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Distribution and Marketing

Source: API 5/1/2006, Location: North America

Distribution and marketing of petroleum products represent the third segment of the petroleum supply chain. They involve the movement of refined products – gasoline, diesel, heating oil, kerosene, and jet fuel – from the refinery to the end consumer. Like crude oil, petroleum products are bought and sold throughout the chain of distribution.? Distribution and marketing, however, represent a relatively small share of the price paid by consumers. For example, the marketing and distribution of gasoline typically represent less than 15 percent of the pump price paid by the average motorist.

Gasoline, which represents nearly 45 percent of the domestic production of all refined products, is the petroleum product most demanded by U.S. consumers. There are almost 169,000 retail gasoline outlets in the United States, selling 17 different formulations of gasoline designed to meet different air quality standards around the country. While, as discussed above, the cost of crude oil is the largest single component of the retail price of gasoline, gasoline prices ultimately are established by the forces of supply and demand, with retail prices reflecting local, state, and federal taxes and the value added to the distribution of gasoline as it moves from the refinery to the ultimate consumer. Of course, for any particular retailer, a number of factors go into determining the pump price, including the location of the station, delivery costs, the commercial arrangements with the station’s supplier, whether the station sells branded or unbranded gasoline, the size of the station, and taxes – to name just a few.

Competition in the retail sector is intense. The overwhelming trend has been the increasing efficiency with which gasoline is delivered to the consumer. The rapid entry of hypermarketers, such as Wal-Mart® and Costco,® into the retail gasoline sector is the most current evidence of the level of competition found within this segment of the industry. Prices, of course, can and do vary among stations for a host of reasons, including location advantages (e.g., with respect to the flow of traffic or proximity to locations like shopping malls that attract large number of motorists); cost differences among stations (e.g., rent, insurance, wages); and the commercial arrangements under which the station is supplied with product – again, to list just a few.

Any retailer’s pump price, however, must be competitive with local retail stations to attract customers. That is, retail pricing behavior ultimately is limited by the fact that pump prices are transparent and, therefore, readily known by motorists. Stations that set prices that are not competitive quickly lose business as motorists change their buying patterns.

There is a common, often implicit, belief that retail prices are or should be based on what the dealer has paid for the gasoline in his storage tanks. This misconstrues how competitive markets work. As noted above, prices for petroleum products, including gasoline, are a function of current as well as expected future supply and demand conditions, not historical costs. This is true even at the local level. If a retailer, for example, has relatively full tanks but other stations are forced to raise their prices due to increasing wholesale prices, the retailer will have an incentive to raise prices even before the retailer’s own actual costs have increased based on the expectation that the retailer’s future replacement costs will be higher. That is, the market is telling the retailer that the cost of gasoline has increased and, therefore, so has the retailer’s cost of replacing existing inventory. (This is sometimes referred to as the retailer’s opportunity cost: the retailer must replace whatever inventory is sold with higher-cost supply.) In contrast, however, when wholesale prices are falling and other retailers are lowering their prices, the same retailer faces the following stark choice: either lower retail prices (and, thereby, lower margins on existing inventory) or accept lower sales.

Of course, actual retail pricing decisions are much more complicated due, in part, to the multiple pricing-related factors noted above. What cannot be lost, however, is the fact retail marketing is a very competitive segment of the industry and, consequently, retail prices are forced to respond to that competition. The price changes arising as a consequence of the damage caused in 2005 by Hurricanes Katrina and Rita illustrate this point. Shortly after the storms, prices for all petroleum products, including gasoline, rose as a consequence of the damage suffered by Gulf Coast refineries. The expectation that the supply of products would be less readily available (which turned out to be true) gave rise to higher prices. As imports started arriving from foreign refineries and domestic refineries came back on line, prices once again declined.

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