For information
on 26 April 1999

Legislative Council Panel on Economic Services

RETAIL PRICES OF MAJOR FUELS
INTRODUCTION

This paper informs Members of findings from analysis of the retail prices of three major fuels, namely unleaded petrol, automotive diesel and cylinder Liquified Petroleum Gas (LPG).

BACKGROUND

2. At the meeting on 23 November 1998, Members considered submissions by Caltex Oil Hong Kong Limited, Mobil Oil Hong Kong Limited and Shell Hong Kong Limited on their pricing practices for major retail fuels and by the Consumer Council on their study of retail prices of petroleum products. Members considered that data available to the public were insufficient for an assessment of whether the retail prices of oil products were fair.

3. The Administration undertook to collect more data from the oil companies for further analysis.

4. The five oil companies supplying oil products in Hong Kong were requested to provide a breakdown of their cost components for three retail fuels, namely, unleaded petrol, automotive diesel and cylinder LPG for the years 1997, 1998 and 1999 respectively. The data for 1999 were to be estimated by the oil companies based on information available to them up to the middle of January 1999.

5. The oil companies provided data to us on a confidential basis and maintained that the data provided were proprietary and commercially sensitive. To preserve the confidentiality of the data whilst letting Members and the public have a better understanding of their cost structures and pricing practices, the oil companies have agreed to our presenting their data on an aggregated and non-attributable basis, and in relative terms. As only three oil companies have been able to provide the data up to the level of detail requested by us, the observations set out in the following paragraphs are largely drawn from analyses of the data of these three oil companies on a weighted average basis. The situation of these three oil companies should be fairly representative of that of the whole oil products supply sector in Hong Kong as they represented over 70% of the retail market of both unleaded petrol and automotive diesel and over 65% of the wholesale market of cylinder LPG.

6. In analysing the data, we examine whether there is difference in major cost components among the oil companies. We also try to ascertain the relationship between changes in different cost components and its impact on both the retail price and profit of the companies concerned. The purpose is to see whether there is competition among the oil companies, what affects adjustments in retail/wholesale price and profit and the extent to which such adjustment is related to change in the cost of imported product.

7. In the process we have provided the Consumer Council with data from the oil companies on the same basis (i.e. aggregated and non-attributable) as set out in para. 5 above and have consulted them on the analysis.

ANALYSIS

8. Whilst analyses relating to 1997 and 1998 are based on historical figures, that relating to 1999 is based on estimates by the oil companies. In practice, components could be subject to changes in the course of 1999 and the analysis in respect of 1999 should therefore be viewed in that context.

UNLEADED PETROL AND AUTOMOTIVE DIESEL

Components making up the retail price

9. The retail prices (also often called pump prices) of unleaded petrol ($9.84/litre at present) and automotive diesel ($5.59/litre at present) are the same among the oil companies. The average retail price in 1998 was $10.10 ($10.16 in 1997) for unleaded petrol and $6.14 ($7.00 in 1997) for automotive diesel. The key components making up the retail price per litre of the oil products are set out in Annex 1.

Government duty

10. In the case of unleaded petrol, Government duty represented around 60% of the average retail price for all three years. In the case of automotive diesel, it represented about 43%, 40% and 36% of the average retail price in 1997, 1998 and 1999 respectively. Duty for unleaded petrol has essentially remained at $6.06/litre since March 1997 and that for automotive diesel had fallen from $2.89/litre since March 1996 by 30% to $2.00/litre in June 1998. Therefore, the revenue yield from fuel duty has in fact been reduced in real terms.

Costs

11. Costs could be classified as variable or fixed costs. Variable costs are directly attributable to each litre of the oil product, e.g. imported product, dealers' margin, fleet/card/coupon/discounts (discounts), promotional give-aways. Fixed costs are not so directly attributable. They are generally required irrespective of the quantity of sales, e.g. land premium and rent, other operating costs.

12. Fixed costs are allocated to each litre of the product based on the sales quantity; therefore, given a sum of fixed cost, the higher the sales volume, the smaller will be the fixed cost element of each litre of the product sold. There is therefore incentive for the oil companies to seek growth in their sales quantity to keep the overall unit cost down and thereby maximise the profit from each litre of the product sold. The fixed cost elements represented around 40% of the average net cost (excluding duty and profit) per litre of both unleaded petrol and automotive diesel for all three years.

Major cost components

13. Major cost components for both unleaded petrol and automotive diesel are imported product, dealers' margin, discounts, and land premium and rent for the filling stations. Imported product and discounts were found to be more volatile than other cost components.

14. In the case of unleaded petrol, of the average net cost per litre of the product, imported product represented 39% in 1997, 29% in 1998 and 21% in 1999. Dealers' margin and promotional costs represented 26% in 1997, 33% in 1998 and 44% in 1999. Land premium and rent for the filling stations represented 16% in 1997, 20% in 1998 and 19% in 1999. Other costs represented 19% in 1997, 18% in 1998 and 16% in 1999.

15. In the case of automotive diesel, of the average net cost per litre of the product, imported product represented 36% in 1997, 25% in 1998 and 21% in 1999. Dealers' margin and promotional costs represented 30% in 1997, 37% in 1998 and 44% in 1999. Premium and rent for the filling stations represented 16% in 1997, 22% in 1998 and 21% in 1999. Other costs represented 18% in 1997, 16% in 1998 and 14% in 1999.

Cost structure and profit level among the oil companies

16. Two tables showing the difference in the unit cost of the major components among the oil companies with the highest unit cost and that with the lowest unit cost for the relevant component for unleaded petrol and automotive diesel are at Annex 2. The data provided show that the oil companies had different cost structure and profit level.

17. Differences in land premium and rent for the filling stations were wide in 1997. There was a bulk renewal of 31 petrol filling station leases in 1997 at full premium and the differences narrowed in 1998 and 1999. Differences in discounts fluctuated. For unleaded petrol, the difference narrowed in 1998 and 1999 probably reflecting individual companies' efforts to increase sales. For automotive diesel, the difference increased because particular oil company increased their discounts considerably. Differences in the profit were the result of changes in the differences in the cost elements. Profit in 1998 on average represented around 9% (17% in 1997) of the average net cost for unleaded petrol. In the case of automotive diesel, it represented around 7% (11% in 1997). In terms of the average retail price, the profit represented around 4% in 1998 (6% in 1997) for both products.

Changes in costs and their implications for retail price

18. The components with major changes in unit costs in 1998 over 1997 and in 1999 over 1998 are shown in Annex 3 (in respect of unleaded petrol) and in Annex 4 (in respect of automotive diesel). It should be noted that the effect of certain cost changes, e.g. payment of land premium/new rents for petrol filling stations, were partially felt in the first year they happened with the full-year effect only reflected in the following year.

Unleaded Petrol

19. In 1998 the retail price of unleaded petrol at the start of the year was $10.24/litre (with duty at $6.06/litre) and became $9.84/litre (with duty at $6.06/litre) at the end of the year. During the year, while the average cost of imported product fell by $0.32/litre, the average retail price excluding duty decreased by only $0.18/litre. At the same time, there were cost increases in other components, e.g. land premium and rent for petrol filling stations were up by $0.18/litre and discounts were up by $0.28/litre. As a result, the average profit decreased by $0.28/litre.

20. For 1999 up to the middle of January, there had been no changes in the retail price and duty. While the average cost of imported product fell by $0.18/litre, the average retail price excluding duty decreased by $0.21/litre. At the same time, there were cost increases in other components, e.g. discounts were up by $0.62/litre. As a result, it was estimated that the average profit would decrease by $0.59/litre. As an indication of the price movement of the imported product, it is noted that since the middle of January 1999, the quoted F.O.B. price of unleaded petrol refined in Singapore which is the major source of supply for Hong Kong, has risen by about 37%.

Automotive Diesel

21. In 1998 the retail price of automotive diesel at the start of the year was $6.91/litre (with duty at $2.89/litre) and became $5.59/litre (with duty at $2.00/litre) at the end of the year. During the year, while the average cost of imported product of automotive diesel fell by $0.45/litre and the average retail price excluding duty decreased by $0.31/litre. At the same time, there were cost increases in other components, e.g. land premium and rent for petrol filling stations and discounts were up by $0.17/litre each. As a result, the average profit decreased by $0.15/litre.

22. Up to the middle of January 1999, there had been no changes in the retail price and duty. Whilst the average cost of imported product fell by $0.07/litre, the retail price excluding duty decreased by $0.12/litre. In addition, discounts increased by $0.35/litre. As a result, it was estimated that the average profit would decrease by $0.36/litre. As an indication of the price movement of the imported product, it is noted that since the middle of January 1999, the quoted F.O.B. price of automotive diesel refined in Singapore which is the major source of supply for Hong Kong, has risen by about 11%.

CYLINDER LIQUEFIED PETROLEUM GAS (LPG)

Wholesale price

23. The oil companies sell cylinder LPG on a wholesale basis to their dealers who then on-sell it to the end-users on a retail basis. At present there are over 300 cylinder LPG dealers operating in the territory.

Retail price

24. Retail prices of cylinder LPG have been fixed at a nominal rate by the oil companies and have remained at $8.35 since November 1996. Actual retail prices are determined by the dealers. In setting their own retail prices, the retailers take into account the local operating environment and running costs such as wages, shop rentals, insurance, transportation and storage. Before the reduction in wholesale price of $0.40 announced in late January, the actual retail prices ranged from around $8.40 to around $12.40. Details of retail prices of cylinder LPG are beyond the scope of this study.

Components making up the wholesale price

25. The key components which make up the wholesale price per kilogram (kg) of cylinder LPG are shown in Annex 5. Similar to unleaded petrol and automotive diesel, the cost components included variable costs, e.g. imported product, and fixed costs, e.g. storage and distribution, rent on cylinder wagon parking sites. Fixed costs represented about 52%, 64% and 61% of the average net cost (before profit) per kg in 1997, 1998 and 1999 respectively.

26. The major variable cost item was imported product which represented about 48%, 36% and 39% of the average net cost per kg. in 1997, 1998 and 1999 respectively.

Cost structure and profit level among the oil companies

27. Similar to the two oil products above, the oil companies had different cost structure and profit level for cylinder LPG. A table showing the difference in the unit cost of the major components between the oil company with the highest unit cost and that with the lowest unit cost for the relevant components are at Annex 6.

28. There were differences in the wholesale prices of individual oil companies. Profit in 1998 on average represented around 28% of average net cost (22% in 1997). In terms of the average wholesale price, the profit represented around 22% (18% in 1997).

Changes in costs and their implications for the wholesale price

29. In comparison with 1997, while the average cost of imported product fell by $0.68/kg in 1998, the average wholesale price only decreased by $0.03/kg. At the same time there were cost increases for other components, e.g. other operating costs went up by $0.27/kg. As a result, the average profit increased by $0.23/kg. In late January 1999, the oil companies reduced the wholesale price by $0.40/kg as described in para. 30 below. Had the latter reduction of $0.20 been effected fully in 1998, the profit margin for 1998 would have been reduced to 23% of average net cost, or 18% in terms of the average wholesale price. The components with major changes in unit costs are shown in Annex 7.

Introduction of a mechanism for pricing cylinder LPG

30. On 27 January 1999 Shell Hong Kong Limited reduced the wholesale price of cylinder LPG by $0.40/kg : $0.20/kg was attributable to the additional profits made by the Company in 1998 due to the fall in the cost of the imported product, partly offset by other cost increases in the year; and $0.20/kg was attributable to their forecast of a further drop in product cost for the coming six months. The reduction was immediately followed by other oil companies.

31. At the same time, Shell announced the adoption of a mechanism for adjusting their LPG prices at half-yearly intervals in future. Under the mechanism, the Company will review their imported price of LPG every six months and their operational costs every twelve months. In each six-monthly review, the Company will review the changes in the imported price of LPG since the last review, forecast the likely price level for the coming six months and adjust the wholesale price accordingly. In other words, the Company will not make any gain/loss from any change in imported price of LPG and will pass on any such changes to consumers through making an adjustment every six months to their wholesale price. In each twelve-monthly review, the Company will take into account their operational costs when making the wholesale price adjustments. This should mean that future changes in import price would be fully taken into account in future changes in the wholesale price of cylinder LPG.

OBSERVATIONS

32. Data provided by the oil companies have given a better idea of the cost structure and profitability of oil companies in relation to their Hong Kong operations.

33. The data show that oil companies have different cost structures. These should provide scope for competitive retail pricing of unleaded petrol and automotive diesel and wholesale pricing of cylinder LPG. In practice, there is differential wholesale pricing for cylinder LPG. However, changes in pricing for unleaded petrol and automotive diesel by any oil company with a substantial market share were quickly followed by others. Due to the close proximity of petrol filling stations in the urban areas and the general homogeneity of the product, there could be market pressure for oil companies to follow the lead of others in reduction of prices in order to maintain market share. By the same token, the fact that pump prices are observable between competitors could also mean that price increases could move uniformly. The question as to whether the observable prices are competitive or not, in these circumstances, is answerable from examining whether profits on retail prices are excessive (see paragraph 17).

34. The high fixed costs for all three major fuels should provide a strong incentive for oil companies to compete for market share. The data show certain competitive elements in their operations e.g. it is noted that discounts vary considerably among the oil companies and that the differences changed over time as well. It would appear that the oil companies mainly compete through varying their discounts and promotional costs whilst tracking each other closely on the retail price for unleaded petrol and automotive diesel and wholesale price for cylinder LPG.

35. Changes in retail prices (excluding duty) of unleaded petrol and automotive diesel tended to be led by changes in the cost of the imported product though the changes might not be of the same magnitude since other costs also had a role to play. On the other hand, unit profit seemed to change as the level of discounts changed.

36. In the case of cylinder LPG, adjustment in the wholesale price in 1999 fell behind reduction in the cost of imported product even taking into account changes in other cost components. The adoption of the pricing mechanism by Shell Hong Kong Limited in January 1999 should mean that changes in price of the imported product would be taken into account fully in its future adjustment of the wholesale price of LPG. It also increases transparency in its pricing. We hope that other oil companies would also take steps to the same end. The implemented reduction in wholesale price in 1999 would, barring changes in other cost components, result in reduction in the profit margin.

37. The unit profit margin for cylinder LPG (see paragraph 28) is much higher than that for unleaded petrol and automotive diesel. The actual profit for the former might however decrease over time given the high fixed costs and the prospect of further reduction in the market share of cylinder LPG in the gas market. It is noted that the sales volume of cylinder LPG has decreased by about 7% between 1997 and 1998.

38. It should be noted that whilst the above analyses have highlighted the profit margin on each litre of unleaded petrol/automotive diesel or each kg of cylinder LPG sold by the oil companies, their actual profits are determined by the actual sales volume. It should also be noted that another way of measuring business profitability is in terms of a percentage return on the capital employed. However, the oil companies have so far been unable to provide the data in this regard for each of the products. They advised that they employed capital on an overall business basis, rather than on an individual product line basis, such as in respect of unleaded petrol, automotive diesel and cylinder LPG.

39. The Consumer Council generally shares the view expressed above. It is currently conducting a study on the functional aspects of competition in the Hong Kong petroleum products industry. It has indicated that the cost and pricing information in this paper will be considered for inclusion, where appropriate, in its study.

Economic Services Bureau
21 April 1999

Annex 1

Annex 2

Difference in cost of major components among the oil companies
- Highest Unit Cost vs Lowest Unit Cost

Table 1 : Unleaded Petrol

Table 2 : Automotive Diesel

Annex 3

Unleaded Petrol
Year-over-year change in the unit cost of each component (based on aggregated weighted average costs of the oil companies)

Note :	(1)	It should be noted that the figure does not include price changes since mid January 1999. The quoted F.O.B. for unleaded petrol refined in Singapore has risen by about 37% between mid-January 1999 and first week of April 1999.
	(2)	The figure includes the special promotion discounts of 12% which has been withdrawn since early April 1999.

Annex 4

Automotive Diesel
Year-over-year change in the unit cost of each component (based on aggregated weighted average costs of the oil companies)

Note :	(1)	It should be noted that the figure does not include price changes since mid January 1999. The quoted F.O.B. for automotive diesel refined in Singapore has risen by about 11% between mid-January 1999 and first week of April 1999.
	(2)	The figure includes the special promotion discounts of 15% which has been withdrawn since early April 1999.

Annex 5

Cylinder LPG
Components of wholesale price

Annex 6

Difference in cost of major components among the oil companies
Highest unit cost vs Lowest unit cost
Cylinder LPG

Annex 7

Cylinder LPG
Year-over-year change in the unit cost of each component (based on aggregated weighted average costs of the oil companies)

Note :

(1)

It should be noted that the figure does not include the $0.40 reduction in wholesale price announced in end of January 1999.