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HIGH
GASOLINE PRICES
Part 2: Long-Term Factors
by Robert
Rapier
R-Squared Blogspot
June 7, 2007
Introduction
In
Part I, I
discussed the short term factors that have resulted in the recent,
rapid increase in the price of gasoline. But there are a number of
underlying, long-term issues that have been major contributors. I will
attempt to address them and answer a number of related questions, such
as: Why have no new refineries been built in the past 30 years? Are U.S.
refineries breaking down more than normal? Are oil companies purposely
withholding supplies to keep prices high? Have environmental regulations
played a role? Does the use of ethanol influence gasoline demand growth?
The answers to some of these questions may surprise you.
Please note that my essays should not be confused with financial advice.
Following my last essay, I received a number of e-mails requesting
financial advice. While there are often potential financial
implications, I am not a financial planner. If you choose to make
investment decisions based on what you read here, you are on your own.
Further note that it is not my contention that refiners are not
benefitting from higher prices. They are. But my contention is that
prices aren't higher because they have increased
margins. Margins have increased because prices are higher.
U.S.
Refinery Capacity
The problem, I have read on many occasions, is that we aren't building
any new refineries, and that "limiting
refinery capacity seems to make more money for oil companies than
expanding it." Claims like
the following from the Foundation
for Consumer and Taxpayer Rights - are quite common:
America's
big oil companies figured out long ago that they could make more money
by making less gasoline. That's why the industry hasn't built a new
refinery in 30 years. Since deregulation of the refinery business in
1982, oil consumption has increased 33% but oil companies have kept
refining capacity near what it was 25 years ago. Why not? They know that
the scarcer the product, the bigger the profit.
Even members of the Senate
Committee on Energy and Natural Resources seem to believe this, with
New Jersey Senator Robert Menendez
recently commenting in a Senate
hearing on gas prices:
Senator
Menendez: Isn't there a reality that we are paying for some
industry decisions that actually reduced refining capacity in this
country? I mean there was a time that we had greater refining capacity,
and the industry reduced that refining capacity, and as a result of
making that decision, consumers today find themselves with exactly the
consequences that you have described in your testimony before.
There
are elements of fact and elements of fiction in the preceding
statements. So, what's the scoop? Are oil companies cutting refinery
capacity in order to boost profits?
In the past 10 years, refining
capacity in the U.S. has increased by about 2 million barrels per day,
which is equivalent to about 10 good-sized refineries. Capacity
expansions equivalent to 8 more new refineries have
been announced for the next 4 years (although some refiners have
recently suggested that some expansions may be put on hold as
a result of the stated goal of reducing gasoline consumption by 20%
in 10 years - in order to avoid an oversupply situation). So while it is
true that new refineries aren't being built, it is certainly not true
that capacity is stagnant. There are several reasons for expanding
refineries as opposed to building new ones.
First, it is less expensive per barrel to expand an existing refinery
than to build a new one. The estimates I have seen suggest that existing
refineries can be expanded at 60% of the per barrel cost of building a
new refinery. Second, the permitting process for building a new refinery
is onerous. A group in Arizona has been trying to build a new refinery,
and it
took them 7 years just to get the permit. If they proceed and build
the refinery, it will have taken 13 years from the time they started the
process. (Even as I was working on this essay, they
have announced a further 1 year delay). Finally, while everyone
seems to want more refining capacity, nobody seems to want a refinery in
their community. This makes building a new refinery next to impossible.
As Investor's Business Daily recently
asked Senator Chuck Schumer: "Just where in New York state
would you like a new refinery to be built...?"
However, the critics are correct on one point. Starting in the early
80's, U.S. refining capacity did drop significantly, before beginning to
climb back up in the 90's. The reason for this is quite simple: There
was far more refining capacity than was warranted by the demand. The
result was that gasoline was $1.00 a gallon, and oil companies were
losing a tremendous amount of money. Many refineries shut down. Some oil
companies went out of business. Yet many view oil companies as if they
are public utilities. But the majority are owned by shareholders, who
expect a return on their investment. Billions of dollars of capital are
risked in this business, and if the rewards are poor (or negative), the
risks won't be taken.
No industry can be expected to maintain high production levels in the
face of poor or even negative margins. If milk producers make too much
milk, prices fall and some producers go out of business. When that
happens, supply is reduced and prices go up. The same is true for any
other business. Yet people don't accept this very well in the case of
oil companies, because many have come to view cheap gas as an
entitlement.
U.S. Senator Ron Wyden has spent quite a bit of time investigating these
issues, and his view is probably typical with respect to the evolution
of refining capacity:
The
Oil Industry, Gas Supply and Refinery Capacity: More Than Meets the Eye
In this report, Senator Wyden presents a number of "smoking
guns", such as this internal Texaco document from 1996:
“As
observed over the last few years and as projected well into the future,
the most critical factor facing the refining industry on the West Coast
is the surplus refining capacity, and the surplus gasoline production
capacity. The same situation exists for the entire U.S. refining
industry. Supply significantly exceeds demand year-round. This
results in very poor refinery margins, and very poor refinery financial
results. Significant events need to occur to assist in reducing
supplies and/or increasing the demand for gasoline.”
Senator Wyden seems to have skipped right past the part about poor
margins and poor financial results, and focused on the "smoking
gun", that either supplies needed to be reduced or demand for
gasoline increased. He then gives a list of the refineries that have
closed since the mid-90's, apparently failing to connect these events
with "poor refining margins." Here are the refineries he lists
that closed in 1995:
Indian
Refining Lawrenceville, IL
Cyril Petrochemical Corp. Cyril, OK
Powerine Oil Co. Sante Fe Springs, CA
Sunland Refining Corp. Bakersfield, CA
Caribbean Petroleum Corp. San Juan, Puerto Rico
Do you recognize any of those names? Probably not, because most of the
companies that shut down did so because they went out of business.
Margins were too poor to remain in business for some. For others, it was
failure to comply with environmental regulations (some of the closed
refineries are now Superfund
sites). Yet Senator Wyden presents a picture in which it was a
systematic and cooperative effort between oil companies to reduce
refining capacity - and that refinery capacity should have been
maintained at any cost (as long as oil company shareholders are the ones
to bear those costs). Somehow "the industry" is culpable for
the closure of a number of marginal producers - many of whom went
completely out of business. But it was years of poor returns in this
cyclical business that drove down refining capacity.
Paul Sankey, an analyst with Deutsche Bank, testified
on May 15th before the Senate Committee on Energy and Natural Resources.
He pointed out the long-term factors that have resulted in the refinery
capacity we have today:
The
reason for the massive recent run up in prices can be traced back to the
last significant period of high prices, in the late 1970s, which forced
lower gasoline demand, then more efficient cars, which led to excess
refining capacity, which led to years of poor returns in refining (and
cheap gasoline prices), which disincentivised investment in refining and
encouraged demand, and which has ultimately led to today’s intense
market tightness.
The
bottom line on the refinery capacity issue is that yes, refining
capacity has been reduced at times. And there were perfectly valid
reasons that this happened. It is also true that capacity is short at
the moment - if the objective is to maintain sub-$3 gasoline prices.
But, reduced investment in refining capacity is indeed a key factor
behind the current gasoline price spike. If some want to level the
charge that refiners failed to accurately anticipate demand growth, then
that charge is accurate. But like the rest of us, refiners don't have
crystal balls.
Are Oil
Companies Purposely Withholding Supplies?
This charge has been repeated quite a bit lately. Oil companies are
either accused of withholding supplies ala OPEC, or they are accused of
stretching out their maintenance in order to keep supplies low. Let's
address that.
In a very tight market, events that take supply off of the market are
likely to drive prices higher. In light of that, would it be a wise
business practice if BP, for instance, purposely slowed down the
maintenance at their Whiting, Indiana refinery that is partially closed
due to a fire? Not a chance. When BP has supply off the market, it
benefits everyone BUT BP. They are losing money every day they have that
capacity offline. The refinery manager at Whiting will have part of his
performance graded based on the financial returns of his refinery. The
longer the supply is offline, the worse that grade will be.
Consider a couple of examples. Say that you operate a 200,000 barrel a
day refinery. Margins are quite good right now - let's say in your area
they are $20 a barrel. So, when the refinery is running normally, you
are grossing $4 million a day. Would it make good business sense to cut
your capacity in half - to 100,000 barrels a day? While such action
would probably cause the overall price of gasoline to rise, it is going
to have a disproportionate effect on your refinery. If margins go up to
$30 a barrel (although there is no way taking 100,000 barrels off the
market would impact margins to that degree), you are still $1 million a
day worse of than you were. You have given up $365 million a year in
order to reduce your capacity. You would have made an incredibly stupid
business decision. In fact, you would be much better off if you could
boost capacity by 100,000 barrels a day. Sure, prices might slightly
drop, but your overall profits will be higher, especially in such a
tight market.
Furthermore, you don't know if Shell down the street might be able to
make up the production shortfall, pocketing the money that would have
been made by your refinery. You also don't know if exporters from Europe
will respond. If they respond by boosting exports to the U.S., now they
are pocketing the money that your refinery is losing. In summary, this
is not a rational way to conduct business - unless your margins are
negative. You would be making a decision that will certainly cut the
returns at your refinery, while not knowing how your competitors will
respond to the supply shortfall.
For another example that many can relate to, consider that you wish to
put your house on the market. Housing prices in your area have been
outstanding, and you want to capitalize. However, you are afraid that by
putting your house on the market, you may boost the supply in your area
and cause prices to fall. So, you decide to be a charitable neighbor and
keep your house off of the market in order to maintain prices for
everyone else. You will sell some other time, even though the market may
not be as good. If your primary objective is to capitalize on the good
housing market, have you made a rational business decision? Of course
not. The same is true regarding the charge that oil companies are
deliberately prolonging maintenance. It just wouldn't make good business
sense in this market.
Are
Refineries Breaking Down More Than Normal?
It certainly seems each week brings several new refinery outages. While
refineries still have not reached pre-Hurricane Katrina production
levels, most of the outages that you read about are the kinds of things
that happen every year. Practically all refineries have one or more
unplanned outages each year. Most years, when the market is amply
supplied, these sorts of events don't make the news. But this year, as
we have seen, is very different.
As the afore-mentioned Paul Sankey testified:
The
poor returns of the 1980s and 1990s have indirectly caused some
additional external events that have played into the problems. The years
of losing money caused companies to neglect refining investment,
culminating in BP’s Texas City disaster. Texas City has now rightly
caused other refiners to operate more cautiously – and so less
capacity is available.
A second impact of years of reduced investment has been a lack of
qualified engineering, procurement and construction staff. One vital
issue here is that the tightness of US refining capacity at this time is
not because companies are unwilling to invest in more capacity, it is
that they are unable
Refineries are complex. Heat is being added to flammable materials, and
the entire chain of events depends on a steady supply of raw materials,
equipment, and qualified people to keep things running smoothly.
Equipment is going to break down. A refinery is much more complex than
your car. Yet you would not be surprised if your 30-year old car had
annual maintenance problems.
While this year's outages may be somewhat above average, similar outages
happen every year. The only difference is that most years there is
enough spare capacity that the outages go unnoticed by the media.
The Impact
of Environmental Regulations
Let me make it clear that I have no objection at all to the
environmental regulations we have in place. They have made our air and
water cleaner. But there is a price to be paid for those regulations,
and consumers should understand that, as they are the ones who will
ultimately bear those costs.
There are several things that can happen when a new regulation is
implemented. First, new regulations may redirect capital that might have
gone into expanding refining facilities. Second, they may increase the
costs of producing the fuel. Third, additional processing, as in the
case of ultra-low
sulfur diesel (ULSD) and gasoline - can reduce the overall product
yield. Fourth, and perhaps of greatest importance, additional equipment
will increase the complexity of the refinery.
Those are the consequences. The more complex the refineries are, the
more unreliable they are going to be. With each additional complexity
that is added, there are more ways for them to break down. There is more
danger as the inventory of hazardous materials increases. Politicians
who are quick to point fingers should understand that they make their
own contribution to supply shortages. If they are going to hold hearings
on gas prices, they needn't ponder "Gosh, I wonder why prices are
going up?" Stricter environmental regulations - necessary as they
may be - are one more piece of the puzzle. They have helped crimp
supplies and add to costs.
Investor's Business Daily recently
touched on this:
Our
refineries are doing more than ever, but their numbers are dwindling and
no new ones are being built. The reason is not greed, but cost and
regulations. From 1994 to 2003, the refining industry spent $47.4
billion, not to build new refineries, but to bring existing ones into
compliance with ever new and stringent environmental rules. That's where
those allegedly excessive profits go.
I think most people are willing to pay higher prices for a cleaner
environment, but it is important that they understand that this is a
component of fuel prices.
The Ethanol
Factor
It is a fact that ethanol only contains about 65% of the energy content
of gasoline on a volumetric basis. Therefore, to displace the gross
energy content of 1 gallon of gasoline requires 1/0.65, or 1.5 gallons
of ethanol. What this means is that as ethanol is put into the gasoline
pool, demand will go up simply because the pool now contains less
energy. Is this enough to explain why motor gasoline demand (which
includes blended ethanol) is at a record high?
In March of 2007, ethanol
contributed 539 million gallons to the gasoline pool, according to
the Renewable Fuels Association (RFA). This is almost 50% greater than
the 365 million gallon ethanol demand in March of 2006. Gasoline demand
in March, according to the Energy Information Administration, averaged
9.266 million barrels per day (up from 9.076 a year earlier). Total
gasoline demand in March was then 9.266 million * 31 days * 42
gallons/bbl, or 12.06 billion gallons. The breakdown would have then
been 11.52 billion gallons of gasoline and 0.54 billion gallons of
ethanol.
The energy content, however, of the 12.1 billion gallons would have been
equivalent to 11.52 gallons of gasoline plus 0.54 billion gallons of
ethanol * 0.65 (factoring the lower energy content), or 11.87 billion
gallons of gasoline equivalent fuel. Therefore, our perceived gasoline
demand is 1.9% (12.06/11.87) higher than it would be without ethanol in
the pool.
In other words, part of the record high gasoline demand we are currently
experiencing is due to the fact that ethanol is scaling up rapidly, and
it is being counted in the finished motor gasoline pool. Even if demand
was constant on a BTU basis, increasing the fraction of ethanol in the
pool will increase the volume demand.
Conclusions
While the immediate cause of skyrocketing gas prices is a combination of
record demand and low gasoline inventories in the U.S., several
longer-term factors have contributed. Following years of poor returns
and expensive new environmental regulations, investments into expanding
existing refineries dried up. Many refineries closed their doors
permanently, as a number of smaller producers went completely out of
business in the 80's and 90's. The cumulative effect was that refining
capacity fell starting in the early 80's, but has recently been climbing
back as margins have improved. Just as we were in an oversupply
situation in the 80's, we are now in an undersupply situation if the
goal is to keep gasoline below $3.00/gallon. However, refining capacity
has increased significantly in the past 10 years, and looks to continue
this trend in the foreseeable future. But demand growth has remained
robust in the face of higher prices, so an oversupply situation in which
gasoline returns to $2/gal does not appear likely in the foreseeable
future.
© 2007 Robert Rapier
Editorial
Archive
Robert
Rapier has a master's degree in chemical engineering, and bachelor's
degrees in chemistry and mathematics. He has 15 years of experience in
the petrochemicals industry, including experience with cellulose
ethanol, gas-to-liquids (GTL), and butanol production. He holds several
U.S. and international patents, and is currently employed by a major oil
company. Robert maintains an energy blog at http://i-r-squared.blogspot.com/.
CONTACT
INFORMATION
Robert Rapier
Editor, R-Squared Blogspot
Aberdeen, Scotland, UK
Email | Website
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