not available. The second change identified by industry officials is 
that refiners now prefer dealing with large distributors and retailers. 
This preference, according to the officials, has motivated further 
consolidation in both the distributor and retail markets, including the 
rise of hypermarkets--a relatively new breed of gasoline market 
participants that includes such large retail warehouses as Wal-Mart and 
Costco.

GAO's econometric analyses show that oil industry mergers and increased 
market concentration generally led to higher wholesale gasoline prices 
(measured in this report as wholesale prices less crude oil prices) for 
different gasoline types in the United States in the second half of the 
1990s, although prices sometimes decreased. Six of the eight specific 
mergers GAO modeled--which mostly involved large, fully vertically 
integrated companies--generally resulted in increases in wholesale 
prices for branded and/or unbranded gasoline of about 2 cents per 
gallon, on average. Two of the mergers generally led to price 
decreases, of about 1 cent per gallon, on average. For conventional 
gasoline--the predominant type used in the United States except in 
areas that require special gasoline formulations to meet clean air 
standards--the change in wholesale prices ranged from a decrease of 
about 1 cent per gallon to an increase of about 5 cents per gallon. The 
preponderance of price increases over decreases indicates that the 
market power effects, which tend to increase prices, for the most part 
outweighed the efficiency effects, which tend to decrease prices. 
Increased market concentration, which captures the cumulative effects 
of mergers as well as other market structure factors, also generally 
led to higher prices for conventional gasoline, which is sold 
nationwide, and for boutique fuels--gasoline that has been reformulated 
for certain areas in the East Coast and Gulf Coast regions and in 
California, to lower pollution. The price increases were particularly 
large in California, where they averaged about 7 cents per gallon. 
Higher wholesale gasoline prices were also a result of other factors: 
low gasoline inventories, which typically occur in the summer driving 
months; high refinery capacity utilization rates; and supply 
disruptions, which occurred in the Midwest and the West Coast.

GAO's findings are generally consistent with previous studies of the 
effects of specific oil mergers and of market concentration on 
wholesale and retail gasoline prices. GAO used extensive peer review to 
obtain comments from outside experts, which were incorporated as 
appropriate. GAO believes that this is the first study to model the 
impact of the petroleum industry's 1990s merger wave on wholesale 
gasoline prices for the primary gasoline specifications for the entire 
United States, an effort that required GAO to acquire large datasets 
and perform complex analyses.

Principal Findings: 

Mergers Occurred in All Segments of the U.S. Petroleum Industry in the 
1990s for Several Reasons: 

Over 2,600 merger transactions occurred from 1991 through 2000 
involving all three segments of the U.S. petroleum industry. Almost 85 
percent of the mergers occurred in the upstream segment (exploration 
and production), while the downstream segment (refining and marketing 
of petroleum) accounted for about 13 percent, and the midstream segment 
(transportation) accounted for over 2 percent. The vast majority of the 
mergers--about 80 percent--involved one company's purchase of a segment 
or asset of another company, while about 20 percent involved the 
acquisition of one company's total assets by another so that the two 
became one company. Most of the mergers occurred in the second half of 
the decade, including those involving large partially or fully 
vertically integrated companies.

Petroleum industry officials and experts GAO contacted cited several 
reasons for the industry's wave of mergers in the 1990s, including 
achieving synergies, increasing growth and diversifying assets, and 
reducing costs. Economic literature indicates that enhancing market 
power is also sometimes a motive for mergers. These reasons mostly 
relate to companies' ultimate desire to maximize profit or stock 
values.

Mergers Contributed to Increases in Market Concentration and to Changes 
in Other Aspects of Market Structure That Affect Competition: 

Mergers in the 1990s have contributed to increases in market 
concentration in the downstream segment of the U.S. petroleum industry, 
while the upstream segment experienced little change overall. Increased 
market concentration can result in greater market power, potentially 
allowing firms to increase prices above competitive levels. On the 
other hand, increased market concentration may also lead to efficiency 
gains that can be passed on to consumers as lower prices. Whether 
increased market concentration results in higher or lower prices 
depends on which effect predominates. GAO found that market 
concentration, as measured by the HHI, decreased slightly in the 
upstream segment, based on crude oil production activities at the 
national level, from 290 in 1990 to 217 in 2000. Moreover, based on 
benchmarks established jointly by DOJ and FTC, the upstream segment of 
the U.S. petroleum industry remained unconcentrated at the end of the 
1990s. The increases in market concentration in the downstream segment 
varied by activity and region. For example, the HHI of the refining 
market in the East Coast region increased from a moderately 
concentrated level of 1136 in 1990 to a highly concentrated level of 
1819 in 2000. In the Rocky Mountain and the West Coast regions it 
increased from 1029 to 1124 and from 937 to 1267, respectively, in that 
same period. Thus, while each of these refining markets increased, the 
Rocky Mountain region remained within the moderately concentrated range 
but the West Coast region changed from unconcentrated in 1990 to 
moderately concentrated in 2000. The HHI of refining markets also 
increased from 699 to 980 in the Midwest region and from 534 to 704 in 
the Gulf Coast region during the same period, although these markets 
remained unconcentrated. In wholesale gasoline markets, GAO found that 
market concentration increased broadly throughout the United States 
between 1994 and 2002. Specifically, GAO found that 46 states and the 
District of Columbia had moderately or highly concentrated markets by 
2002, compared to 27 in 1994. For both the refining and wholesale 
markets of the downstream segment, GAO found that merger activity and 
market concentration were highly correlated for most regions of the 
country.

Evidence from various sources indicates that in addition to increasing 
market concentration, mergers also contributed to changes in other 
aspects of market structure in the U.S. petroleum industry that affect 
competition--specifically, vertical integration and barriers to entry. 
However, GAO could not quantify the extent of these changes because of 
a lack of relevant data. Vertical integration can conceptually have 
both pro-and anticompetitive effects. Based on anecdotal evidence and 
economic analyses by some industry experts, GAO determined that a 
number of mergers that have occurred since the 1990s have led to 
greater vertical integration in the U.S. petroleum industry, especially 
in the refining and marketing segment. For example, GAO identified 
eight mergers that occurred between 1995 and 2001 that might have 
enhanced the degree of vertical integration, particularly in the 
downstream segment. Concerning barriers to entry, GAO's interviews with 
petroleum industry officials and experts provide evidence that mergers 
had some impact on the U.S. petroleum industry. Barriers to entry could 
have implications for market competition because companies that operate 
in concentrated industries with high barriers to entry are more likely 
to possess market power. Industry officials pointed out that large 
capital requirements and environmental regulations constitute barriers 
for potential new entrants into the U.S. refining business. For 
example, the officials indicated that a typical refinery could cost 
billions of dollars to build and that it may be difficult to obtain the 
necessary permits from the relevant state or local authorities. At the 
wholesale and retail marketing levels, industry officials pointed out 
that mergers may have exacerbated barriers to entry in some markets. 
For example, the officials noted that mergers have contributed to a 
situation where pipelines and terminals are owned by fewer, mostly 
integrated companies that sometimes deny access to third-party users, 
especially when supply is tight--which creates a disincentive for 
potential new entrants into such wholesale markets.

U.S. Gasoline Marketing Has Changed in Two Major Ways: 

According to some petroleum industry officials that GAO interviewed, 
gasoline marketing in the United States has changed in two major ways 
since the 1990s. First, the availability of unbranded gasoline has 
decreased, partly due to mergers. Officials noted that unbranded 
gasoline is generally priced lower than branded. They generally 
attributed the decreased availability of unbranded gasoline to one or 
more of the following factors: 

* There are now fewer independent refiners, who typically supply mostly 
unbranded gasoline. These refiners have been acquired by branded 
companies, have grown large enough to be considered a brand, or have 
simply closed down.

* Partially or fully vertically integrated oil companies have sold or 
mothballed some refineries. As a result, some of these companies now 
have only enough refinery capacity to supply their own branded needs, 
with little or no excess to sell as unbranded.

* Major branded refiners are managing their inventory more efficiently, 
ensuring that they produce only enough gasoline to meet their current 
branded needs.

GAO could not quantify the extent of the decrease in the unbranded 
gasoline supply because the data required for such analyses do not 
exist.

The second change identified by these officials is that refiners now 
prefer dealing with large distributors and retailers because they 
present a lower credit risk and because it is more efficient to sell a 
larger volume through fewer entities. Refiners manifest this preference 
by setting minimum volume requirements for gasoline purchases. These 
requirements have motivated further consolidation in the distributor 
and retail sectors, including the rise of hypermarkets.

Mergers and Increased Market Concentration Generally Led to Higher U.S. 
Wholesale Gasoline Prices: 

GAO's econometric modeling shows that the mergers GAO examined mostly 
led to higher wholesale gasoline prices in the second half of the 
1990s. GAO's analysis shows that the majority of the eight specific 
mergers examined--Ultramar Diamond Shamrock (UDS)-Total, Tosco-Unocal, 
Marathon-Ashland, Shell-Texaco I (Equilon), Shell-Texaco II (Motiva), 
BP-Amoco, Exxon-Mobil, and Marathon Ashland Petroleum (MAP)-UDS--
resulted in higher prices of wholesale gasoline in the cities where the 
merging companies supplied gasoline before they merged. For the seven 
mergers that GAO modeled for conventional gasoline, five led to 
increased prices, especially the MAP-UDS and Exxon-Mobil mergers, where 
the increases generally exceeded 2 cents per gallon. For the four 
mergers that GAO modeled for reformulated gasoline, two--Exxon-Mobil 
and Marathon-Ashland--led to increased prices of about 1 cent per 
gallon, on average. In contrast, the Shell-Texaco II (Motiva) merger 
led to price decreases of less than one-half cent per gallon for 
branded gasoline only. For the two mergers--Tosco-Unocal and Shell-
Texaco I (Equilon)--that GAO modeled for the reformulated gasoline used 
in California, known as California Air Resources Board (CARB) gasoline, 
only the Tosco-Unocal merger led to price increases. The increases were 
for branded gasoline only and exceeded 6 cents per gallon. The effects 
of some of the mergers were inconclusive, especially for boutique fuels 
sold in the East Coast and Gulf Coast regions and in California.

For market concentration, which captures the cumulative effects of 
mergers as well as other competitive factors, GAO's econometric 
analysis shows that increased market concentration resulted in higher 
wholesale gasoline prices. Prices increased for conventional (non-
boutique) gasoline, the dominant type of gasoline sold nationwide from 
1994 through 2000, by less than one-half cent per gallon for branded 
and unbranded gasoline. The increases were larger in the West than in 
the East--the increases were between one-half cent and 1 cent per 
gallon in the West, and about one-quarter cent in the East (for branded 
gasoline only). Price increases for boutique fuels sold in some parts 
of the East Coast and Gulf Coast regions and in California were larger 
compared to the increases for conventional gasoline. The wholesale 
prices increased by about 1 cent per gallon for boutique fuel sold in 
the East Coast and Gulf Coast regions between 1995 and 2000, and by 
over 7 cents per gallon in California between 1996 and 2000.

GAO's analysis shows that wholesale gasoline prices were also affected 
by other factors included in the econometric models--particularly, 
gasoline inventories relative to demand, refinery capacity utilization 
rates, and the supply disruptions that occurred in some parts of the 
Midwest and the West Coast. In particular, wholesale gasoline prices 
were about 1 cent per gallon higher when gasoline inventories were low 
relative to demand, typically in the summer driving months. Also, 
prices were higher by about one-tenth to two-tenths of 1 cent per 
gallon when refinery capacity utilization rates increased by 1 percent. 
The prices of conventional gasoline were about 4 to 5 cents per gallon 
higher on average during the Midwest and West Coast supply disruptions. 
The increase in prices for CARB gasoline was about 4 to 7 cents per 
gallon, on average, during the West Coast supply disruptions.

Recommendations for Executive Action: 

GAO is not making recommendations in this report.

Agency Comments and GAO's Evaluation: 

GAO provided a draft of this report to FTC for its review and comment. 
FTC stated that the draft report was flawed and did not provide a basis 
for reliable judgments about the competitive effects of mergers in the 
petroleum industry. However, GAO believes that its analyses are sound 
and consistent with the views of independent economists and experts 
that peer reviewed GAO's overall modeling approach. In particular, Dr. 
Severin Borenstein, a recognized expert in the modeling of gasoline 
markets, reviewed and commented on GAO's econometric analysis and 
results at several stages. In response, GAO made revisions in the 
course of developing and estimating its models and in its final report, 
as appropriate. In addition, partly in response to FTC's comments, GAO 
re-estimated its models to account for the effects of gasoline supply 
disruptions that occurred in some parts of the West Coast and Midwest 
regions.

FTC focused a substantial portion of its comments on GAO's econometric 
models, outlining five concerns. First, FTC asserted that the models 
did not control for the many factors that could cause gasoline price 
increases, citing the following factors: seasonality, temperature, 
income, changes in gasoline formulations, and supply disruptions in the 
Midwest and West Coast regions. This assertion is not correct. GAO's 
models incorporated key factors that affect wholesale gasoline prices, 
including crude oil prices, refinery capacity utilization rates, and 
gasoline inventory-to-demand ratio--a ratio that captures the effects 
of seasonality and temperature. GAO considered the available data for 
income by city but found that income data did not vary over time and 
therefore would not be appropriate for the estimation technique (fixed-
effects) that GAO used. GAO controlled for changes in gasoline 
formulations between seasons through the inventory-to-demand ratio; 
other changes in formulations either occurred outside the time period 
that GAO examined or were unlikely to significantly affect the results. 
During GAO's December 2002 meeting with FTC staff, the staff agreed 
that the effects of other formulations could be minimal because these 
other formulations are typically a small percentage of the total volume 
of gasoline in the areas that GAO modeled. Regarding the potential 
effects of the Midwest and West coast supply disruptions, GAO believes 
that the models indirectly captured these effects through the 
inventory-to-demand ratio. Nonetheless, in response to FTC's comments, 
GAO included a proxy for these disruptions in its models.

Second, FTC stated that GAO's modeling of the effect of market 
concentration on wholesale gasoline prices was problematic, primarily 
because the agency claimed that the methodology GAO used did not 
meaningfully distinguish correlation from causation. GAO disagrees. 
Modeling using appropriate economic structure is a common basis for 
inferring causation, and GAO's market concentration model is consistent 
with previous studies on prices and market concentration.

Third, FTC said that GAO used geographic markets that were empirically 
unjustified to conduct its analysis. GAO recognizes the importance and 
difficulty of defining relevant geographic markets for gasoline, 
especially at the wholesale level, and discussed this issue with FTC 
and other industry experts. FTC indicated that it could not provide 
specific evidence on what the actual geographic markets for wholesale 
gasoline were across the United States because, when analyzing 
potential mergers, FTC focuses on a limited geographic area and relies 
substantially on proprietary company data. Like other industry experts 
that GAO contacted, FTC staff agreed in a December 2002 meeting that it 
was appropriate to use terminal cities and even states, in some cases, 
as geographic markets for wholesale gasoline. GAO therefore used 
terminal (rack) cities as the geographic unit. In measuring market 
concentration at the wholesale level, the draft report that GAO 
provided to FTC used HHI data from DOE's Energy Information 
Administration (EIA) that were based on sales of prime suppliers of 
wholesale gasoline and available only at the state level. In the final 
report, GAO measured market concentration using HHI data that GAO 
constructed based on refinery capacity at the PADD level, after 
consultation with GAO's expert consultant/reviewer, because GAO 
believes that market concentration at the refining level more 
effectively captures the potential market power of the refiners.

Fourth, FTC said that GAO's modeling results are, in many cases, not 
robust. By robustness, FTC meant that model results yielded by 
alternative modeling approaches should be consistent. GAO believes that 
the results for its models' key variables--mergers and market 
concentration--are robust because these models yielded consistent 
results using alternative model specifications. In particular, when GAO 
estimated its models without including the effects of supply 
disruptions in the affected markets, the effects of the key policy 
variables--mergers and market concentration--were consistent with the 
results obtained when GAO incorporated the effects of supply 
disruptions. Furthermore, because market concentration reflects the 
cumulative effects of the mergers and other competitive factors, one 
would expect the results from both approaches--market concentration 
models and mergers models--to be similar if mergers are the predominant 
contributing factor to market concentration. In GAO's study, the 
overall results for both approaches were consistent. GAO believes these 
are valid demonstrations of the robustness of its model results.

Fifth, FTC said that GAO did not provide complete technical 
documentation for its econometric models. This is not correct. GAO 
provided a detailed and complete description of the basis of its 
econometric models, including data sources, sample selection processes 
(including tables detailing the list of variables, definitions, 
sources, data frequency, and level), specifications of the econometric 
models, and estimation techniques.

In addition to criticizing GAO's models, FTC also criticized GAO's 
findings about the effects of mergers on the structure of the petroleum 
industry and U.S. gasoline marketing. Specifically, the agency 
commented that GAO's findings--that mergers have contributed to 
barriers to entry and vertical integration and that the availability of 
unbranded gasoline has decreased--lacked quantitative foundations and 
were therefore flawed. GAO disagrees with this opinion. Economic 
findings can be qualitative or quantitative. GAO stated in its report 
that it could not quantify the extent to which mergers have affected 
barriers to entry and vertical integration because of a lack of 
comprehensive data to fully measure these factors and because there is 
no consensus on how to appropriately measure them. GAO's finding that 
mergers have contributed to barriers to entry was based on information 
from industry officials who provided examples, which GAO included in 
its report, to validate this finding. While GAO discussed the overall 
importance of barriers to entry in a market, which FTC recognizes in 
its merger guidelines, GAO did not conclude, contrary to FTC's 
assertions, that barriers to entry have harmed or eliminated 
competition in the industry. To validate GAO's finding that mergers 
have contributed to vertical integration, GAO presented examples of 
mergers--particularly in the downstream segment between refiners and 
marketers--that were vertical in nature (that is, the mergers involved 
different functional levels of the merging companies) and would 
contribute to increased vertical integration. GAO also added language 
to its report, as suggested by EIA, acknowledging the shift during the 
1990s toward fully integrated companies' divestiture of certain 
downstream assets, such as refineries, to nonintegrated companies. For 
its finding that unbranded gasoline has become less available, GAO 
relied on extensive interviews with industry participants in different 
regions of the country. While it would be desirable to ascertain this 
finding quantitatively, GAO noted in its report that EIA--the federal 
agency mandated by Congress to collect energy data, including data on 
gasoline supply--told GAO that the agency does not require petroleum 
companies to report gasoline data in the form that would permit the 
identification of branded and unbranded sales.

The full text of FTC's comments and GAO's responses are included in 
appendixes V and VI. Appendix V contains the comments from FTC 
Commissioners and appendix VI contains the comments from FTC's Bureau 
of Economics staff.

[End of section]

Chapter 1: Introduction: 

Since the 1990s, the U.S. petroleum industry has experienced a wave of 
mergers, acquisitions, and joint ventures (hereafter referred to as 
mergers). Some of these mergers involved well known major petroleum 
companies that had previously competed with each other for the sale of 
gasoline and other petroleum products. There were also numerous mergers 
between smaller companies. Some policy makers and consumer groups 
believe that these mergers may have reduced competition in the U.S. 
petroleum industry and ultimately led to higher gasoline prices. During 
the second half of the 1990s, U.S. gasoline prices exhibited periods of 
high price volatility, with fairly frequent price spikes. The price of 
crude oil, the primary input for producing gasoline, was similarly 
volatile.

The Petroleum Industry Consists of Three Main Segments: 

As depicted in figure 1, the U.S. petroleum industry consists of the 
exploration and production segment (upstream); the refining and 
marketing segment (downstream); and a third segment typically referred 
to as the midstream, which consists of the infrastructure used to 
transport crude oil and petroleum products. Some of the petroleum 
companies in the United States, like Exxon-Mobil and Chevron-Texaco, 
operate in all segments of the industry--that is, they are fully 
vertically integrated. Others, like Anadarko and Valero, that operate 
in one or more but not all segments are generally called partially 
vertically integrated or independents.[Footnote 2]

Figure 1: U.S. Petroleum Industry Chain: 

[See PDF for image]

[End of figure]

The Upstream Segment: 

The activities of the upstream segment consist essentially of 
exploration for and production of crude oil and natural gas. Hence, the 
upstream is also referred to as the exploration and production segment. 
Participants in the U.S. upstream include fully vertically integrated 
companies and independent producers. The U.S. upstream segment is 
characterized by a large number of independent producers and a smaller 
number of fully vertically integrated oil companies.

The Energy Information Administration (EIA)--the independent 
statistical and analytical agency within the U.S. Department of Energy 
(DOE)--has classified U.S. upstream operators into three main 
categories according to the size of their production in 2001, not 
according to whether they are integrated or independent: 

* large operators--who produced a total of 1.5 million barrels or more 
of crude, 15 billion cubic feet of natural gas, or both;

* intermediate operators--who produced a total of at least 400,000 
barrels of crude oil, 2 billion cubic feet of natural gas, or both, but 
less than the large operators; and: 

* small operators--who produced less than the intermediate operators.

Based on this classification, EIA estimated that as of 2001, there were 
179 large operators, which accounted for 84.2 percent of crude oil 
production; 430 intermediate operators, which accounted for 5.8 percent 
of crude oil production; and 22,519 small operators, which accounted 
for 10 percent of crude oil production.

Fully vertically integrated companies are generally large operators, 
while independent producers are generally small operators, with a few 
medium and large operators. While the fully vertically integrated 
companies are generally multibillion dollar companies that are publicly 
traded, the independent producers include many extremely small, 
privately owned operations as well as a few multibillion dollar and 
publicly traded companies. In general, the fully vertically integrated 
companies have upstream operations both in the United States and 
overseas and accounted for about 60 percent of U.S. crude oil 
production in 2002. On the other hand, the exploration and production 
activities of the independents occur: 

mostly in the United States and accounted for about 40 percent of the 
crude oil produced in the United States in 2002.[Footnote 3]

The price of crude oil produced in the United States is determined in 
the world oil market because the decontrol of domestic oil prices in 
1981 has effectively linked the U.S. oil market to the world oil 
market. In 2000, the United States contained only about 2 percent of 
world's estimated oil reserves but accounted for about 26 percent of 
the world's oil demand. From 1990 to 2000, U.S. production decreased 
significantly, from about 7.4 million barrels per day (mmb/d), or about 
55.5 percent of total U.S. crude oil supply, to about 5.8 mmb/d, or 39 
percent of total crude oil supply. Nevertheless, the United States was 
still the world's third largest producer of crude oil. U.S. reliance on 
oil imports has increased over the last decade as domestic production 
has dwindled.

The Midstream Segment: 

The midstream segment transports crude oil and petroleum products. 
Petroleum transportation facilities include pipelines, marine tankers 
and barges, railways, and trucks. Pipelines and, to a lesser extent, 
the other carriers transport domestically produced crude oil from the 
production points to the refineries, while marine carriers generally 
transport imported oil. Refined products, such as gasoline, are also 
carried via these modes from refineries to storage terminals, from 
which they are generally transported by trucks to retail stations.

In general, pipelines are the dominant and most efficient mode of 
transporting crude oil and petroleum products in the United States. 
According to data from the Association of Oil Pipelines, pipelines 
transported 66.1 percent of all the crude and petroleum products in the 
United States in 2000. Marine tankers and barges transported 28 
percent, while trucks and railways hauled 3.6 percent and 2.3 percent, 
respectively. According to DOE's Office of Transportation Technology, 
there are more than 200,000 miles of oil pipelines in the United States 
in all 50 states. The Federal Energy Regulatory Commission (FERC) 
regulates the rates on common carrier pipelines. The Association of Oil 
Pipelines told us that FERC currently regulates about 202 pipeline 
companies. According to the pipeline association, 84 percent of the 
pipelines are federally regulated while 16 percent are not.

The Downstream Segment: 

Refining and marketing are the main activities of the downstream 
segment. Refining is the process of transforming crude oil into 
petroleum products ranging from gasoline and distillate fuel oil 
(heating oil) to heavier products such as asphalt. As figure 2 shows, 
gasoline accounted for nearly half of U.S. refinery output in 
2000.[Footnote 4]

Figure 2: Product Yield from a Barrel of Crude Oil, 2000: 

[See PDF for image]

[End of figure]

According to data from EIA, as of January 1, 2002, there were 149 
operable refineries in the United States, with a total crude oil 
distillation capacity of about 16.8 mmb/d. Overall, 60 refining firms, 
including large fully vertically integrated companies and independent 
refiners, owned these refineries.[Footnote 5] The refining companies 
ranged in size from the smallest, with only 880 barrels per day of 
crude oil distillation capacity, to the biggest, with a combined 
refinery capacity of 1.8 mmb/d of crude distillation. Not all of these 
refineries produce gasoline; some, especially those with small 
distillation capacity, produce only asphalt.

Marketing in the downstream involves selling petroleum products to 
customers, who are generally wholesale and retail purchasers. For 
gasoline, as shown in figure 1, refiners arrange to move products from 
the refineries to storage terminals, from which they sell the product 
to wholesale purchasers. As discussed in detail in chapter 4, there are 
different classes of wholesale gasoline purchasers in the United 
States, and the prices they pay depend, in part, on the type of 
relationship they have with the refiners. From the terminals, gasoline 
is distributed to retail stations for sale to final consumers.

Different Entities Have Historically Exerted Influence over the World 
Petroleum Market: 

The world petroleum market, of which the U.S. market is a part, has 
been characterized by eras when a relatively small number of entities 
exerted considerable influence on the market. Three entities in 
particular have significantly influenced the world petroleum market 
during their eras: (1) Standard Oil, (2) the "Seven Sisters," and (3) 
the Organization of Petroleum Exporting Countries (OPEC). Figure 3 
shows a timeline of the major events that shaped the eras dominated by 
these entities.

Figure 3: Major Events in the World Petroleum Market: 

[See PDF for image]

[End of figure]

The Standard Oil Era: 

The Standard Oil Company was established in 1870, about a decade after 
the discovery of crude oil in commercial quantity in the United States, 
and the company quickly became the dominating force in the emerging 
U.S. petroleum industry. During the decade prior to the establishment 
of Standard Oil, the new industry experienced periods of overcapacity 
in both crude oil production and refining. The industry consisted of 
numerous independent producers and refiners. Railroad companies 
provided transportation services for crude oil and refined products. 
Thus, the industry tended to be intensely competitive and, by the end 
of the 1860s, the industry had excess crude oil supply and refinery 
capacity, resulting in frequent price fluctuations and price collapses.

In response to these conditions, Standard Oil adopted a process of 
consolidation that would ultimately lead to the virtual monopolization 
of the industry. Specifically, it employed a combination of tactics 
that included acquisitions and buyouts of competitors, vertical 
integration, control of transportation, and below-cost pricing to force 
competitors out of business. By the time Standard Oil was broken into 
separate companies in 1911 under the Sherman Antitrust Act, the company 
was able to effectively determine the purchase price for American crude 
oil. The breakup of Standard Oil ended its dominance as a single 
company over the U.S. petroleum market. However, the resulting separate 
companies began seeking ways to cooperate among themselves and with 
other foreign oil companies to control the global supply and price of 
oil.

The "Seven Sisters" Era: 

During the decades following the breakup of Standard Oil until about 
1970, seven oil companies--Exxon, Mobil, Chevron, Gulf, Texaco, Royal 
Dutch/Shell, and British Petroleum (BP)--dominated and controlled the 
global network for supplying, pricing, and marketing crude oil. Because 
of their close association and multiple joint ventures, these companies 
ultimately became known as the "Seven Sisters." The strategies the 
companies employed to control the world petroleum market sometimes 
included cooperation and collusion among themselves. For example, as a 
surge of oil supply from the United States and other countries flooded 
the world market in the 1920s, the ensuing competition between some of 
the companies for market share precipitated collapsing oil prices and 
threatened the security of their markets. In response, Exxon, Royal 
Dutch Shell, and BP met to draw up a series of agreements in the late 
1920s and 1930s to curb what they viewed as "ruinous competition" in 
the market. The overall thrust of the agreements was to allocate market 
shares or quotas; fix prices; and eliminate, through acquisitions and 
other means, the potential competitive impact of other oil companies 
outside their group, namely the independent producers and refiners.

Although by the 1960s the Seven Sisters had lost some ground in the 
world petroleum market--especially in the United States where the role 
of the independents continued to increase--as late as 1972, the seven 
companies were still producing 91 percent of the Middle East's crude 
oil and 77 percent of the supply outside the United States and the 
former Soviet Union. By the 1960s and 1970s, the United States had 
become a substantial net importer of oil.

The OPEC Era: 

OPEC was formed in 1960 after members of the Seven Sisters unilaterally 
cut the posted price of Middle Eastern crude oil--upon which they paid 
taxes and royalties to the producing nations--without consulting the 
producing nations. The founding members of OPEC were Saudi Arabia, 
Iraq, Iran, Kuwait, and Venezuela. Over time, the organization's 
membership grew to 13, with the addition of the United Arab Emirates, 
Nigeria, Libya, Qatar, Algeria, Indonesia, Ecuador, and Gabon.[Footnote 
6] The aim of the organization was to create an entity through which 
member countries could jointly confront the Seven Sisters over the 
control of their oil. The group had little or no influence on the world 
oil market during its first 10 years, partly because the international 
oil companies, not OPEC member countries, owned and controlled oil 
reserves in those countries in the 1960s. OPEC also lacked sufficient 
cohesion among its members to effectively challenge the influence of 
the Seven Sisters. Since the 1970s, however, OPEC has been a dominant 
force in the world oil market. OPEC became a major influence in 1973 
when it orchestrated a nearly fourfold price increase in a matter of 
months through an oil embargo by its Arab members against the United 
States and other countries friendly to Israel. Two other major oil 
price episodes resulting from events in OPEC member countries also 
occurred. In 1979 the Iranian revolution caused the doubling of crude 
oil prices from about $14 a barrel to $34 a barrel, and in 1990 the 
Iraqi invasion of Kuwait caused an immediate increase in the crude oil 
price from about $16 a barrel to about $28 barrel.

As a group, OPEC holds the world's largest and lowest-cost reserves of 
crude oil. As figure 4 shows, OPEC countries accounted for over two-
thirds of the world's estimated conventional reserves of about 1 
trillion barrels in 2001 (the latest available data). Persian Gulf OPEC 
countries had by far the largest reserves, with Saudi Arabia alone 
accounting for over one-fourth of world reserves. In contrast, the 
United States contained an estimated 2 percent of world reserves.

Figure 4: Shares of the World's Conventional Crude Oil Reserves 
(February 2003): 

[See PDF for image]

[End of figure]

Moreover, as shown in figure 5, OPEC countries, especially Saudi 
Arabia, also hold most of the world's excess production capacity, which 
means they are the only countries in a position to increase production 
relatively quickly if there is a supply shortage in the world oil 
market. These conditions give OPEC countries considerable flexibility 
to influence world oil prices.

Figure 5: World's Estimated Excess Production Capacity (February 2003): 

[See PDF for image]

[End of figure]

During the 1980s, OPEC nations abandoned their strategy of setting 
"official" prices for their crude oil, but the individual and/or 
collective actions of the organization's member countries can still 
have a significant impact on world oil prices. OPEC now establishes a 
"target" price during its biannual meetings. To achieve this price, 
OPEC sets an aggregate production level, or quota, based on the 
organization's determination of the demand for its oil. OPEC then 
allocates voluntary production quotas among its members, primarily 
based on the size of each member's oil reserves and other negotiated 
factors. Whether or not the target price is achieved depends on the 
discipline exercised in producing oil, as well as the actual demand for 
oil and non-OPEC countries' production levels. If, by adjusting its 
production, OPEC keeps the world's oil supply relatively tight with 
respect to demand, the average world price will likely be close to the 
target price range.

FTC and DOJ Review Proposed Mergers to Preserve Market Competition: 

While crude oil prices are determined by global market forces and 
particularly by OPEC countries' actions, the prices of gasoline and 
other petroleum products are generally influenced by, among other 
things, the extent of domestic market competition. Thus, U.S. antitrust 
laws, which are enforced by the Federal Trade Commission (FTC) and the 
Department of Justice (DOJ), prohibit mergers and other activities that 
may be anticompetitive. As part of their responsibility for enforcing 
the antitrust laws, FTC and DOJ review proposed mergers to ensure they 
would not be anticompetitive. Under the Hart-Scott-Rodino Act of 
1976,[Footnote 7] as amended, companies contemplating a merger valued 
at $15 million or more ($50 million or more from February 1, 2001) and 
meeting certain other conditions must formally notify these agencies. 
There is then a 30-day waiting period to allow FTC or DOJ to review the 
proposed merger to determine its potential effect on 
competition.[Footnote 8] If the review does not indicate a need for 
further investigation, the merger can be consummated at the end of the 
waiting period or earlier if the parties request early termination of 
the waiting period and the request is granted.[Footnote 9] According to 
an FTC official, FTC generally handles mergers in the petroleum 
industry because of its expertise in the area.

The agencies will challenge a merger if it may substantially lessen 
competition or tend to create or enhance market power or to facilitate 
its exercise. Guidelines issued jointly by DOJ and FTC in 1992 outline 
how the agencies generally analyze proposed horizontal mergers and 
indicate when the government is likely to challenge a merger.[Footnote 
10] For a recent GAO report, FTC staff told us that the majority of 
mergers that raise antitrust concerns are horizontal mergers (mergers 
between firms operating in the same market).[Footnote 11] The 
guidelines indicate that horizontal mergers should not be permitted to 
create, enhance or facilitate the exercise of market power, which is 
the ability of one or more firms to profitably maintain prices above 
competitive levels for a significant period of time.

In reviewing proposed horizontal mergers, FTC first examines market 
concentration--a function of the number of firms in a market and their 
respective market shares. Other things being equal, market 
concentration affects the likelihood that one company, or a small group 
of firms, could successfully exercise market power. The merger 
guidelines identify the Herfindahl-Hirshman Index (HHI) as the measure 
used in evaluating market concentration. The HHI reflects the 
composition of a market while giving proportionately greater weight to 
the market shares of the larger firms.[Footnote 12] The higher the HHI, 
the greater the market concentration. According to the guidelines, a 
merger will generally not be challenged in a market where HHI after the 
proposed merger would be: 

* less than 1,000 points (an unconcentrated market);

* 1,000 to 1,800 points (a moderately concentrated market), and the HHI 
would be increased by less than 100 points by the merger; or: 

* over 1,800 points (a highly concentrated market), and the merger 
would increase it by less than 50 points.

Mergers that would increase the concentration above these levels will 
be examined further by the agency. Other factors that affect market 
competitiveness, such as barriers to entry into a market, are also 
considered in deciding whether to challenge a proposed merger. (See 
chapter three of this report for further discussion of these factors 
and HHI).

If FTC determines that a merger has potential anticompetitive effects, 
it can litigate to block the merger; negotiate a settlement to resolve 
anticompetitive aspects of the merger while allowing the transaction to 
go forward; or develop a consent arrangement that allows the merger to 
proceed but requires divestiture of assets to remedy the decrease in 
competition that would otherwise result. FTC has required divestiture 
of assets in some of the mergers in the petroleum industry since the 
1990s. For example, FTC required that Exxon divest all its retail 
stations from New York to New England and that Mobil divest all its 
retail stations from New Jersey to Virginia as a condition for the 
merger between the two companies. Tosco acquired these stations.

Objectives, Scope, and Methodology: 

As requested by the Ranking Minority Member, Permanent Subcommittee on 
Investigations of the Senate Committee on Governmental Affairs, this 
report examines the impact of mergers on the U.S. petroleum industry. 
It includes an econometric modeling of the effects of mergers and 
market concentration on U.S. wholesale gasoline markets. Specifically, 
the report examines: 

* mergers in the U.S. petroleum industry from the 1990s through 2000 
and why they occurred,

* the extent to which market concentration and other aspects of market 
structure in the petroleum industry have changed since the 1990s as a 
result of mergers,

* the major changes that have occurred in U.S. gasoline marketing since 
the 1990s, and: 

* the effect of mergers and market concentration in the U.S. petroleum 
industry on U.S. gasoline prices at the wholesale level.

To examine mergers in the U.S. petroleum industry in the 1990s and why 
they occurred, we analyzed a large body of data on petroleum industry 
merger transactions that occurred in the United States from the 1990s 
through 2000. We purchased data on mergers that occurred in all 
segments of the U.S. petroleum industry from 1990 through 2000 from 
John S. Herold, Inc., and Thompson Financial. We also obtained 
information from EIA on some of the industry's mergers since the 1990s. 
In addition, we interviewed officials from these entities. We also 
interviewed petroleum industry officials, including those whose firms 
were involved in mergers, and experts to obtain their views on the 
reasons for the mergers and reviewed relevant economic literature and 
FTC documents.

To assess the extent to which market concentration and other aspects of 
market structure have changed since the 1990s as a result of mergers, 
we obtained data on petroleum industry market shares from the Oil and 
Gas Journal (OGJ) and EIA. We also used the merger data from John S. 
Herold, Inc., and Thomson Financial. Using these data, we calculated 
and analyzed changes in the HHI--a measure of market concentration--for 
the various segments of the industry and, as necessary, for the 
relevant geographic markets, from the 1990s through 2000 or 2001, where 
data availability allowed.[Footnote 13] We also calculated correlation 
coefficients, where data availability permitted, to determine the 
extent to which changes in market concentration were statistically 
correlated with mergers. Because empirical data on other aspects of 
market structure--essentially vertical integration and barriers to 
entry--are usually not available, particularly at the broad levels that 
our study examined, we relied instead on an extensive body of relevant 
economic literature. Economic research on market structure is abundant 
and well developed, although it has rarely been applied specifically to 
the petroleum industry. We also interviewed oil industry officials and 
experts to obtain their views.

To determine what major changes have occurred in U.S. gasoline 
marketing since the 1990s, we analyzed EIA's data on gasoline 
marketing, reviewed relevant studies and documents from EIA and 
industry sources, and interviewed petroleum industry officials and 
experts and EIA officials.

To examine how mergers and market concentration have affected U.S. 
gasoline prices at the wholesale level, we developed econometric models 
that examined the effect of mergers and of market concentration on U.S. 
wholesale gasoline markets from 1994 through 2000. We chose 1994 as the 
initial year of our analysis because the market concentration (HHI) 
data on wholesale gasoline provided by EIA were available from 1994. 
Also, the Oil Price Information Service (OPIS), the company from whom 
we purchased the wholesale gasoline price data, informed us that it had 
more comprehensive data on U.S. wholesale gasoline prices starting in 
the second half of the 1990s than earlier. We developed two groups of 
econometric models: 

* one to estimate the impact of selected individual mergers on the 
wholesale gasoline price (measured in this report as wholesale gasoline 
price minus crude oil cost) in affected terminal markets and: 

* another to estimate the impact of market concentration, which 
essentially captures the cumulative effects of all the mergers in the 
U.S. wholesale petroleum industry during the 1990s as well as the 
effects of other changes in the structure of U.S. wholesale gasoline 
markets on wholesale gasoline prices in different U.S. geographic 
regions.

In doing so, we isolated the effects of mergers and market 
concentration from several other factors that could influence wholesale 
gasoline prices, such as crude oil costs, gasoline inventories relative 
to demand, refinery capacity utilization rates, and gasoline supply 
disruptions. We also differentiated among fuel formulations in our 
analyses. Retail gasoline prices that consumers ultimately pay may be 
affected by many other factors that vary from location to location, 
including, among other things, taxes, land values, zoning regulations, 
and competition at the retail level. We did not examine the effects of 
such factors because this study focuses on wholesale gasoline prices.

We provided a detailed draft outline of our econometric methodology, 
including a description of the types and sources of data we used, to a 
cross section of experts in academia, industry, and government for peer 
review and comment. We discussed extensively our econometric 
methodology, including data requirements, with the staff of FTC's 
Bureau of Economics. We requested comments from the American Petroleum 
Institute (API) on our econometric methodology, but they did not 
provide any comments. We also provided the same draft outline and our 
estimated results and interpretations to our consultant/peer reviewer, 
Dr. Severin Borenstein, E.T. Grether Professor of Business 
Administration and Public Policy and Director of the California Energy 
Institute at the University of California, Berkeley, for review and 
comment. See appendix II for a list of expert peer reviewers. Based on 
comments from and discussions with these experts and this consultant, 
we revised our models and interpretations as appropriate. Also, we 
interviewed industry officials and representatives involved in all 
aspects of the petroleum industry and in all major U.S. regions, oil 
industry experts, and officials from relevant federal and state 
agencies. In addition, we reviewed numerous economic studies on 
gasoline markets and pricing, including the few studies that have 
modeled the impact of mergers on gasoline markets; several textbooks on 
econometrics and industrial organization; and econometric studies of 
the impact of mergers and market concentration on other industries. 
Appendix IV contains details on our models' methodology, types and 
sources of data we used, and our econometric analysis.

Although in building our models we drew substantial insight from 
existing models, our models differ from most previous ones in three 
principal ways. First, to our knowledge, our study is the first to 
model the impact of the petroleum industry's merger wave in the 1990s 
on the wholesale gasoline prices for the entire United States, while 
isolating the effects of major boutique fuels and unique geographic 
markets as well as the effects of specific (individual) mergers, 
including some of the largest in the industry's history. Doing so 
required us to acquire large and expensive data and make complex 
computations. Second, we studied the behavior of wholesale prices 
because this allows us to capture the net effect of any potential 
market power and efficiency gains from mergers and market 
concentration. Third, we included the effects of refinery capacity 
utilization rates and of gasoline inventories, whereas other studies 
have either omitted these variables entirely or included only one.

Most of the data used for our econometric analysis of the impact of 
mergers and market concentration on wholesale prices were purchased 
from OPIS, a company that collects and sells oil industry information 
to oil companies and other entities. We also obtained data from EIA and 
the Department of Commerce's Bureau of the Census.

This report did not assess the appropriateness of FTC's review or the 
actions they took regarding mergers in the petroleum industry. However, 
we obtained detailed comments from FTC staff and commissioners and EIA 
staff on our modeling approach and revised our models and report where 
appropriate.

We conducted our review between June 2001 and April 2004 in accordance 
with generally accepted government auditing standards.

[End of section]

Chapter 2: All Segments of the Petroleum Industry Experienced Mergers 
for Several Reasons: 

During the 1990s, mergers occurred in all segments of the U.S. 
petroleum industry, but the upstream segment had the most mergers. The 
majority of the mergers--especially mergers among large firms--occurred 
in the second half of the decade. According to petroleum industry 
officials, mergers occurred in the petroleum industry for several 
reasons mostly related to the firms' desire to maximize profits through 
efficiency gains and cost savings. In addition to these reasons, 
economic literature also indicates that firms' desire to enhance their 
market power is a motive for mergers.

Mergers Occurred in All Three Segments, but Most Frequently in the 
Upstream: 

A total of over 2,600 merger transactions occurred in the U.S. 
petroleum industry from 1991 through 2000.[Footnote 14] As shown in 
figure 6, the upstream segment accounted for almost 85 percent of these 
mergers. About 13 percent of the mergers occurred in the downstream 
segment. The midstream segment, specifically pipelines--a key 
infrastructure for moving crude oil and petroleum products--accounted 
for about 2 percent of the mergers.[Footnote 15]

Figure 6: Percentage of Mergers That Occurred in Each Segment of the 
Petroleum Industry (1991-2000): 

[See PDF for image]

Note: When a merger involved the acquisition of assets simultaneously 
in each segment, it was counted in the segment with the largest 
monetary value.

[End of figure]

As shown in figure 7, mergers in all segments occurred more frequently 
in the mid-to late 1990s than in the early 1990s. Some of the mergers 
involving vertically integrated oil companies and large independent 
refiners occurred during this time (see figure 8).[Footnote 16]

Figure 7: Petroleum Industry Merger Trends (1991-2000): 

[See PDF for image]

[End of figure]

Figure 8: Selected Major Petroleum Mergers (1996-2002): 

[See PDF for image]

[End of figure]

Mergers that occurred in the petroleum industry in the 1990s were 
categorized into two broad transaction types: corporate mergers and 
asset mergers.[Footnote 17] About 20 percent of the mergers that 
occurred in the U.S. petroleum industry were corporate mergers,which 
generally involve the acquisition of a company's total assets by 
another so that the two become one company.[Footnote 18] Most of the 
mergers depicted in figure 8, such as Exxon-Mobil, BP-Amoco, Chevron-
Texaco, and Valero-UDS, were corporate mergers.

The majority of the mergers (about 80 percent) were asset mergers, 
which involved one company's purchase of only a segment or asset of 
another company, such as Williams' purchase of three storage and 
distribution terminals from Amerada Hess in 1999 and Tosco's 
acquisition of Unocal's refining and marketing assets on the West 
Coast. Similarly, the majority of the mergers that occurred in each of 
the segments were asset mergers. In the upstream, about 85 percent of 
the merger transactions were asset mergers, involving the acquisition 
of oil and/or gas reserves.[Footnote 19] In the downstream segment, 
about 54 percent were asset mergers, where one or more downstream 
assets--such as refining or gasoline service station assets--were 
purchased. As figure 9 shows, 71 percent of all mergers in the 
downstream segment involved the acquisition of wholesale distribution 
assets.

Figure 9: Percentage of Merger Transactions within the Downstream 
Segment by Type of Key Assets Acquired: 

[See PDF for image]

Note: According to the data from John S. Herold, Inc., the wholesale 
marketing category presented here includes both those establishments 
engaged in wholesale gasoline marketing and those engaged in the 
storage and/or wholesale distribution of crude petroleum, other 
petroleum products, and natural gas (including liquid petroleum gas).

[End of figure]

As shown earlier, mergers involving transportation assets in the 
midstream segment accounted for a small percentage of the total merger 
transactions in the industry. About 65 percent of the midstream merger 
transactions were asset mergers.

The mergers varied widely in terms of transaction values,but the 
highest value mergers were corporate mergers. Our merger data included 
transaction values for about 57 percent of the mergers, and those 
values ranged from less than $1 million to over $10 billion. As 
indicated in chapter 1, under the Hart-Scott-Rodino Act, firms 
contemplating mergers with a transaction valued at $50 million or more 
are required to provide information to FTC and the Department of 
Justice and to observe a waiting period before completing the 
transaction while it is reviewed for potential anticompetitive effects. 
FTC reviews required some petroleum companies that merged to divest 
assets to remedy potential anticompetitive effects.

As figure 10 shows, the majority of the reported transaction values 
were below $50 million, and over 89 percent of these mergers were asset 
transactions. Of the mergers with reported transactions values, about 
32 percent of them exceeded $50 million, and about 3 percent were over 
$1 billion. The latter accounted for over 83 percent of the total 
dollar value reported for all petroleum mergers during the past decade.

Figure 10: Range of Reported Merger Transaction Values (1991-2000): 

[See PDF for image]

[End of figure]

Several Reasons Were Cited for Mergers in the Petroleum Industry: 

Petroleum industry officials and experts that we spoke with cited a 
number of reasons for the wave of mergers in the industry in the 1990s. 
These reasons generally related to the need for increased efficiency 
and cost savings to ultimately maximize profits. Specifically, as 
discussed below, the officials and experts said that mergers were 
motivated by the firms' desire to achieve synergies, diversify their 
assets, reduce costs, enhance stock values, and respond to price 
volatility.[Footnote 20] However, economic literature also indicates 
that the desire to enhance and use market power--as a means to help 
maximize profits--may also have been a motive.

Achieving Synergies: 

Many oil industry officials indicated that achieving synergies--
benefits from the combined strengths of different companies--was an 
important motivation for some of the mergers in the industry in the 
1990s. Firms that engage in different but complementary activities may 
achieve synergies from mergers because it is more efficient and less 
costly for one company to perform two related activities than for two 
specialized firms to perform them separately. Furthermore, economic 
literature states that mergers can create synergies that improve firms' 
growth potential by yielding scale economies in production, marketing, 
research and development, and management, among other things. We found 
several instances of mergers where company officials cited synergies or 
complementary activities as a factor for the transactions. These 
mergers include Marathon Ashland's acquisition of Ultramar Diamond 
Shamrock's Michigan terminals, jobber networks, convenience stores, and 
pipelines in 1999; Sunoco's acquisition of crude oil transportation and 
marketing business assets from Pride Refining in 1999; and Tesoro's 
acquisition of BP Amoco's West Coast marine fuels operations in 1999.

Diversifying Assets: 

According to industry officials, the need for firms to diversify their 
portfolios in order to maintain stable profits played a role in 
petroleum industry mergers. Officials cited the acquisition of natural 
gas assets as a reason for mergers. Within the upstream segment, most 
independent exploration and production firms have both oil and gas in 
their portfolios because crude oil and natural gas are generally 
produced jointly. However, in the 1990s, some companies sought to 
increase their natural gas reserves through acquisition. For example, 
in 1999, Dominion acquired Remington Energy, Ltd., a natural gas 
production and exploration company, and increased its natural gas 
reserves to one trillion cubic feet. For a producer, natural gas could 
become a cushion during periods of low oil prices, all things being 
equal, allowing the producer to develop and produce more gas when oil 
prices are low, and vice versa. Moreover, EIA has reported that natural 
gas demand is likely to increase in coming years due to its relatively 
clean-burning qualities in comparison with other fossil fuels.

Within the downstream segment, some independent refiners acquired 
marketing and retail assets to expand their presence in U.S. retail 
markets. For example, Tosco's acquisition of Unocal's West Coast 
refining, marketing, and transportation assets allowed Tosco to 
diversify into retail operations on the West Coast.

Reducing Costs: 

Industry officials said that some mergers occurred as part of efforts 
to cut costs. Petroleum companies generally view each activity--such as 
exploration and production, refining, wholesaling, and retailing--as an 
individual "profit center." As a prudent business practice, petroleum 
firms assess the performance of each profit center relative to their 
overall business to determine where they could reduce costs or improve 
efficiency by acquiring or divesting assets. For example, one industry 
official said that mergers occurred frequently in the upstream segment 
partly because it is more cost effective and less risky to buy existing 
reserve assets than to discover new ones. Industry officials also told 
us that some firms divested refineries partly because of high operating 
costs and low returns. For companies acquiring these refineries, it was 
more cost effective to acquire an existing refinery than to build one, 
especially given the high cost and stringent environmental requirements 
for refinery construction in the United States.

Enhancing Stock Values: 

Some industry officials said that mergers, especially those involving 
publicly traded companies, were also partly motivated by the need to 
enhance stock values. The value of a company's common stock depends on 
investor expectations regarding its future profits. According to one 
industry official, the technology-fueled stock market boom of the 1990s 
heightened investor expectations for firms to consistently generate 
high stock appreciation. Thus, like other so-called old economy 
sectors, the petroleum industry was under pressure to meet Wall 
Street's expectations for rapid growth. Mergers were seen as a quick 
strategy for achieving this growth. Industry officials also believe 
that companies used mergers as a growth strategy to facilitate access 
to the capital markets, which seemingly favored bigger companies.

Responding to Price Volatility: 

Some industry officials believe that the large number of mergers that 
occurred in the second half of the 1990s may have been related, in 
part, to increased oil price volatility. According to one industry 
official, the collapse in crude oil prices, which dropped from $18.46 
per barrel in 1996 to $10.87 in 1998,dried up access to capital and 
made long-term investment difficult, especially for small firms. As a 
result, some high-cost producers became financially distressed, making 
them valuable yet inexpensive takeover targets.

Enhancing Market Power: 

While many of the reasons that industry officials cited for mergers are 
broadly consistent with achieving efficiency, economic literature also 
cites companies' desire to enhance market power as a motive for some 
mergers.[Footnote 21] As described in the literature, mergers increase 
market concentration and could reduce competition, allowing companies 
to exert greater control over prices. However, while mergers raise 
concern about potential anticompetitive effects,as stated in the 
previous chapter, U.S. antitrust laws are intended to mitigate such 
effects. Chapter 3 of this report examines in more detail the 
relationship between mergers and market concentration and other aspects 
of market structure that can affect competition in the U.S. petroleum 
industry.

[End of section]

Chapter 3: Mergers Contributed to Increases in Market Concentration and 
Other Changes in Market Structure: 

Mergers contributed to substantial increases in market concentration--
the extent to which a small number of firms controls most of an 
industry's sales--in the downstream segment of the U.S. petroleum 
industry, while concentration in the upstream segment changed very 
little by the end of the 1990s. Within the downstream segment, the 
increases were most significant in refining and wholesale gasoline 
markets. The overall impact of mergers is less clear for other aspects 
of petroleum market structure that also affect competition--in 
particular, vertical integration (the extent to which the same firms 
own the various stages of production and marketing of a product) and 
entry barriers (market conditions that provide established sellers in 
an industry an advantage over potential entrants). However, anecdotal 
evidence and economic studies indicate that mergers have affected these 
aspects as well.

Market Concentration Increased Mostly in the Downstream Segment of the 
Petroleum Industry During the 1990s: 

While market concentration in the upstream segment changed very little, 
the downstream segment of the petroleum industry experienced increases 
in concentration by the end of the 1990s that were largely associated 
with mergers during that period.[Footnote 22] Although mergers also 
occurred in the midstream segment, we could not determine the extent of 
midstream concentration during this period.[Footnote 23]

Analyzing Market Concentration in Relation to Mergers: 

Increased market concentration can result in greater market power, 
potentially increasing prices above competitive levels.[Footnote 24] 
Economists have posited that the extent of market power in a given 
market is directly and positively related to the degree of market 
concentration as measured by the Herfindahl-Hirschman Index (HHI) of 
that market, other things held constant. This index, as discussed 
earlier, reflects the composition of a market while giving 
proportionately greater weight to the market shares of the larger 
firms.[Footnote 25] On the other hand, increased concentration may also 
lead to cost savings and efficiency gains, which may be passed on to 
consumers in lower prices. Ultimately, the impact of higher 
concentration on prices depends on whether market power or efficiency 
dominates. (The effects of mergers and market concentration on 
wholesale gasoline prices are analyzed in chapter 5.): 

Economists and federal antitrust agencies have identified mergers as a 
major factor leading to higher market concentration. For example, in a 
1989 study on mergers in the petroleum industry, FTC reported that 
mergers and acquisitions, as well as other factors, affected changes in 
concentration in the petroleum industry. DOJ and FTC pay close 
attention to market concentration when reviewing proposed mergers. In 
the DOJ/FTC 1992 Horizontal Merger Guidelines[Footnote 26] for 
determining the potential anticompetitive effect of a proposed merger 
and whether to challenge such a merger, a central analysis is to assess 
whether the merger would significantly increase market concentration, 
as measured by the HHI, after defining the relevant geographic and 
product market. We based our analysis of market concentration in the 
various segments of the U.S. petroleum industry on the HHI criteria 
established by the guidelines. These guidelines, previously outlined in 
chapter 1, are summarized in table 1.

Table 1: FTC/DOJ Horizontal Merger Guidelines on the General Standards 
for Evaluating Postmerger Market Concentration: 

Postmerger HHI: HHI less than 1,000; 
Degree of market concentration: Unconcentrated; 
Change in HHI that would result from the proposed merger: 
Not applicable; 
Potential competitive consequences and likely need for 
further DOJ/FTC analysis: Mergers in this category require no further 
analysis.

Postmerger HHI: HHI between 1,000 and 1,800; 
Degree of market concentration: Moderately concentrated; 
Change in HHI that would result from the proposed merger: 
HHI increase <100; 
Potential competitive consequences and likely need for 
further DOJ/FTC analysis: No further analysis.

Postmerger HHI: HHI between 1,000 and 1,800; 
Degree of market concentration: Moderately concentrated;
Change in HHI that would result from the proposed merger: 
HHI increase > 100; 
Potential competitive consequences and likely need for 
further DOJ/FTC analysis: Could raise significant competitive concerns, 
depending on other factors.

Postmerger HHI: HHI greater than 1,800; 
Degree of market concentration: Highly concentrated; 
Change in HHI that would result from the proposed merger: 
HHI increase < 50; 
Potential competitive consequences and likely need for 
further DOJ/FTC analysis: No further analysis.

Postmerger HHI: HHI greater than 1,800; 
Degree of market concentration: Highly concentrated; 
Change in HHI that would result from the proposed merger: 
HHI increase > 50; 
Potential competitive consequences and likely need for 
further DOJ/FTC analysis: Could raise significant competitive concerns, 
depending on other factors.

Postmerger HHI: HHI greater than 1,800; 
Degree of market concentration: Highly concentrated; 
Change in HHI that would result from the proposed merger: 
HHI increase > 100; 
Potential competitive consequences and likely need for 
further DOJ/FTC analysis: Likely to create or enhance market power or 
facilitate its exercise. 

Sources: FTC and DOJ.

[End of table]

As table 1 shows, the guidelines establish market concentration into 
three broad categories of market concentration as measured by the HHI: 
an unconcentrated market has an HHI less than 1,000, a moderately 
concentrated market has an HHI between 1,000 and 1,800, and a highly 
concentrated market has an HHI over 1,800. Along with the level of HHI, 
the agencies also consider changes in HHI that would result from a 
proposed merger. In order to examine market concentration and any 
changes in the proper market context, the guidelines stipulate that the 
relevant geographic and product markets be defined on a case-by-case 
basis. For example, firms selling a given product may compete at the 
national level--in which case the relevant geographic market is 
national--while firms selling another product may compete at less than 
the national level--in which case the relevant geographic market could 
be regional, statewide, or smaller.

In analyzing market concentration, we based our choice of relevant 
geographic markets on various criteria, including what FTC officials 
and industry experts told us. We also based our choice of relevant 
market on the availability of data.

For the U.S. petroleum upstream segment, we analyzed market 
concentration, as measured by HHI,[Footnote 27] at the national level. 
For the downstream segment, we examined market concentration separately 
for refining and wholesale gasoline marketing, focusing our HHI 
analyses for refining at the regional (or the Petroleum Administration 
for Defense Districts or PADD) level and, for wholesale gasoline 
marketing, at the state level.[Footnote 28]'[Footnote 29] Figure 11 
depicts the U.S. PADDs and the states within each PADD.

Figure 11: Petroleum Administration for Defense Districts: 

[See PDF for image]

[End of figure]

To determine the extent to which mergers were associated with increased 
market concentration in the U.S. petroleum industry in the 1990s, we 
performed statistical correlation analyses. Correlation numbers (or 
coefficients), which range from -1 to +1, measure the strength and 
direction of the relationship between two variables.[Footnote 30] A 
positive number denotes a positive and direct relationship, while a 
negative number denotes a negative or inverse relationship. Overall, 
the higher the number, the stronger the relationship between the two 
variables being analyzed. (See appendix III for a more detailed 
discussion of our correlation analysis). For our analysis, we used as a 
surrogate for the level of merger activity the average transaction 
value of all the mergers for which such values were reported.[Footnote 
31] We correlated this value with the HHI for the upstream segment, 
refining (at the PADD level), and the wholesale gasoline market (at the 
state level).[Footnote 32] Other factors besides mergers that can 
affect market concentration include firms entering and exiting the 
industry. For example, if a company withdraws from a market and is not 
replaced by a new company, both the market shares of the remaining 
firms and concentration would increase.[Footnote 33]

The Upstream Segment Experienced Little Change in Market Concentration 
and Remained Unconcentrated Over the 1990s: 

Based on crude oil production activities, concentration in the upstream 
segment of the U.S. petroleum industry experienced little change over 
the decade. Specifically, the HHI for the upstream market decreased 
somewhat from 290 in 1990 to 217 in 2000 (see figure 12). Hence, the 
upstream segment of the U.S. petroleum industry remained unconcentrated 
as of the year 2000. Moreover, notwithstanding the level of domestic 
upstream concentration, industry officials and experts believe that 
because crude oil prices are generally determined in the world market, 
individual U.S. companies are not likely to have much influence on the 
global market.

Figure 12: Market Concentration for the Upstream Segment, as Measured 
by the HHI (1990-2000): 

[See PDF for image]

[End of figure]

For the upstream market, we did not find a statistically significant 
correlation between mergers in the 1990s and market concentration, as 
measured by the HHI, for U.S. crude oil production.

Overall, the Downstream Segment of the Market Became More Concentrated: 

In general, the downstream segment--consisting of the refining, 
wholesale, and retail marketing levels--became more concentrated in the 
1990s. However, the extent to which concentration increased varied 
among operating levels and geographic regions.

Refining: 

Overall, the U.S. refining market experienced increasing levels of 
market concentration (based on refinery capacity) during the 1990s, 
especially during the latter part of the decade, but the levels as well 
as the changes of concentration varied geographically.

In PADD I--the East Coast--the HHI for the refining market increased 
from 1136 in 1990 to 1819 in 2000, an increase of 683 (see figure 13). 
Consequently, this market went from moderately concentrated to highly 
concentrated. Compared to other U.S. PADDs, a greater share of the 
gasoline consumed in PADD I comes from other supply sources--mostly 
from PADD III and imports--than within the PADD. Consequently, some 
industry officials and experts believe that the competitive impact of 
increased refiner concentration within the PADD could be 
mitigated.[Footnote 34]

Figure 13: Refining Market Concentration for PADD I Based on Crude Oil 
Distillation Capacity (1990-2000): 

[See PDF for image]

Note: Data for 1996 and 1998 were unavailable.

[End of figure]

For PADD II (the Midwest), the refinery market concentration increased 
from 699 to 980 --an increase of 281--between 1990 and 2000. However, 
as figure 14 shows, this PADD's refining market remained unconcentrated 
at the end of the decade. According to EIA's data, as of 2001, the 
quantity of gasoline refined in PADD II was slightly less than the 
quantity consumed within the PADD.

Figure 14: Refining Market Concentration for PADD II Based on Crude Oil 
Distillation Capacity (1990-2000): 

[See PDF for image]

Note: Data for 1996 and 1998 were unavailable.

[End of figure]

The refining market in PADD III (the Gulf Coast), like PADD II, was 
unconcentrated as of the end of 2000, although its HHI increased by 
170--from 534 in 1990 to 704 in 2000 (see figure 15). According to 
EIA's data, much more gasoline is refined in PADD III than is consumed 
within the PADD, making PADD III the largest net exporter of gasoline 
to other parts of the United States.

Figure 15: Refining Market Concentration for PADD III Based on Crude 
Oil Distillation Capacity (1990-2000): 

[See PDF for image]

Note: Data for 1996 and 1998 were unavailable.

[End of figure]

The HHI for the refining market in PADD IV--the Rocky Mountain region-
-where gasoline production and consumption are almost balanced--
increased by 95 between 1990 and 2000. This increase changed the PADD's 
refining market from 1029 in 1990 to 1124 in 2000, within the moderate 
level of market concentration (see figure 16).

Figure 16: Refining Market Concentration for PADD IV Based on Crude Oil 
Distillation Capacity (1990-2000): 

[See PDF for image]

Note: Data for 1996 and 1998 were unavailable.

[End of figure]

The refining market's HHI for PADD V--the West Coast--increased from 
937 to 1267, an increase of 330, between 1990 and 2000 and changed the 
West Coast refining market, which produces most of the gasoline it 
consumes, from unconcentrated to moderately concentrated by the end of 
the decade (see figure 17).[Footnote 35]

Figure 17: Refining Market Concentration for PADD V Based on Crude Oil 
Distillation Capacity (1990-2000): 

[See PDF for image]

Note: Data for 1996 and 1998 were unavailable.

[End of figure]

We estimated a high and statistically significant degree of correlation 
between merger activity and the HHIs for refining in PADDs I, II, and V 
for 1991 through 2000. Specifically, the corresponding correlation 
numbers are 91 percent for PADD V (West Coast), 93 percent for PADD II 
(Midwest), and 80 percent for PADD I (East Coast). While mergers were 
positively correlated with refining HHIs in PADDs III and IV--the Gulf 
Coast and the Rocky Mountains--the estimated correlations were not 
statistically significant. (See table 11 in appendix III for 
correlation coefficients and associated statistics for each of the 
PADDs.): 

Wholesale Gasoline: 

The overall U.S. wholesale gasoline market--measured at the state 
level[Footnote 36]--also experienced significant increases in and 
higher levels of concentration, based on HHI data for wholesale 
gasoline from 1994 to 2002 that we obtained from the Department of 
Energy's Energy Information Administration (EIA).[Footnote 37] We found 
that all but four states and the District of Columbia experienced 
increases in wholesale gasoline market concentration between 1994 and 
2002. (See table 10, app. III.) Forty-six states and the District of 
Columbia had moderately or highly concentrated wholesale gasoline 
markets in 2002, compared to 27 in 1994. For the years 1994, 2000, and 
2002, figure 18 illustrates how the percentage of states categorized as 
unconcentrated has fallen while the percentage of states categorized as 
moderately to highly concentrated has risen. Specifically, the 
proportion of states categorized as unconcentrated has decreased from 
47 percent to 8 percent, while the percentage of states in the moderate 
category has risen from 43 percent to 75 percent. The percentage of 
states in the highly concentrated category has risen from 10 percent to 
18 percent.

Figure 18: Percentage of U.S. States with Unconcentrated, Moderately 
Concentrated, and Highly Concentrated Wholesale Gasoline Markets (1994, 
2000, and 2002): 

[See PDF for image]

[End of figure]

To determine the degree to which mergers and market concentration in 
wholesale gasoline were related and how closely they moved together 
during this period, we performed a correlation analysis for this 
operating level. We found that mergers, as measured by their 
transaction values, were significantly and highly positively correlated 
with market concentration, as measured by the state HHI, for wholesale 
gasoline. (See table 12, appendix III for the correlation coefficients 
and associated statistics for individual states.)[Footnote 38] This was 
especially the case for states that exhibited high levels of 
concentration or experienced large changes in concentration between 
1994 and 2001.

Figure 19 shows a comparison of concentration levels in individual 
states and the District of Columbia--grouped within PADDs--between 1994 
and 2002.

Figure 19: Wholesale Gasoline Market Concentration by State in Each 
PADD (1994 and 2002): 

[See PDF for image]

[End of figure]

* As can be observed, the wholesale gasoline market in 16 states in 
PADD I (the East Coast) were moderately concentrated in 2002, compared 
to 7 states in 1994. Also, in PADD I, the number of states that had 
unconcentrated wholesale gasoline markets decreased from 10 in 1994 to 
just 1 in 2002. Some key mergers that affected PADD I during this 
period include Exxon-Mobil, BP-Amoco, and Shell-Texaco (Motiva).

* In PADD II (the Midwest) the wholesale gasoline markets in 5 states 
were highly concentrated, 8 were moderately concentrated, and 2 were 
unconcentrated as of 2002. By comparison, in 1994, there were no highly 
concentrated markets, 7 states were moderately concentrated, and 8 
states were unconcentrated in this PADD. Some key mergers that affected 
PADD II during the period included Marathon-Ashland, Marathon-Ultramar 
Diamond Shamrock (UDS), BP-Amoco, Shell-Texaco (Equilon), and UDS-
Total.

* The wholesale gasoline market in all the states in PADD III (the Gulf 
Coast region) except one had become moderately concentrated in 2002, 
compared to 1994 when all were unconcentrated. Key mergers that 
affected PADD III during the period include Exxon-Mobil, Shell Texaco 
(Motiva), Marathon-Ashland, and Valero-UDS.

* For the states included in PADDs IV and V (the Rocky Mountains and 
the West Coast, respectively), wholesale gasoline markets remained in 
the moderately or highly concentrated range in 2002 as in 1994. Within 
this range, concentration levels increased in all but one state in PADD 
IV and in all but one state in PADD V between 1994 and 2002. Key 
mergers that affected PADD IV during this period include Shell-Texaco 
(Equilon), Phillips-Tosco, Conoco-Phillips, and UDS-Total. Key mergers 
that affected PADD V during the period included Tosco-Unocal, Shell-
Texaco (Equilon), Chevron-Texaco, Phillips-Tosco, and Valero-UDS.

Mergers Have Caused Changes in Other Aspects of Market Structure, but 
the Extent of These Changes Is Not Easily Quantifiable: 

Evidence from various sources suggests that in addition to market 
concentration, mergers affected other aspects of market structure--in 
particular, vertical integration and barriers to entry. The extent to 
which they did so, however, could not be easily quantified because, in 
addition to lack of consensus on how to appropriately measure these 
aspects, there are no comprehensive data on them.

Vertical Integration: 

Like increased concentration, increased vertical integration, as 
measured by the extent to which the various stages of production and 
marketing of a product are owned by the same firms, could conceptually 
have both procompetitive and anticompetitive effects, with the net 
effect depending on which effects dominate. One procompetitive view of 
vertical integration is that it promotes efficiencies and leads to 
lower prices by allowing a company to lower costs by making 
transactions that are internal rather than external to the company. On 
the other hand, a high degree of vertical integration in an industry 
could be anticompetitive by creating disincentives for new firms to 
enter a market because of the need to enter at several levels of the 
market in order to compete effectively. Vertical integration could also 
allow firms to use a strategy of "market foreclosure" against their 
non-vertically-integrated rivals by reducing input supply for rivals, 
raising prices paid by rival retailers, or totally refusing to sell 
product to rival retailers. Some studies have recently found that 
increased vertical integration in the U.S. petroleum industry has been 
associated with higher wholesale gasoline prices.[Footnote 39]

While our review was not comprehensive, we found that a number of the 
mergers since the 1990s led to greater vertical integration in the U.S. 
petroleum industry, especially in the downstream market, as shown in 
table 2. EIA has also reported that a substantial number of vertical 
mergers have occurred between independent refiners and marketers in the 
United States since the 1990s.[Footnote 40] Table 2 presents some 
examples of petroleum industry mergers since the mid-1990s that created 
or enhanced vertical integration.

Table 2: Selected Vertical Mergers in the Petroleum Industry Since the 
1990s: 

Year: 1995; 
Acquiring company: Diamond Shamrock; 
Stage of operation: Refining; 
Company acquired: Stop-N-Go; 
Stage of operation for assets purchased: Gasoline retailing.

Year: 1996; 
Acquiring company: Tosco; 
Stage of operation: Refining; 
Company acquired: Circle K; 
Stage of operation for assets purchased: Gasoline retailing.

Year: 1997; 
Acquiring company: Tosco; 
Stage of operation: Refining; 
Company acquired: Unocal Corporation; 
Stage of operation for assets purchased: Refining/marketing/ retail.

Year: 1997; 
Acquiring company: ARCO; 
Stage of operation: Integrated; 
Company acquired: Thrifty; 
Stage of operation for assets purchased: Gasoline retailing in 
California.

Year: 1998; 
Acquiring company: Shell; (Joint Venture); 
Stage of operation: Integrated; (with small downstream market share); 
Company acquired: Texaco; 
Stage of operation for assets purchased: Integrated; (with large 
downstream market share).

Year: 2000; 
Acquiring company: Tosco; 
Stage of operation: Refining; 
Company acquired: Some of Exxon's and Mobil's East Coast retail 
gasoline stations; 
Stage of operation for assets purchased: Retail gasoline stations.

Year: 2001; 
Acquiring company: Phillips; 
Stage of operation: Integrated; 
Company acquired: Tosco; 
Stage of operation for assets purchased: Refining/marketing/retail.

Year: 2001; 
Acquiring company: Valero; 
Stage of operation: Refining; 
Company acquired: Ultramar Diamond Shamrock; 
Stage of operation for assets purchased: Refining/marketing/retail. 

Source: GAO.

[End of table]

Typically, firms in the petroleum industry are either fully vertically 
integrated--operating across the entire industry spectrum from crude 
production to retail gasoline sales--or partially vertically 
integrated--operating in more than one but not all stages of the 
petroleum industry's operation. We included in our analysis mergers 
that have led to either type of vertical integration. Also, we have 
included in our analysis mergers that have enhanced the degree of 
vertical integration in the market--even if the mergers were 
essentially horizontal--such as the acquisition of an independent 
refiner by an already partially or fully vertically integrated company. 
Our analysis of mergers encompassed all these types of vertical 
integration because they all can affect competition in the market.

As shown in table 2, many mergers that contributed to increased 
vertical integration occurred between independents as well as between 
fully vertically integrated companies and independents.[Footnote 41] 
For example, Tosco, a previously independent refiner that had no retail 
operation, acquired several retail assets on the West Coast, such as 
Circle K (a retail chain) and Unocal's retail stations and other 
downstream assets.[Footnote 42] These acquisitions essentially 
transformed Tosco into a partially vertically integrated downstream 
company before Phillips Petroleum, a fully vertically integrated 
company, acquired it. This acquisition most likely boosted Phillips' 
downstream position in both refining and wholesale and retail 
marketing. Also, the acquisition of Thrifty, an independent chain 
retailer on the West Coast, by ARCO, an integrated company, enhanced 
the latter's retail position in the West Coast retail market. Likewise, 
the acquisition of UDS' wholesale gasoline terminals and retail outlets 
in Michigan by Marathon Ashland Petroleum--a joint venture between 
Marathon and Ashland, which are both fully vertically integrated oil 
companies--enhanced Marathon Ashland Petroleum's position in 
Michigan's wholesale and retail market.

Barriers to Entry: 

Our interviews with petroleum industry officials and experts provided 
anecdotal evidence that mergers have had some impact on barriers to 
entry in the U.S. petroleum industry, but there are generally no 
empirical data to quantify the extent of the impact. Barriers to entry 
can be defined as market conditions that provide established sellers in 
an industry an advantage (typically cost advantage) over potential 
entrants. Entry barriers are important in a market because of their 
effect on competitive conditions; theoretically, industries that are 
highly concentrated and have high entry barriers are more likely to 
possess market power. Industry officials that we interviewed indicated 
that large investment capital requirements, regulatory impediments/
environmental concerns, and public opposition to siting facilities 
constitute significant entry barriers that may have been exacerbated by 
mergers.

For example, industry officials told us that in the upstream segment, 
crude oil exploration and production activities moved increasingly 
offshore to areas such as the deep waters of the Gulf of Mexico during 
the 1990s because of the greater likelihood of finding oil. Offshore 
operations are generally riskier and require much higher capital 
investments than onshore operations.[Footnote 43] One official 
estimated that it could cost a company about $40 million to $100 
million just to drill several wells in deep waters and purchase 
equipment, and some operations could cost as much as $1 billion. As a 
result, some firms, mostly large producers that already had the 
wherewithal to engage in offshore activities, merged to further share 
the risks and costs. These mergers tended to help consolidate their 
dominance in offshore activities and made it more difficult for smaller 
firms to enter the market.

For the transportation infrastructure segment--pipelines--the 
potential barriers to entry include high investment costs and large 
economies of scale.[Footnote 44] Moreover, as noted by one source, 
procedural requirements and associated legal costs for entry into the 
pipeline business have limited the number of companies in the segment.
[Footnote 45] Thus, as mergers, and possibly concentration, increased, 
entry barriers also increased because firms must make large and high-
cost investments in order to enter the market and be competitive at 
large scales of operation.

Like the upstream and midstream segments, the downstream segment of the 
U.S. petroleum industry is characterized by pervasive barriers to 
entry, including large capital investment requirements at the refining 
level, and regulatory and permitting impediments at the refining and 
wholesale/retail levels. For example, regarding refining, industry 
officials told us that building a typical refinery or even upgrading an 
existing one is a multibillion dollar investment. Also, they said that 
it is extremely difficult to obtain a permit from the relevant state or 
local authorities to build a new refinery in many parts of the country 
because of regulatory hurdles and public opposition. In addition, they 
noted that federal and state environmental regulations to meet clean 
air requirements have contributed to the high cost of owning and 
operating a refinery. Furthermore, they pointed out that return on 
investment in refining has been relatively low compared to investment 
in other industries. They attributed the failure to build any new 
refineries in the United States in over 20 years to these factors.

We could not quantify the extent to which mergers may have increased or 
decreased these barriers because of the lack of empirical data to 
properly measure entry barriers. Industry officials said that mergers 
have not caused these barriers. Instead, they opined that some of the 
mergers and acquisitions in refining have been partly a result of these 
barriers because merging with or acquiring existing refineries is less 
expensive than building a new one. During the 1990s, many refiners 
expanded through mergers and acquisitions as well as through upgrading 
existing facilities. For example, refiners such as Tosco and Tesoro 
entered the industry through acquisitions in the early 1990s.

Entry barriers also exist at the wholesale gasoline marketing level of 
the downstream segment in the form of high investment capital 
requirements, regulatory/permitting impediments, and infrastructure 
barriers. For example, a potential entrant into the wholesale gasoline 
supply market may enter by operating his own refinery and producing 
gasoline and/or buying from existing domestic refiners or importing 
gasoline for distribution. As a potential refiner, he faces the entry 
barriers in refining discussed above. On the other hand, industry 
officials told us that while it is possible to enter this market as an 
independent purchaser from domestic refiners and/or importers, there 
are potential infrastructure impediments to doing so, such as lack of 
access to pipelines and terminals. They pointed out that although 
shipping gasoline through a third-party, common carrier pipeline 
operator such as Kinder Morgan offers an option in some markets, this 
option may not be available in the particular market that the shipper 
wants to bring gasoline into. Moreover, to ship gasoline through such a 
common-carrier pipeline, the shipper must have access to a terminal on 
that route to receive the product, or the pipeline operator cannot 
accept such shipment. According to some industry officials, oil 
companies who own most of the gasoline terminals around the nation 
sometimes deny access to third-party users, especially when supply is 
tight. Some industry officials indicated that mergers have exacerbated 
entry barriers at the wholesale level in some markets because mergers 
have created a situation in which pipelines and terminals in some 
markets are owned by fewer, mostly integrated companies who use these 
facilities mostly proprietarily. In addition, industry officials 
pointed out that there has been a preference for larger distributors 
over smaller distributors in the market. For example, wholesale 
marketers or distributors need to be large enough to secure credit 
lines to make large volume purchases or minimum volume requirements set 
by refiners. Also, in some markets, such as California, boutique fuel 
specifications to meet clean air requirements limit the ability of 
potential independent wholesalers to enter the market because the 
unique gasoline blends are not widely produced in other refining 
centers.

At the retail level, industry officials pointed out that mergers have 
exacerbated the barriers for potential retail entrants because there 
are fewer companies to supply gasoline to retailers and, as discussed 
in more detail in chapter 4, retailers must operate at a large scale in 
order to meet minimum volume requirements preferred by refiners. They 
also indicated that restrictive land-use laws and permitting processes 
in some areas of the country, such as California and Washington, D.C., 
constitute a barrier for potential retailers seeking to build new 
stations.[Footnote 46]

[End of section]

Chapter 4: Gasoline Marketing Has Changed in Two Major Ways: 

According to industry officials, two major changes have occurred in 
gasoline marketing since the 1990s, partly related to mergers. First, 
the availability of generic (unbranded) gasoline has decreased for 
various reasons; more gasoline is now marketed as branded, under the 
refiner's trademark. Branded gasoline is generally higher priced than 
unbranded. We could not statistically quantify the extent of this 
change because no data on the supply of unbranded gasoline exist. 
Second, refiners now prefer dealing with large distributors and 
retailers. This preference, officials told us, has motivated further 
consolidation in both the distributor and retail sectors, including the 
rise of "hypermarkets"--a relatively new breed of gasoline market 
participants that include such large retail warehouses as Wal-Mart and 
Costco.

The Availability of Unbranded Gasoline Decreased: 

Refiners market either branded or unbranded gasoline through several 
wholesale channels, but since the 1990s the availability of unbranded 
gasoline from refiners has decreased substantially, according to 
industry officials. Officials generally attributed this decrease to a 
reduction in the number of independent refiners, the sale and/or 
mothballing of refineries by mostly fully vertically integrated oil 
companies, and better inventory management by major branded refiners. 
The decrease cannot be precisely quantified because the data are not 
adequate to do so.

Refiners Market Either Unbranded or Branded Gasoline through Several 
Channels: 

The gasoline market consists of various supply arrangements that 
ultimately influence gasoline prices throughout the supply chain. 
Gasoline flows through several marketing channels, as shown in figure 
20. The refiner can market gasoline to the consumer through a direct 
distribution system and an indirect distribution system.

Figure 20: The Flow of Gasoline Marketing: 

[See PDF for image]

[End of figure]

The direct system typically involves the sale and/or supply of branded 
gasoline by a refiner to its company-operated stations or other retail 
outlets operated by lessee dealers who lease the service station and 
basic equipment from the refiner or distributor but operate their own 
retail outlets. Branded gasoline is marketed under the refiner's 
trademark. Refiners can also sell unbranded gasoline directly to 
hypermarkets--including such large retail warehouses as Wal-Mart and 
Costco, as well as grocery store chains such as Safeway--that have over 
the last decade added gasoline retailing to their locations. (The role 
of hypermarkets is discussed later in this chapter.) Retailers of 
unbranded gasoline can sell it as a generic/private brand and tend to 
compete mostly through lower prices than their branded competitors. In 
the direct distribution system, these hypermarkets have, over the last 
decade, taken the place of open dealers who either own their own 
stations or lease them from distributors or third parties in the supply 
structure.

In the indirect distribution system, refiners sell branded or unbranded 
gasoline to independent middlemen--generally called distributors, 
marketers, or jobbers--who resell the gasoline to other retailers or 
sell to consumers through their own retail operations. Branded gasoline 
that flows through the indirect system must also be marketed by 
distributors or retailers under the refiner's trademark, while 
unbranded could be sold under the distributor's or retailer's private 
name. Many market participants told us that much of the gasoline sold 
through both the direct and indirect channels is now branded.

Depending on the type of supply arrangement with the supplier, gasoline 
distributors and retailers may pay one or more of the distinct 
wholesale prices summarized in table 3 below. Under normal market 
conditions, the spot price is the lowest wholesale price, followed by 
the unbranded rack price, branded rack price, and dealer-tankwagon 
price. Because, as discussed below, transfer prices are generally 
considered proprietary, it is not clear how high or low they are 
relative to the other prices.

Table 3: Types of Wholesale Prices Paid for Gasoline: 

Wholesale purchaser of gasoline: Distributor; 
Spot: Yes; 
Unbranded rack: Yes; 
Branded rack: Yes; 
Dealer-tankwagon: No; 
Transfer[A] price: No. 

Wholesale purchaser of gasoline: Company-operated outlet; 
Spot: No; 
Unbranded rack: No; 
Branded rack: No; 
Dealer-tankwagon: No; 
Transfer[A] price: Yes.

Wholesale purchaser of gasoline: Lessee dealer; 
Spot: No; 
Unbranded rack: No; 
Branded rack: No; 
Dealer-tankwagon: Yes; 
Transfer[A] price: No.

Wholesale purchaser of gasoline: Open dealer; 
Spot: No; 
Unbranded rack: Yes; 
Branded rack: Yes; 
Dealer-tankwagon: Yes; 
Transfer[A] price: No.

Wholesale purchaser of gasoline: Hypermarket; 
Spot: Yes; 
Unbranded rack: Yes; 
Branded rack: No; 
Dealer-tankwagon: No; 
Transfer[A] price: No.

Source: GAO.

[A] Transfer prices are internal prices at which refiners and 
distributors supply gasoline to their company-owned and -operated 
stations.

[End of table]

Spot Prices are generally the lowest wholesale price under normal 
market conditions because there is no binding contract between the 
seller and the buyer, and gasoline sold in the spot market is typically 
unbranded. Market participants typically use the spot market when faced 
with surpluses or shortages that may arise from their contractual 
transactions. The spot market accounts for only a small portion of 
domestic gasoline sales, even smaller than it was a decade ago, partly 
because just-in-time inventory management leaves less gasoline for spot 
sales. Nonetheless, spot prices, as well as futures prices, strongly 
influence the other wholesale prices.

Rack Prices are the prices that distributors and retailers pay for 
gasoline supplied at a refiner's wholesale terminal or rack. Typically, 
rack prices are set daily by refiners and are generally influenced by 
prices in the spot and futures markets, as well as by the extent of 
competition among refiners within a particular market. Average rack 
prices are generally higher than spot prices under normal market 
conditions. There are two types of rack prices--branded and unbranded.

* Branded rack prices are paid by distributors who buy gasoline 
supplies from major refiners selling under their trademarks. Branded 
rack prices include a premium reflecting the recognized brand name, the 
costs of issuing company credit cards, and other costs such as 
advertising. In addition, when refiners sell branded gasoline to 
distributors and retailers, the contracts tend to be less flexible than 
contracts for unbranded gasoline but guarantee a more secure supply. 
Thus, branded rack prices may also include a premium for this 
additional security.

* Unbranded rack prices are paid by distributors, hypermarkets, and 
open dealers for unbranded gasoline supplied primarily by independent 
refiners and, to a small extent, by fully vertically integrated 
refiners. Under normal market conditions, unbranded rack prices tend to 
be lower than branded rack prices. Buyers of unbranded gasoline may or 
may not have a binding contractual arrangement with a refiner.[Footnote 
47] Therefore, a buyer of unbranded gasoline may not be guaranteed a 
secure supply or lower prices, particularly during a market shock 
involving a reduction in overall gasoline supply. Thus, when there is a 
disruption in the supply system, such as those caused by pipeline or 
refinery breakdowns, unbranded rack prices can be higher than branded 
rack.[Footnote 48]

Dealer-tankwagon (DTW) prices are contract prices paid by lessee 
dealers and some open dealers to refiners or distributors for branded 
gasoline delivered