John E. Petite| Greensfelder, Hemker & Gale, P.C.
For more than a decade, major refiners unbundled their integrated operations to focus on the more lucrative upstream business (resource production and refining operations) in markets that had robust prices. They increased expensive exploration efforts and made major investments to augment refining capacity. In part to fund those activities, they sold or spun off downstream assets. These divestment initiatives focused on retail operations, where margins had been steadily shrinking for decades and litigation and retail network management costs had been ballooning. This move to divest retail assets came after a decade or so in which those same companies heavily invested in company-owned and – operated retail sites with convenience store operations.
In the wake of that divestment era, of the approximately 125,000 convenience stores selling fuels, less than 0.5 percent are owned by one of the five major oil companies. Still, the brands of the major oil companies remain omnipresent, as half of retail outlets sell fuel under the brand of one of the 15 largest refiner-suppliers. In many cases, according to the National Association of Convenience Stores (NACS), that branded fuel is distributed by large regional jobbers, with multi-year supply contracts with multiple branded refiners. Those jobbers have their own retail networks of dealers or company-operated stores. The branded jobber channel has thus been reformed from a sleepy rural segment of the branded fuel industry to one that dominates it.
The remaining 50 percent of retailers sell “unbranded” fuel at stations often “owned by companies that have established their own fuel brand (i.e., QuikTrip, 7-Eleven) and purchase fuels either on the open market or via unbranded contracts with a refiner/distributor.” These unbranded operations are frequently owned by jobbers who also sell branded fuel, further increasing the vitality and independence of the jobber channel. The growth of the unbranded segment has caused the majors to rely more heavily on commercial or unbranded sales. In addition, convenience stores are now dominating the industry, where they sell an estimated 80 percent of the fuels purchased in the United States, a percentage that looks as if it will continue to grow.
Since the majors divested their retail assets, retail margins have grown steadily. According to NACS, “despite extreme volatility, retail margins for fuel are fairly consistent on an annual basis” and, since 2010, have “averaged 18.9 cents per gallon.” In many markets, these margins are twice what they were in the mid-2000s, when the retail divestment trend began. With these consistently healthy margins, and the fat margins available in c-stores, retailers have less incentive to pursue marketing strategies to increase the volume of fuel they sell. In this way, the retailers’ interests are not aligned with the refiners who indirectly supply them.
In the meantime, U.S. demand for gasoline had declined from its peak in 2007 and domestic production has nearly doubled over the last six years. Historically, major oil companies could weather these boom-bust dynamics in the price of oil because of their integrated operations. Their upstream and downstream segments worked as a hedge. After all, fuel retailers typically see profitability decrease as prices rise, and increase when prices fall. But the retail divestment trend largely left the majors without that hedge or that provided by profitable downstream c-store operations. In addition, the recent plunge in demand has for large oil companies hammered home the lesson that whoever controls the retail site real estate controls the demand for a given brand or source of fuel.
Now, with a worldwide glut of cheap oil, the profit opportunity has moved to downstream assets. This focus is not just driven by improving margins in the downstream sector, but the fact that reduced demand has put pressure on all refiners that invested heavily in upstream activities to stabilize the off take from their refining assets. Consequently, refiners are reentering retail but in a vastly different landscape than what existed even ten years ago when they divested those assets. This transformational process carries with it a grocery list of legal issues that integrated refiners had eliminated or greatly reduced through their divestment strategies. To get the downstream margin and secure reliable off take demand, refiners must assume the risks – and in some cases risks greater than those of 10-20 years ago – associated with again operating a network of retailers in this new climate with more robust jobber and unbranded fuel operations.
Those risks include discriminatory and bad faith pricing claims associated with dual-distribution markets, where the refiner distributes through jobbers and dealers, as well as company operations. That competitive friction is a recipe for litigation. Better funded, and more independent and commercially sophisticated jobbers may claim that their suppliers are trying to drive them out of business as part of a scheme to steal their branded retail sites and convert them to company operations. Retail dealers will have complaints of their own. Such claims arise under the Petroleum Marketing Practices Act (PMPA), state franchise and distribution statutes, federal and state pricing-claims (including UCC § 2-305 claims and Robinson-Patman Act (RPA) claims), federal and state antitrust claims and breach-of-contract and business tort claims.
Because refiners after divestment grew more reliant on unbranded commercial sales, purchasers of higher priced branded fuel may face greater competition from those unbranded resellers and claim discrimination. Although such a claim faces high obstacles under § 2-305, where the alleged favored and disfavored purchaser must have similar contract arrangements with their shared seller, it may find an easier path under the RPA, which will likely view branded and unbranded fuel as “of like grade and quality” absent meaningful chemical differences. With such increased reliance comes greater exposure.
Reviving c-store programs, either through a franchise system or direct company operations, also presents a challenge. Many refiners exited that space when they realized they were not as proficient as their well-established competition at running such programs. Reentering will require refiners to compete with c-store operators who have spent the last decade further honing their competitive edge and building mega c-stores that function as quasi-supermarkets. Those existing c-store operators often have co-branding arrangements with fast food restaurant systems, who may be unwilling or contractually restricted from engaging new partners. Reentry will not only be an expensive and daunting task, it will also generate new risks, such as those created by the National Labor Relations Board’s new joint employer liability standards for franchisors vis-à-vis their franchisees’ employees.
Maintaining a retail channel also carries risk associated with establishing and implementing certain business models for distribution and retailing, including PMPA franchise programs, company operations, commission marketers, brand licensees and on-franchise operating models. Reentering the retail segment implicates promotional campaigns and similar incentive programs, such as price discounts or branding incentives. Having more franchisees with retail operations creates risk on emerging joint employer issues, distribution terminations and nonrenewals, franchising issues, and storage and transportation arrangements.
Reestablishing a retail channel requires that refiners buy or lease retail sites to acquire outlets for their branded fuel. Even putting aside the cost of acquiring those sites (or persuading site owners to rebrand through expensive rebranding incentives), rebranding those sites may not be so easy. Indeed, it carries risk created by brand covenants or deed restrictions on the use of retail motor fuel sites and first refusal rights on the sale of previously divested retail assets, two tools that major oil refiners used when divesting assets in an effort to ensure continuing demand from those sites. Expensive litigation is often the result.
Retail operations also implicate consumer-interface risk involving retail motor-fuel pricing, temperature-correction issues and discount and credit card programs. Similarly, other retail risks arise from payment card issues (credit/debit), data security protocols, reward or loyalty programs, weights and measures issues and other consumer posting issues. These risks can be a fertile ground for enterprising class action plaintiffs’ lawyers.
George Santayana once said that those who cannot remember the past are condemned to repeat it. That observation is apt here, as refiners looking to reenter the retail segment must not only remember why they left it in the first instance, and strive to weigh and better manage those risks on the front end, but also understand the new risks such a strategy carries with it in today’s petroleum marketing landscape.