According to an AP report, President Bush has ordered a temporary suspension of the new environmental rules for gasoline. Which means refineries can mix additives (MBTE) at the refineries, rather than mixing ethanol at the pump. He also halted the purchase of crude oil for the government’s emergency reserve for the summer months.

This should relieve some of the gas price increases we have been seeing nationwide, but at what cost? Despite the political timebomb for Bush and the Republicans, the environmental measures were created for a reason. Ethanol being mixed at the filling station, rather than MBTE at the refinery was an environmental initiative passed by Congress and signed by the president.

The properties of methyl tertiary-butyl ether (MBTE) allow more oxygen into gasoline and as such it falls into a category of chemicals referred to as “oxygenates.” MBTE is being phased out because it was being found in the water supply all across the nation. But then, Congress is currently considering blocking any lawsuits against MBTE industries, which will protect them in the future.

USNews.com: AP News

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With the switchover to ethanol in gasoline from the additive MBTE, gas shortages are occuring at some filling stations across the US. The disruption may continue for several months according to US Energy Secretary Samuel Bodman.

It’s not the supply of ethanol that’s the problem. It’s the logistics of shipping it to where it needs to be that is causing the issues relating to the shortages. The ethanol is actually mixed at the stations, rather than at the refineries, as MBTE was. That and the filling stations need to empty out and clean the tanks before the switch-over. The cleaning process can take up to two days.

In early April, up to 60 service stations in Dallas ran out of gasoline, because the tanker trucks that would normally be delivering their gas were delivering ethanol instead.

The average price of gasoline is rising to $3 a gallon with concerns over the switchover, the summer traveling season, and leftover issues relating to Katrina all contributing to the climbing rate.

Source: Bloomberg.

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Russian regulators have tentatively cleared a three-way deal that would create the world’s biggest aluminium producer, the Federal Antimonopoly Service and the buyer said Wednesday.

Under terms of the deal, OAO Rusal, Russia’s biggest aluminium producer, will absorb rival Sual as well as the aluminium assets of Swiss-based commodities trader Glencore, creating a global giant with smelters and refineries across Russia and facilities on four continents.

“We have made a decision in principle to approve of the deal and within two weeks we plan to complete the paperwork related to our final conclusion,” the head of the Federal Antimonopoly Service, Igor Artyemyev, said in a joint statement with Rusal.

“This move will strengthen Russia’s role as a fully fledged participant in international economic integration and encourage growth of its influence on the global market,” he said.

Russian regulatory approval had been anticipated, but the deal, which was announced in October, remains to be approved by antitrust bodies in other jurisdictions including the European Union.

Company officials have said they hope the deal will be completed by April.

Under the terms of the agreement, Rusal will issue new shares to acquire Sual, which is controlled by metals and oil tycoon Viktor Vekselberg, as well as the Glencore assets.

Sual and Glencore will hold 22 percent and 12 percent stakes respectively in the new company, which would generate produce nearly 4 million tons of aluminium per year, or about 12 percent of global output. That would put the new company on pace to surpass the current industry leader, U.S.-based Alcoa Inc.

Alumina Ltd said the outlook for alumina and aluminium prices will be driven by demand in China with market fundamentals for aluminium robust, although some oversupply is expected to continue in the alumina market.

Chief executive John Marlay said the scaling back of high cost refinery production in the Western world has seen alumina supplies ease from mid 2006 levels but the market’s outlook remains dependent on the rate in which China’s scales up domestic production.

“We believe the aluminium market is very robust and strong but there are some issues around alumina,” Marlay told a media briefing.

He was speaking after the company reported a 62 pct rise in 2006 net profit to a record 511 mln aud, reflecting strong demand for aluminium and fixed-price sales of alumina. Alumina Ltd expects Chinese domestic demand for aluminium to grow by at least 14 pct this year with growth in western countries seen at about three pct.

Aluminium markets are expected to be balanced to potentially short, while alumina markets are expected to be in an oversupply of between 1.5 to 3.0 mln tons.

The Alcoa Inc, managed Alcoa World Alumina Chemical joint venture (AWAC), which is 40 pct owned by Alumina, expects to lift sales in 2007, principally to supply Alcoa’s new Iceland smelter, scheduled to start up the second quarter of 2007. Alcoa said AWAC’s 2007 production will increase with its expanded Pinjarra refinery in Western Australia operating at full expanded capacity, the commissioning of the Jamalco refinery upgrade in Jamaica, and some increased capacity at other refineries.
See also:

The stock market believes the US aluminium giant Alcoa is ripe for a takeover bid. Rio Tinto and BHP Billiton are being named as the likely predators, but watch out for private equity raiders.

Whether the stories are true or false, whoever contemplates buying Alcoa must come to grips with the fact that the jewel in Alcoa is a joint-venture operation, AWAC (Alcoa World Alumina and Chemicals), where the American company owns only 60 per cent. The Australian listed group Alumina Ltd owns the remaining 40 per cent in what is a most unusual corporate structure.

AWAC is the world’s largest combined bauxite miner and alumina producer – the first two steps in making aluminium. Bauxite and alumina production is often more profitable than smelting aluminium and rolling final products. Accordingly, in recent times the market has awarded Alumina Ltd a higher price-earnings ratio than Alcoa and substantially higher than either BHP or Rio Tinto.

While on the surface that makes it hard for Rio and BHP to bid for the Australian company, there may be offsetting factors because AWAC has a unique global opportunity.

AWAC owns eight of the world’s largest alumina refineries, of which five are in the bottom cost quartile. Better still, in coming years it will be able to increase the capacity of its existing refining operations by about a third from the 2006 level and, because it is adding to base plant, the operating costs (excluding raw materials) of the new capacity will be some 30 per cent below current levels.

At the same time, Alcoa believes with a passion that despite greenhouse, the world’s use of aluminium will double between 2005 and 2020. The Australian CEO of Alumina, John Marlay, is totally convinced that Alcoa’s future projections are right and so the Australian company is taking up its entitlement to fund 40 per cent of what is the world’s largest alumina production expansion.

Rio Tinto and BHP also produce alumina but have been much more restrained.

Australian savers have retained this amazing asset – Alumina – to boost their retirement returns thanks to the long-term strategic investment policies of the late Lindsay Clark, Avi Parbo and Hugh Morgan.

Morgan had to fight the short-term institutional analysts who did not understand how to value the old WMC company correctly, which almost led to Alcoa buying WMC at a price that was nearly as low as the French bid for Axa and the Xstrata takeover of MIM.

The attempt by the Americans to take advantage of Australia’s poorly trained analysts forced the board of WMC to split the company into two. BHP later bought the uranium, copper and nickel business at what still turned out to be a low price. But it will be much harder to secure Alumina cheaply because there are now at least a few institutional analysts who have taken the time to understand the company’s potential.

Aluminium has been described as “solid electricity” – so why, in a greenhouse/carbon emissions-obsessed world would consumption of aluminium double between 2005 and 2020?

John Marlay believes that aluminium, rather being part of the problem, is “part of the solution”. He says that its light weight substantially improves the fuel consumption in the transportation industry and it is a brilliant building and packaging material.

“I think that it is important to realise the embedded energy which is stored within aluminium,” he says.

“In 2007 the world will consume about 36 million tonnes of aluminium. One-third of that consumption is actually from recycled aluminium requiring 95 per cent less energy than the first time that it was manufactured as primary metal.

“Over 60 per cent of the aluminium ever produced in the world over the last 80 years is still in use.

“In construction materials you are getting close to 100 per cent recycling. In the automotive sector, it is 90 per cent recycling, and in packaging, depending on the particular economy, it is between 50 and 60 per cent.”

Marlay says that the vast majority of new aluminium will come from gas-fired power stations in the Middle East and Russia plus hydro in places like Iceland (Alcoa) and possibly Greenland.

The bulk of AWAC’s alumina production is fired by natural gas, which generates processed steam. The group is planning co-generation plants in Australia and elsewhere to use that steam to generate power which will substantially improve its carbon economics. It also owns the two Alcoa aluminium smelters in Australia, in Geelong and Portland, which gain most of their electricity from brown coal.

Any group bidding for Alcoa or Alumina will need to be confident that any future legislation taxing carbon emissions (perhaps via trading) will not stunt the growth of aluminium and leave the world with substantial over-capacity in both aluminium and alumina. China is, of course, leading the demand for aluminium. The country is planning much more investment in dwellings and cars which will propel future demand. The Chinese alumina company, Chalco, is estimated to produce between 9 million and 10 million tonnes of alumina, compared to 14.3 million tonnes by AWAC.

Over at The Oil Drum, geologist Jeffrey Brown, aka westexas, made a claim back in January that we face an imminent export crises because the major exporting countries have peaked. In other words, Peak Oil is here. I have disputed his interpretation of the data. I have argued that imports closely track refinery utilization, and that in the first quarter when imports were falling, refineries were in the midst of their turnarounds. When the refineries came back up, so did imports. We have argued back and forth about this for several months, so I finally challenged him to a debate to get our positions on the record and documented.

My primary concern with his position is that I believe he has used anecdotal evidence, ad hoc evidence, and has ignored certain data to make his point. If he says “imports are down as predicted, Peak Oil is here” and then imports go up next year, credibility is lost. For those of us concerned about Peak Oil and wishing the matter to be taken very seriously by the politicians, press, and public, crying wolf is not something we can afford. So I consider this to be peer review of an argument that we have already peaked based on import data.

So, here is Jeff’s opening salvo. I will post my reply in about a week.

A Debate on the Substance and Timing of the Peak of Oil Production and Consumption, Part I

Resolved: World Net Oil Export Capacity is Now Declining Because of Involuntary Reductions in Production and/or Because of Increases in Domestic Consumption in Major Oil Exporting Countries

Robert Rapier suggested that we debate this topic, and I agreed. In reality, there are only shades of gray difference between us regarding the timing of Peak Oil and Peak Exports. I believe that the crisis has hit, while Robert believes that the worst won’t be upon us until some time shortly after 2010. Robert will file his rejoinder about a week from today.

In any case, in a guest post on The Oil Drum (TOD) in January 2006, I predicted, based on graphs primarily done by Khebab that the world would see declining net oil exports this year.

I focused on the top three net oil exporters–Saudi Arabia (KSA); Russia and Norway–which together accounted for 48% of the (total liquids) exports by the top net oil exporters in 2004 (all production data based on EIA numbers, unless noted otherwise). Top exporters are defined as those exporting one mbpd or more.

In his most recent book, “Beyond Oil: The View from Hubbert’s Peak,” Kenneth Deffeyes outlined a simplified version of the mathematical techniques that M. King Hubbert used to accurately pick the time frame for the peak of Lower 48 oil production. The method, named “Hubbert Linearization” (HL) by Stuart Staniford on TOD, is outlined in the article “Texas and US Lower 48 oil production as a model for Saudi Arabia and the World“.

Deffeyes defines Qt as a mathematical estimate of the ultimate recoverable reserves for a region. Regions tend to peak, and start declining when they are about 50% depleted, i.e., the 50% of Qt mark.

The following regions have now shown lower production after crossing the 50% of Qt mark: Texas; Lower 48; Total US (which had a secondary, but still lower peak, after the North Slope production came on line); Russia; North Sea; KSA and Mexico.

In the January article, I outlined my “Export Land” model, which was inspired by work done earlier by Matt Simmons. I stipulated that we had a country producing 20 mbpd and consuming 10 mbpd.

I then stipulated Export Land hits the 50% of Qt mark, and over a five year period, production declines by 25% and consumption increases by 20%. Because of these two factors–falling production and rising domestic consumption–the net oil exports from out hypothetical exporter decline by 70%, from 10 mbpd to 3 mbpd.

Note that the underlying assumption, which I think is generally true, is that domestic demand is generally satisfied before oil is exported. We have a real life example of the Export Land model in the UK, which has gone from exporting one mbpd in 1999 to being a net importer in 2005.

Also note that I expect domestic consumption in the exporting countries to go up quite rapidly, at least initially, as oil prices rise faster than their production is falling.

What I found deeply troubling in January was that the top three net oil exporters were all past their respective 50% of Qt marks. In January, KSA was showing stable production, Russia was showing a slow rate of growth and Norway was in decline. I predicted, based on the HL method and based on the Export Land model, that we would see lower exports from these three countries in 2006.

2006 Data

The EIA has now released a table showing the estimated production and exports from the top net exporters for 2005 (again all total liquids), and the data are very interesting, since we can compare the 2005 production, consumption and exports for various countries to the 2004 numbers.

KSA, Russia and Norway collectively have shown a 13% increase in domestic consumption from 2004 to 2005. Even Norway, which I expected to be flat, showed an 11% increase in consumption.

It appears that the only readily available current production data are for crude + condensate (C+C), but the EIA shows that these three countries are down, in September, 2006 by 3.7% from their December, 2005 production levels (KSA and Norway are down; Russia is basically flat). These data are subject to revision, but Khebab has demonstrated that the revisions tend to be downward with time.

In any case, if we assume that Total Liquids behave similarly to C+C, and if we use the same rate of increase in domestic consumption as 2004 to 2005 (which may be conservative given the rapidly escalating demand in KSA and Russia), this suggests that the top three net oil exporters are experiencing about an 8% decline (1.5 mbpd) in net oil exports in 2006 versus 2005 (based on data through September, 2006).

The EIA tracks C+C for 11 of the other 12 largest exporters. Their combined C+C production is up just barely (by 0.6% or 0.16 mbpd) from 12/05 to 9/06, which almost certainly translates to a decline in net exports, given the increasing consumption in most exporting countries.

Saudi Arabia: Why is their production falling?

No one, as far as I know, now disputes that KSA’s production is falling. The question is why.

KSA is now at about the same stage of depletion that the prior swing producer, Texas, started declining.

In the spring, the Saudis announced that they could not find buyers for all of their oil, “Even their light, sweet oil,” when light, sweet oil was going for about $70 per barrel in the US.

At the same time that the Saudis were announcing that they could not find buyers for all of their oil, and that they were “voluntarily” reducing their production, they were vastly expanding their drilling program.

Their largest field, Ghawar, which at one time accounted for more than 50% of their production, is now at about the same stage of depletion that an analogue field, Yibal, started declining. The best case for Ghawar is that they are producing one-third water, after the field was redeveloped with horizontal wells.

At the same time that the Saudis announced their “voluntary” production cutbacks in the spring, their stock market started crashing. Interesting enough, Venezuela, which has long life unconventional oil reserves, has a booming stock market.

In my opinion, Saudi Arabia, like Texas in 1973, is at the start of a long term and irreversible decline in conventional oil production, with a long-term decline rate in the 4% to 5% range, perhaps sharper at first if Ghawar is crashing.

Russia: What next?

Mathematically, Khebab has demonstrated that the recent rebound in Russian production was just making up for what was not produced following the collapse of the Soviet Union.

In my opinion, Russia will join Saudi Arabia in showing a long term and irreversible decline in conventional oil production next year.

The “Bidding Cycle” Theory

Given the reports of lower production by the top three exporters, and one can assume increased consumption, someone must be conserving.

The Wall Street Journal recently ran a story, which profiled an African country, Guinea, which has been forced to conserve, “As fuel prices soar, a country unravels.”

An excerpt from the article:

“The impact of today’s energy crunch on the poor is plain in rich nations such as America: Expensive gasoline and soaring heating bills make a hard life harder. In impoverished countries such as Guinea, where per capita income is just $370 a year and surging gasoline prices have helped spark bloody riots, the energy shock has become a matter of life and death.”

I believe that we are going to see rounds of bidding cycles with available exports going to the winning bidders, e.g., the US so far this year, and with the losing bidders being forced to conserve, e.g., Guinea so far this year.

However, I predict that the next round of bidding (which I believe that we are currently in), against regions like Europe and China, instead of Africa, will be much tougher for the US.

The Expectation of an Infinite Exponential Growth Rate Versus The Reality of Exponential Decline

Because of a steady increase in US petroleum consumption and because of a steady decline in US oil production, total US petroleum (crude oil + product) imports have been increasing at an annual rate of about 4% per year since 2001. This is one reason that assertions that year over year US petroleum imports may be flat is not much of a comfort.

In most of the US, it is simply a given that the “American Way of Life” is non-negotiable and that we can continue to increase our petroleum imports year after year.

Unfortunately, I predict that Americans are going to realize that the reality of exponential decline is going to trump expectations of an infinite growth rate.

While there are many suggestions for alternative energy sources and for the expanded use of other fossil fuel sources and the expanded use of nuclear energy, the reality in my opinion, is that the Net Oil Export Crisis is hitting so hard and so fast that our only recourse is to effectively implement a triage operation, where large portions of American suburbia are effectively abandoned.

I do strongly support a proposal to tax energy consumption to fund Social Security and Medicare, offset by eliminating or reducing the Payroll Tax, combined with a major push to implement Alan Drake’s Proposal for Electrification of Transportation.

I am primarily supporting Alan’s proposal because he is advocating proven technology that we essentially perfected more than 100 years ago. Furthermore, he documents how the Swiss were able to survive– by electrifying their transportation system and by restricting oil supplies to emergency uses–an oil supply cutoff in the Second World War.

The average American today uses about as much oil as 400 Swiss citizens used in the Second World War.

Whoa! The analysts missed this one by a mile. Here were the predictions, prior to the release of the report:

Analysts surveyed by Dow Jones Newswires on average predict crude inventories rose 300,000 barrels during the week ended Oct. 19, and Vienna’s PVM Oil Associates also noted that “expectations for this week’s U.S. oil inventory data are for a rise in crude oil stocks.”

However, some analysts predict a decrease of up to 2 million barrels. Analysts also predict the EIA report will show refinery utilization rose 0.3 percentage point; gasoline supplies, still near record lows, rose 1.1 million barrels; and distillate stockpiles, which include heating oil and diesel, rose 200,000 barrels.

Here’s what they got:

U.S. commercial crude oil inventories fell by 5.3 million barrels compared to the previous week. At 316.6 million barrels, U.S. crude oil inventories are near the upper end of the average range for this time of year. Total motor gasoline inventories decreased by 2.0 million barrels last week, and are at the lower end of the average range.

Both finished gasoline inventories and gasoline blending components fell last week. Distillate fuel inventories decreased by 1.8 million barrels, and are at the upper limit of the average range for this time of year. Propane/propylene inventories increased 0.6 million barrels last week. Total commercial petroleum inventories decreased by 7.9 million barrels last week, but are in the upper half of the average range for this time of year.

I suspect crude will be off to the races again. I had called a (short-term) top on front-month WTI a week ago at $89, and in fact oil was down almost every day since then. But this inventory report will provide a lot of fuel for the bulls for another week.

Here is the rest of the report:

U.S. crude oil refinery inputs averaged 14.9 million barrels per day during the week ending October 19, down 183,000 barrels per day from the previous week’s average. Refineries operated at 87.1 percent of their operable capacity last week. Gasoline production rose compared to the previous week, averaging nearly 9.0 million barrels per day. Distillate fuel production fell last week, averaging 3.9 million barrels per day.

U.S. crude oil imports averaged 9.1 million barrels per day last week, down 1,305,000 barrels per day from the previous week. Over the last four weeks, crude oil imports have averaged 9.9 million barrels per day, or 414,000 barrels per day less than averaged over the same four-week period last year. Total motor gasoline imports (including both finished gasoline and gasoline blending components) last week averaged 838,000 barrels per day. Distillate fuel imports averaged 235,000 barrels per day last week.

Total products supplied over the last four-week period has averaged nearly 20.8 million barrels per day, up by 0.4 percent compared to the similar period last year. Over the last four weeks, motor gasoline demand has averaged 9.2 million barrels per day, or 0.2 percent below the same period last year. Distillate fuel demand has averaged nearly 4.3 million barrels per day over the last four weeks, up 1.0 percent compared to the same period last year. Jet fuel demand is down 3.3 percent over the last four weeks compared to the same four-week period last year.

It is going to be a close call on the $1,000 bet. I do believe the fundamentals for higher oil prices are generally worse now than they were 3 months ago. Peak driving season has passed, OPEC is already pumping more crude, and prices have had a dramatic run-up. On the other hand crude inventories, while still high, have been pulled down, and gasoline inventories continue to hover near record-low levels. But, the sentiment has certainly turned in favor of higher oil prices. And the sentiment of the market can move it quite a bit in a short period of time. You can see some of the analysts on CNBC – after having missed out on most of the run-up – have now moved their clients into oil and so are talking up the price.

But the recent fast run-up in prices, followed by OPEC’s decision to pump more crude, would make me very cautious about buying oil at this level. You might make some money, but it is a much bigger risk than it was earlier in the year when the fundamentals for higher oil prices looked better (at least to me). Of course over the long haul, I am bullish on oil prices and have been for 5 years. I thought $100 oil in 2008 was likely, but a move from $60.77 (the crude price the first week of January) to $100 in a single year would be unprecedented.

I would also add just a bit on refinery utilization. Analysts had predicted utilization to come up this week. Generally, refineries are coming out of their turnarounds now, and you would expect to see utilization at a higher level at the end of October. But you have to take the current crack spreads into account. When crack spreads are at $30/bbl, as they were earlier in the year, you do everything you can to maximize your utilization rate. If that means paying overtime, or paying extra to have equipment fabricated and delivered quickly, you do it. Money is not an object; you get your refinery up and running as quickly as possible.

But when crack spreads are $5/bbl, as they are now, you don’t do those things. You still want to have your refinery up and running, but it doesn’t make economic sense to go all out to boost your utilization. That $5/bbl margin will disappear pretty quickly if you throw money around. So, utilization rates will be less robust in times of low margins. It has absolutely nothing to do with inability to secure crude – as some have suggested. It has everything to do with economics. But given where gasoline inventories are currently setting, I don’t expect margins to stay soft for long.

There has been a lot of speculation lately over whether the Saudi oil production cuts over the past year have been voluntary. I have argued that they were voluntary based on a combination of what was happening with inventories last spring (crude inventories were very high and trending higher), and then price (started falling in the summer and fell for the rest of the year). But I think we will soon know for sure.

This is subscriber information from the daily OPIS report, so I will only post a small portion of the report:

Over the past five weeks, there has been a fundamental shift in the oil Market — a shift that has resulted in increasingly higher prices. The shift has to do with basic fundamentals; not speculation, not hedge funds, not futures trading. Oil supplies in the U.S. have dwindled sharply in the past five weeks, more than some people may realize.

According to the EIA, in the U.S., total company-held oil inventories have shed 87.4 million barrels since OPEC’s 0ct. 20 meeting. By the end of the first quarter of 2007, stocks will be 100 million barrels below end-September 2006 levels, the EIA forecasts. Meanwhile, demand has been higher than normal, so the “supply cushion” has been depleted.

Over the past five weeks total product inventories have dropped nearly 60 million barrels, an average of more than 10 million barrels per week. Gasoline supplies, which comprise the largest part of the U.S. petroleum stock base, have shrunk as well. Inventory dipped almost 4 million barrels this week leaving supplies 8 million barrels under year-ago levels and less than 3 million barrels over the five-year average for this time of year.

What we are seeing right now is a combination of falling inventories and rising prices. This should provide both the opportunity and the motive for Saudi to increase production. Demand will really kick up in April and May, when refineries are coming out of their turnarounds. If the current trend continues, the Saudis are going to be called upon to bump up production pretty soon.

If they don’t, then I will conclude that at least for the time being, they can’t. That may mean that their production has peaked, either due to geological constraints, or because they failed to anticipate demand and didn’t bring their projects online soon enough. I have seen the announced projects they have in the pipeline, and they won’t be enough to satisfy demand any time soon. If their current reduction is involuntary we are in for some tough sledding ahead, resulting in all kinds of price records this year. I might start thinking about buying a more fuel efficient vehicle if I hadn’t just bought one.

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 Part I, 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 benefiting 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 existing 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 many oil companies were losing money. Many refineries shut down. Some oil companies went out of business. Property values in “oil towns” like Houston plummeted. 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 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.

Even in the past 10 years, refinery margins have turned negative on numerous occasions. The problem is that many people take a snapshot of the current view and believe this is normal. See the data that the IEA has accumulated (XLS download warning). Shall we expect that those who are calling for measures to be taken to address the current refinery margin situation will be calling for the government to extend a helping hand the next time margins go negative? Somehow, I doubt it. (Incidentally, for those who think oil companies have boosted their margins by raising prices, how do you explain the incredible variability from month to month? How do you explain negative margins?)

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 foregoing 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. (Contrary to popular opinion, oil companies do not consult each other on such issues). 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 am in favor of 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. (Ethanol imports have been omitted as their impact would have been pretty small).

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.

A few newsworthy items to cover: Gas prices, gas gouging legislation, and food versus fuel.

Gas Prices on the Rise

Surprise! It seems that gas prices are rising:

Gas prices on the rise again, analyst reports

Gas prices are on the rise again, just as Americans hit the highways for Thanksgiving.

Gas prices rose about 5 cents per gallon nationwide compared to two weeks ago, industry analyst Trilby Lundberg said Sunday.

Of course if you read this blog, you knew this was coming. I have made this case in two recent essays, and I have been saying this at The Oil Drum for about a month:

A Case Study in Cluelessness

This Week in Petroleum 11-15-06

Gasoline inventories are being sharply pulled down for three primary reasons. First, demand has picked up as prices have fallen. Second, gasoline imports fell off as prices dropped and European refiners saw profit margins fall on exports to the U.S. Third, we are in the middle of fall turnaround season, when refineries shut down for maintenance. All of these factors are causing gasoline inventories to free fall, and that situation can’t continue, regardless of how the elections turned out, unless 1). Imports make up the difference; 2). Prices rise to slow demand; 3). We start rationing product; or 4). We just keep going like this until stations start to run out of gas.

Keep a close eye on the inventory report this week for a hint of which direction prices are headed in the short term.

Price Gouging and Fuel Supplies

A couple of days ago the following article was highlighted at The Oil Drum:

Congress seen passing price-gouging law

Some excerpts:

WASHINGTON – The head of the Federal Trade Commission predicted Thursday that Congress would pass a gasoline price-gouging law despite her warnings that the country doesn’t need one and it might cause fuel shortages.

FTC Chairwoman Deborah Platt Majoras said she has warned Congress publicly and privately about the dangers of such a law.

Majoras said she understood the public’s frustration and concern but said an upcoming FTC report on the price spikes found that consumer demand was up at the time.

“There is a distinction between a market determination you don’t like and a market failure,” she said.

Testifying in May before the Senate Commerce Committee, Majoras said retailers might let the gas run out rather than raise prices and risk facing prosecution. She noted the price spikes after Hurricane Katrina last year resulted in more fuel getting to market.

I commented on the story:

I think this is likely with the new political climate, but this is very short-sighted. What they don’t seem to realize is that if prices are frozen during a Katrina-like crisis, then rationing is the only other option. I think most people would prefer to pay more for their gas (rationing by price) than for everyone to be told they are only getting 75% of the gas they would like.

I generally get some negative feedback any time I write anything in defense of the oil industry (like this example), but one poster provided the following feedback:

Several years ago the Canadian province of Prince Edward Island implemented a similar scheme to set fixed gas prices for specific periods in an attempt to prevent price “gouging.”

The outcome was as described in the RR blockquote. Gas prices did not rise; there was also no gas available anywhere on the island and no plans to import any.

The legislation was repealed.

Anyone who understands the first thing about economics knows that this has to be the outcome. If you can’t raise prices when demand is high, then we have gas lines, rationing, and ultimately no gas. I don’t know if this is the solution they want, but it’s what they will get.

Food versus Fuel

Many ethanol advocates argue that increasing the amount of corn that is going toward ethanol production is not an issue. However, it is certainly an issue for the people who have relied on those corn imports, and are now watching the price rise. Today, Tyson Foods weighed in on the subject:

Tyson Foods Sees Higher Meat Prices

“The best thing I can say about fiscal 2006 is, it’s over,” Richard L. Bond, president and chief executive officer, said in a statement.

Bond said the price of corn, which is used as animal feed, is going up because of demand from ethanol plants that are springing up to provide alternative fuel sources to oil.

Corn prices recently reached 10-year highs.

“I believe the American consumer is going to have to pay more for protein. We are at new levels on corn that are not likely going to be retrenching back to ‘06 levels,” Bond said in a conference call with analysts.

Bond said meat producers, processors and retailers will have to pass the higher grain price on to consumers because they cannot absorb it in their profit margins.

“Quite frankly the American consumer is making a choice here. This is either corn for feed or corn for fuel, that’s what’s causing this,” Bond said.

Of course food versus fuel is a serious issue going forward. How could it not be? Some people will pay more for food so we can put inefficiently produced ethanol in our vehicles, and some people will have to start making some tough choices as budgets are stretched.