The map used at UCAN's gas project, built specifically to document gas redlining.

1)  Zone Pricing limits the dealer's ability to lower prices:

Pretend, for a moment, that you are a gasoline station owner. Your station is at an intersection where 200,000 cars pass by your station daily. Not only that, but your station is easy to enter from any direction and you make sure the restrooms are clean and that there is always clean soapy water and squeegies. In other words, you own the perfect gas station, and your customers are willing to pay a few pennies more for your gas.

Over the years, you have done such a splendid job of making your station superior, that you are able to charge 10¢ per gallon more for your gasoline than your competitor across the street. However, like all owners of brand-name gas stations, you are required to buy your gas from a single source.  

Sooner or later, the person who sets your wholesale price at the oil company will notice that you are making 10¢ more per gallon on your gasoline. He realizes that if he raises your wholesale price by 10¢ that he will transfer the extra profit from your pocket to the oil company's.  And that's exactly what has happened to the majority of dealers in San Diego: Over the years, retail profit margins have been shrinking as high volume stations have had their profit margins limited to an average of about 6¢ a gallon.

As a branded dealer you have no choice but to pay up and shut up - even if another owner with the same brand of gas located across the street is paying 20¢ less per gallon wholesale.

In other words, as a dealer, your only method for increasing profits is to raise your retail price which causes you to lose customers. In 1999, the California Attorney General studied refinery margins on gasoline and estimated that in California, the average refinery "take" per gallon of gas was about 32¢. Now, almost ten years later, UCAN estimates that the average refinery margin has been as high as $1.31 per gallon in the last five months. Meanwhile, the dealer is limited to a profit of about 6¢ a gallon. 

And this is where the redline price game gets really nasty. Suppose that the refinery you buy your gas from wants to BUY your station and eliminate the middle man. They already have 100% control over your wholesale price, so they can overcharge you to the point of bankruptcy and take over your gas station at fire-sale rates.  

To avoid this ugly fate, many dealers terminate their relationship with a major brand and go "independent," but this option is also fraught with risk ...  again ... because of zone pricing (see point #3 below).

 2) Zone pricing creates high-priced ghettos

In the oil industry nobody likes a cost-cutter. Cost-cutters ruin everybody's profit. The ideal situation in a neighborhood is when all of the stations assume their usual pricing structures. Namely, that Arco generally has the lowest price, Chevron generally has the highest price, and the rest of the stations fall somewhere in between.  Rarely is the price spread between a cluster of competitors more than 12¢.

This type of "run-with-the-pack pricing" creates the illusion of competition between brands. But every so often, an ambitious dealer will try and seize customers from a competitor by lowering his price and cutting into his 6¢ profit margin. The dealer may sell gas at break-even prices just to lure new customers into his or her station.

From the perspective of a refinery pricing manager, this is a VERY dangerous situation. Once one dealer lowers the price, the dealers nearby will respond by lowering their prices. But thanks to zone pricing, this type of unhealthy competition can be stopped immediately by simply raising the offending dealer's price to a point where he is unable to compete at all. This is why you have high-priced ghettos in areas like La Jolla and Carlsbad. Dealers who don't toe the line on pricing are priced into oblivion.

Alternatively, zone pricing can be used to punish and discipline a cost-cutter (see point #4).

3) Zone pricing creates the illusion of competition.

Redlining different neighborhoods and dealers makes it appear as though there is a robust and competitive marketplace, but this is largely an illusion.

The reason there is a variation in prices from neighborhood to neighborhood is that the industry has chosen to zone different neighborhoods at different price points.

UCAN has determined that the cheapest zones are those areas where there is a large population of unbranded independently owned gas stations. Independent stations for the industy to compete.  

4) Zone pricing creates a chilling effect on competition.

Zone Pricing can be used to punish dealers who are too competitive. This punishment is not limited to the oil refineries' own dealers, rather it can be used as a powerful tool for disciplining the small and highly aggressive competitors that are known as unbranded dealers.

Unbranded dealers are almost the most competitive dealers in any give neighborhood. UCAN's research has shown over the last ten years that communities with the most unbranded stations tend to have the lowest gasoline prices.

Unbranded stations are not subject to zone pricing. They can price-shop for the cheapest gas. If Shell's gas is too expensive, they can buy Chevron's, or in many cases, they can buy their gas from a bulk fuel distributor.  Because the unbranded stations can shop for the best price, the competition for their business is fierce. Frequently, an unbranded dealer can make a 25¢ a gallon profit, and still undercut the major brands' retail prices by a dime or more.

The way the oil industry reacts to this type of competition is to "discipline" a competitive dealer by overpricing their gas in the high-price ghettos (see point #2 above), and by underpricing, or subsidizing, their gasoline to the dealers that surround the troublemaker.

It is unlawful to sell gasoline at a loss in order to drive a competitor out of business, but with Zone Pricing, it is lawful to subsidize one dealer's cheaper price by charging other dealers a higher price. Ultimately, the unbranded dealer is whipped into submission.

As a general rule, the owners of unbranded stations in Southern California have all learned that it is unwise to price their gas more than 2¢ below the nearest Arco. They've been disciplined.

Even powerful retailers like CostCo have learned this lesson. In the spring of 2002, retailing giant CostCo began aggressively pricing its San Diego gasoline. Frequently, CostCo gasoline was 20 to 30 cents per gallon cheaper than the nearby Chevron, Citgo, Arco, Shell, and Mobil station. Over time CostCo learned that the safest strategy was to either match Arco, or charge a price that is 2¢ lower than the nearest Arco. To our knowledge, this pricing formula rarely fails. On any given day, the local Arco will be 2¢ higher than the nearest CostCo station.

What this means is that CostCo doesn't decide what its retail price should be; rather, Arco decides what CostCo will charge. 

So the next time you hear an oil industry spokesperson suggest that the gasoline market is working because there are "aggressive competitors like CostCo," just remember that CostCo's retail price is determined by Arco.

 Related articles:
"Gas Prices all over the Map" San Diego Union Tribune, August 16, 2007

"Zones of Contention" LA Times Story, June 19, 2005

Sen. Ron Wyden's "Report on Anticompetitive Concerns in Oregon Gasoline Prices.")