The Tiger in Costco’s Tank

The big box is fueling its revenues with its gas business and freaking the competition.

When gas prices are high, as they are now, you can count on two things: Drivers will feverishly, even irrationally, seek out the lowest price–and Costco will have it. In San Diego, where gas prices averaged a whopping $3.43 per gallon in May, Costco lured customers with fill-ups at $3.27 per. In Atlanta, Costco charged $2.76 versus the city’s average of $2.91. Go to Phoenix or Dallas or just about anywhere else the Issaquah, Washington, warehouse chain operates its 268 gas stations, and it’s the same story. Costco’s gas is cheap, cheaper, or cheapest.


How does the shopping warehouse do it? It says its approach simply matches its overall business model: Get rid of the frills, sell for cheap–and make up for thin margins with high volume. Gas retailers, though, grouse that Costco uses gas as a loss leader to get people into the store. Even though Costco has just 0.16% of the 170,000 places you can fill up your car in the United States, its model is roiling the industry.

While big oil companies are raking in record profits from production, refining, and distribution, the retail gas-station business remains defined by razor-thin profit margins. More and more filling stations rely on ancillary mini-mart sales to make a buck. Costco gas stations (unbranded, of course) are self-service only and don’t take Visa or MasterCard, whose fees hammer a gas retailer’s profitability. There’s nary a squeegee in sight. Costco stations sell enough gas that they typically have to replenish storage tanks daily–three or four times faster than the average local station–yielding a far better return on capital.

Costco’s gas business now accounts for well over $3 billion in revenues, about 5% of the warehouse chain’s $62 billion total. And those fuel revenues are growing faster than the company as a whole. Last year, Costco opened 25 new gas locations; so far this year, it has added another 21. Its goal is to include a gas station at every warehouse that it builds from now on, and to add them to as many existing stores as the law permits and real-estate space allows.

This expansion only exacerbates the squeeze traditional service stations are feeling because of rising wholesale costs and escalating credit-card fees. Gross profits on retail gasoline fell to 14.7 cents per gallon at year-end 2006, versus 16.4 cents the year before, according to the National Association of Convenience Stores. After accounting for credit-card fees, payroll, depreciation on the pumps, and other costs, “most retailers were lucky to make a penny a gallon,” says the association’s spokesman, Jeff Lenard. “It’s a game of chicken where retailers fight for consumers at the expense of margin. Right now, it’s not uncommon to find retailers losing money on every gallon they sell.”

No wonder, then, that some of the service stations crying in their tanks have decided to fight the new competition with litigation. In at least 11 states, laws prohibit gas stations from selling below cost, and there have been suits against Costco (and Wal-Mart ). In a pending case in U.S. District Court for the Northern District of Alabama, the Pantry, a publicly traded firm that operates a chain of convenience stores called Kangaroo Mart and booked $6 billion in revenues last year, alleges that Costco sold gas “below cost” during 2006 and 2007 at its Huntsville location. “These illegal pricing practices have already damaged plaintiff’s business, and caused irreparable harm, and if these violations are allowed to continue, Costco will cause irreparable harm to plaintiff and other competitors,” according to the complaint. Costco has responded that it had “on occasion made some sales below cost … to meet the competition,” but otherwise denied the allegations.

Loss leaders have always been anathema to Costco’s corporate strategy, and the company swears it hasn’t changed its tune at the pumps. “Our strategy is not any different than with anything that we sell,” says Bob Nelson, Costco’s VP of financial planning and investor relations. “We’re willing to make less money than everybody else. But gas is not a loss leader, and we will never make it one.” That said, its gas business serves the same function, driving more frequent visits to its warehouses.


Nelson is quick to point out that profit margins on gas are low even for Costco; while the chain’s overall gross margin is around 10%, its gas margins can dip as low as 1%. In fact, he says, making money selling gas is even tougher for Costco when prices are high and rising. That’s because other retailers that replenish their tanks less frequently don’t need to raise prices quickly to keep pace. Yet Costco’s costs rise almost immediately. Keeping its cost-per-gallon edge generates an immediate hit to profitability.

Costco’s innovations have already led Wal-Mart, as well as grocery chains such as Albertson’s and the Kroger Co., to follow it into the gas business. Those below-cost laws are designed to keep competition in the industry and were originally passed to protect independent retailers from Big Oil-owned stations. Looks like Big Gas now needs protection from the big boxes.