Oil Refining and Inventories: A Tale of Californication

As a small example of the joys of Californication that would spread to the entire US under a Harris administration, a couple of days ago Gavin Newsom signed legislation that would empower the state’s Clean Air Board to require California refiners to hold certain levels of. inventory. The objective of this legislation is to prevent the price spikes that periodically occur in the state.

Implicit in this legislation is the idea that inventories are too low. Why would that be? What market failure is there that induces such allegedly suboptimal behavior? None has been provided.

And no, the existence of price spikes is not evidence of inefficiency, and in particular inefficiently low inventories. In fact, in an efficient market for a storable commodity, price spikes should occur periodically: their absence would be evidence of excessive inventory holding.

The intuition is straightforward. Spikes occur when there are stockouts–when inventories fall to low levels due to supply and demand shocks. But it is optimal to have stockouts. If you didn’t, that would mean that you have produced something that is never consumed, which is obviously wasteful. So inventories should be drawn down to low levels periodically, and prices should spike then. Therefore, prices should spike periodically.

The cover of my book on commodity price dynamics based on the theory of storage has a graph of a simulated efficient, competitive market price for a storable commodity. It has spikes.

Forcing excessive stockholding is inefficient. Moreover, it tends to raise prices on average even if it reduces the frequency of price spikes. The only way to increase inventories that are consumed in certain periods is by reducing consumption during other periods. That requires higher prices in these other periods.

But spikes are politically salient, whereas higher prices most of the time get treated as the baseline, as being normal. The fact that those baseline prices are higher than they would be absent the mandated stockholding is hidden from most voters. So politicians can claim credit for shaving off some of the highly visible spikes, and aren’t blamed for the hidden cost (i.e., higher everyday prices).

That’s all assuming the legislation has the intended (if inefficient) effect of raising inventories. But it might not. As I understand it, the mandate applies to refiners. But non-refiners–traders in particular–hold stocks too. Indeed, those are most likely to be the “speculative stocks” that are used to smooth out supply and demand fluctuations, thereby reducing price volatility.

Mandating higher refiner stocks is likely to result in a reduction in these speculative stocks, thereby reducing the effect of the regulation. Given that holding excessive inventories is inefficient, this offsetting is a good thing. Indeed, it is possible that the offset will be 100 percent, meaning that every increase in refiner stocks is offset exactly by a decline in non-refiner stocks, thereby vitiating entirely the effect of the law.

So, the possibilities are: (a) the regulation will increase what consumers pay for gasoline, or (b) it will have no effect. Making consumers better off is not one of the possibilities.

Newsom has used the legislation to demonize oil companies, whom he claims make too much money, as evidenced by the high prices Californians pay for fuel, relative to those who live elsewhere.

Riddle me this, Gavin: if being in the refining business in the Golden State is so damned lucrative, why have 7 refineries in the state shut down in the last decade? Indeed, hot on the heels of Newsom’s crowing over the law, Phillips66 announced it is closing its refinery in California.

Note to the slow learners (and no learners): exit is not a sign of excess profits. Quite the contrary.

But this is the type of deep economic thinking that infests progressives, and which they want to inflict on all of us. Oh, if what happens in California were to stay in California, what happiness there would be for the rest of us. But the Democratic party wants to Californicate all of America instead.