R-Squared Energy Blog

Pure Energy

Defining Price Gouging

As I warned yesterday, we may be on the verge of runaway gas prices in some areas. Today I spotted this story at CNN:

Complaints of rising gas prices as Ike hits

Some excerpts:

WASHINGTON (CNN) — President Bush Saturday said officials will ensure gasoline stations don’t gouge customers after Hurricane Ike, but with some prices near $5 a gallon, some consumers were not so sure.

Sean Kennedy, of Knoxville, Tennessee, took a photo of a Knoxville station displaying a $4.99 per gallon price for regular gasoline on Saturday. The previous day, he said, he had bought regular gas at the station for $3.59 a gallon. “I know the hurricane is causing a spike, but … [nearly] $1.50 in 24 hours?” Kennedy said.

The governors of Georgia, Louisiana and Florida said complaints of gouging would be investigated. Florida Gov. Charlie Crist said Friday that $5 a gallon “can only be described as unconscionable,” according to the AP.

“Raising rates to exorbitant levels like this only causes unnecessary panic and fear,” Crist said, according to the AP. “This type of behavior will not be tolerated.”

Here’s another from the AP:

Far from Ike’s path, an aftershock is felt: $5 gas

HOUSTON – From Florida to Tennessee, and all the way up to Connecticut, people far from Hurricane Ike’s destruction nonetheless felt one of its tell-tale aftershocks: gasoline prices that surged overnight — to nearly $5 a gallon in some places.

In Knoxville, Tenn., account executive Sharon Cawood said “one of our local gasoline chains called a local TV station Thursday, sometime during the day and said, ‘We’re running out of gas. We’re going up 80 cents a gallon… It caused a major scare.

In Florida, the attorney general’s office reported prices as high as $5.50 a gallon in Tallahassee and said it had received 186 gouging complaints.

What is Price Gouging?

This brings to mind the question, “What is price gouging?” In the past, I have written a number of articles on price gouging, mostly arguing that various accusations were groundless in the context of the particular supply/demand situation. From the perspective of a consumer or a government official, a knee jerk reaction to a sharp price rise may well be to conclude price gouging. But is it valid? Is a sharp price rise ever justified?

Much like the distinctions between various crimes, be it a debate on whether a death was murder, manslaughter, or just an unfortunate accident – my position on price gouging would come down to intent and motivation. If someone raises prices sharply because it looks like they will run out of gasoline supplies before their next delivery, I don’t believe that is price gouging. In other words, if the price rise is inventory driven, then it becomes much harder to argue that price gouging is taking place.

Raising prices in this sort of situation prolongs gasoline supplies, and ensures that those who desperately need gasoline can get it. Failure to raise prices in this sort of situation can mean that consumption will continue on as normal, which will run out supplies even more quickly. Or worse, if people think there are going to be gasoline shortages, and suppliers don’t raise prices (or ration), then they may find that hoarders run them out of gas even faster than normal. Given a choice, I think most people would prefer to have some gasoline at a much higher price rather than have prices stay low, but supplies run out.

On the other hand, let me describe a situation that I believe would qualify as price gouging. If a gasoline supplier has adequate supplies and there are no major concerns that they will run out of fuel – but they still sharply raise prices in the face of a crisis, then that would be price gouging in my opinion. In that situation, a person is not raising prices to protect their supplies, but instead to take financial advantage in an emergency situation.

So, how could one tell the difference? Unfortunately, it’s not black and white, but instead shades of gray. A person who is worried about falling inventories might be justified in raising prices by $1.00/gallon overnight, but what if they raised prices by $10/gallon overnight?

Or, say you had two gas stations across the street from each other, and both increased prices by $1.00/gal. In the first case, let’s say the owner has adequate inventories on hand, and no worries that he is going to run out. I would say that he is taking advantage. In the second case, if the owner is running low on inventories and is concerned about running out (because he gets his supplies from a refinery that has been negatively impacted), then I would say his price increase is justified.

But you can’t tell just by looking. You might think a sharp price rise is unjustified, but you can’t really know for sure unless you have more facts at your disposal. Simply put, my definition of price gouging is “attempting to take financial advantage by raising prices in an emergency.” If you raise prices to protect your inventories, then I wouldn’t necessarily conclude that there was price-gouging taking place. For me it all boils down to intent and motivation (and of course those can be difficult to pin down).

September 14, 2008 Posted by | gas prices, price gouging | 316 Comments

Tyson Slocum Testimony

Consumer advocate Tyson Slocum recently testified before the U.S. House of Representatives Committee on Transportation and Infrastructure about the record high gas prices. I am going to resist the urge to do a deep debunking, because 1). I have already taken a shot at his credibility; 2). I haven’t slept in 36 hours; 3). Maybe he’s got some good points? 😉

Here is a PDF of his testimony:

Testimony of Tyson Slocum

Among some of Slocum’s findings (and a “few” comments, since I can’t resist):

Public Citizen research shows that oil companies aren’t adequately investing these record earnings into projects that will help consumers, as the five largest oil companies have spent $170 billion buying back their stock since 2005.

I am sure the oil companies will be calling for advice on projects you think deserve their investments. Be sure to keep your list handy.

ExxonMobil, ChevronTexaco, ConocoPhillips, BP and Shell produce 10 million barrels of oil a day—more than the combined exports of Saudi Arabia and Qatar.

So the top 5 have total production greater than the exports of two countries? Wouldn’t you then surmise that these companies are dwarfed by the national oil companies that they must compete against?

While major oil companies haven’t applied for a permit to build a new refinery, a small start-up has: Arizona Clean Fuels.

While they have been fiddling with that permit for close to 10 years now, major oil companies have expanded refining capacity by 2 million barrels. Of course inconvenient facts don’t fit Slocum’s agenda. But do let us know when Arizona Clean Fuels breaks ground on their new facility. However, don’t count on it now given Mexico’s declining production (which is where they were expecting to get their oil).

With nearly $1 trillion of combined assets tied up in extracting, refining and marketing petroleum and natural gas, the big five oil companies’ entire business model is designed to squeeze every last cent of profit out of their monopoly control over fossil fuels.

Hmm, that’s a lot of money tied up. How much would you expect to profit if you had a trillion dollars tied up? Would $100 billion a year – 10% return on those assets – do it? Or would that be a windfall?

Margins for U.S. oil refiners have been at record highs. In 1999, U.S. oil refiners enjoyed a 22.8 cent margin for every gallon of gasoline refined from crude oil. By 2006, they posted a 53.5 cent margin for every gallon of gasoline refined, a 135 percent jump.

Given that you testified in 2008, wouldn’t that be a relevant data point? What are margins now, Tyson?

Slocum outlines his plan:

Public Citizen has a five point plan for reform:

• Repeal all existing oil company tax breaks, close loopholes allowing oil companies to escape paying adequate royalties and/or implement a windfall profits tax, dedicating the new revenues to financing clean energy, energy efficiency and mass transit.
• Re-regulate energy trading exchanges to restore transparency and impose firewalls to stop energy traders from speculating on information gleaned from the companies’ affiliates.
• Ensure that new powers provided to the Federal Trade Commission to crack down on unilateral withholding and other anti-competitive actions by oil companies and financial firms are effectively carried out.
• Establish a Strategic Refining Reserve to be financed by a windfall profits tax on oil companies that would complement America’s Strategic Petroleum Reserve (SPR), and cease filling the SPR.
• Improve fuel economy standards from the modest increase approved by Congress in 2007 to reduce gasoline demand.

That should ensure cheap energy for all. All this leads me to wonder exactly what kind of expertise one requires to be invited up to Congress to testify. Simply an ability to speak?

May 7, 2008 Posted by | price gouging, Tyson Slocum, windfall profits | 12 Comments

The Week in Energy – September 7, 2007

Note: This will be my last time to post in this format (a block of stories in one post). Others have commented, and I agree, that this is a bit unwieldly. Besides that, I have been setting on some of these stories for nearly a week. Also, it is taking me more time to link up and format these stories than if I just posted them one at a time as they pop up. By staying out of the comments section and taking my e-mail address offline, I have freed up a lot of the time that I had lost. So, I am just going to post things as I always have, but I still won’t be commenting. Sometimes that may mean I go 10 days without posting a story, and sometimes I may post 3 in a day.

Drilling 5 Miles Deep

Another FTC Investigation, Another Vindication

You Can’t Argue With Doomers

The Energy Emergency

You Go, Hugo

Drilling 5 Miles Deep

When I am cruising along in an airplane at 35,000 feet and I look out the window, sometimes I think about the amazing fact that the distance to the ground is approximately equivalent to the deepest part of the ocean. But it’s even harder to comprehend that some deep-sea rigs could reach from my cruising altitude to the ground:

Pumped Up: Chevron Drills Down 30,000 Feet to Tap Oil-Rich Gulf of Mexico

Today, deep-sea rigs are capable of reaching down 40,000 feet, twice as deep as a decade ago: plunging their drills through 10,000 feet of water and then 30,000 more feet of seabed. One platform sits atop each so-called field, thrusting its tentacles into multiple wells dug into ancient sediment, slurping out oil, and then pumping it back to onshore refineries through underwater pipelines.

It’s a business where huge sums are lost (two years ago, BP suffered a $250 million blow when a hurricane took out one of its platforms) but even more can be made. The mother lode of oil in the deepwater Gulf is so significant that Tahiti and other successful fields in this region are expected to soon produce enough crude to reverse the long-standing decline in US oil production of about 10 percent per year.

Even better, a recent discovery by Chevron has signaled that soon there may be vastly more oil gushing out of the ultradeep seabeds — more than even the optimists were predicting four years ago. In 2004, the company penetrated a 60 million-year-old geological stratum known as the “lower tertiary trend” containing a monster oil patch that holds between 3 billion and 15 billion barrels of crude.

Just as a bit of a reality check, if there actually are 15 billion barrels there, and they could extract it all, that’s less than two years supply for the U.S. It may be a monster field, but we have a monster appetite.

The article also describes life on the rigs:

The galley of the Cajun Express is a prisonlike cafeteria of stainless steel and gray linoleum crammed with engineers in blue coveralls devouring their meals. Today the menu is bratwurst, cheese fries, and twice-baked potatoes. At first glance, it’s hard to believe this is the setting for a proposed Food Network special on the high-caliber cuisine 140 miles offshore. But the grub is lip-smackingly good.

The Cajun is equipped with other perks: an Internet café, a gym, and a movie theater — but these luxuries are hardly used. Few of the men have the energy for entertainment or exercise after working a 12-hour shift on the drilling floor — hauling great vats of mud used for drill lubricant, welding broken iron casings, or repairing robotic submarines that fix problems with seafloor equipment. The living quarters, which house up to 150 workers, are the size of walk-in closets, filled with cot-sized bunk beds that fold out of the walls.

“When you’re here, you’re pretty much working or sleeping,” says Siegele. Stout salaries make up for the extreme conditions: Entry-level tool pushers make about $60,000, and high-level geologists and engineers can earn in the mid six figures. Added bonus: a massive testosterone rush. “This is the best big-boy toy you’ll ever find,” says Chevron spokesperson Mickey Driver.

Return to Top

Another FTC Investigation, Another Vindication

I believe this is now over 30 investigations that have been conducted without finding price-gouging or collusion. What a great use of taxpayer money.

As I have said many times, sure oil companies make more money when prices go up. But they don’t make money by making prices go up. They ride the market up and down just like the speculators who buy oil futures. Because face it, if they could control prices, why would they ever come down?

Big Oil did not manipulate U.S. gasoline prices: FTC

Big oil companies did not conspire to raise U.S. gasoline prices last summer, as it was high crude oil costs and supply problems that caused the spike in pump prices, government investigators said on Thursday.

The Federal Trade Commission said that about 75 percent of the rise in gasoline prices was due to a seasonal increase in summer driving, higher oil costs and more expensive ethanol that was blended into gasoline.

The other 25 percent of the price increase stemmed from lower gasoline production as refiners moved to using ethanol as the main clean-burning fuel additive and lingering damage from hurricanes Katrina and Rita that reduced refining capacity.

“Our targeted examination of major refinery outages revealed no evidence that refiners conspired to restrict supply or otherwise violated antitrust laws,” the FTC said. “We therefore conclude that further investigation of the nationwide 2006 gasoline price spike is not warranted at this time.”

Many lawmakers at the time had accused oil companies, which were raking in billions of dollars in record profits, of overcharging U.S. consumers at the pump.

And they will make those same accusations the next time prices spike, probably next spring. There was a brief dissenting statement by one of the FTC commissioners. The vote was 4-1 that no price-gouging took place, but Commissioner Jon Leibowitz released a statement that read in part:

The oil industry, which posted record profits in 2006, should not view this Report as in any way a vindication of its behavior. Commission staff identified some plausible justifications for the unexpected and dramatic price spikes that bedeviled consumers in the Spring and Summer of 2006, and that raised the average price of gasoline to more than $3.00 per gallon in August of that year.

It was clear that “record profits” got under his skin, and he equated this to bad behavior. I guess Leibowitz prefers “Out of Gas” signs, or gas rationing, instead of allowing prices to dictate demand.

Return to Top

You Can’t Argue With Doomers

My friend Euan Mearns, also a contributor at The Oil Drum, recently published an essay in which he examined Saudi Arabia’s oil reserves:

Saudi Arabia – production forecasts and reserves estimates

I read the essay before he published it, and I warned Euan that despite his scientific approach, he should prepare for mud from the dedicated doomers. And as predicted, they did not disappoint, casting aspersions and accusations his way. As he later wrote to me in frustration, “It’s virtually impossible to debate with them. But it strikes me they are overly defensive of their position which betrays fragile egos.”

Euan also lives in Aberdeen, and we had dinner together a few months ago and discussed how some doomers react when their positions are challenged. Some of them simply lash out, as if their world will end if the world doesn’t end. It is just hard for me to understand.

The gist of the argument revolves around trying to figure out what Saudi Arabia’s oil reserves are. Now, I certainly do not advocate counting on Saudi for our energy security. I think we need to eliminate our dependence on Mideast oil ASAP, as we reduce our overall consumption. But since I don’t expect our government to actually do that, I want to know exactly what’s going on with Saudi’s oil reserves.

Some have latched onto a technique called Hubbert Linearization, which in my opinion is akin to dowsing for water, for information on Saudi’s reserves. They believe this technique shows that Saudi Arabian oil production has peaked, and this is why their oil production is down over the past year. I maintain that they are cutting production to keep prices high. After all, Saudi has cut a lot of production, and yet prices are still where they were a year ago. If their cuts were involuntary, as the HL proponents claim, I would have expected oil prices to skyrocket.

One funny aspect to this argument is that the HL technique is pointing toward a remaining reserve number for Saudi that is impossibly low. If you go back to 1982 when Saudi’s reserves were still open, and merely subtract out the oil that has been produced since then, you end up with 95 billion barrels remaining. This is an argument I made in:

A Different Approach to Calculating Saudi Arabia’s Oil Reserves

But that would presume that Saudi 1). Has not been able to increase the efficiency of their oil extraction, or 2). Has not found any new fields. To put this in perspective, over that same period of time, the U.S. produced 57 billion barrels of oil, but only pulled down reserves by 6 billion barrels because of discoveries and improvements in extracting the oil.

But the HL believers point to the model for Saudi and insist that Saudi only has 65 billion or so barrels left. The model trumps historical measured reserves! And they can be rather nasty about defending this viewpoint, as I found out when I pointed out that the HL technique doesn’t actually predict anything:

Does the Hubbert Linearization Ever Work?

Personally, I don’t put much stock in a model that 1). Doesn’t have a good theoretical basis for why it should work; 2). Can be shown in case after case that it didn’t work. The funny thing is that you can take any random number, increase it by 1% each year, and then do an HL plot on it and get an “answer” for the ultimate amount of oil that should be recovered. The fact that this answer is constantly shifting is hand-waved away by proponents who say “I don’t know why it works, it just does.” You don’t need to know a thing about the oil fields, economics, technology, nothing. It will spit out the answer. Pseudoscience at its best. Think about that: It points to an ultimate recovery rate for the reserve base even if production is increasing at a constant rate. Nonsense. As one person put is succintly:

As it stands, these rationalizations of HL seem to fall in the same category of endless rhetorical arguments. Rhetorical arguments, by definition, are described by the spoken word, so that the only way to keep this up is by producing more rhetoric.

Poor Euan learned the same lesson I learned: You can’t argue with some doomers.

Return to Top

The Energy Emergency

Mort Zuckerman believes we have a problem:

The Energy Emergency

In 1930, we found 10 billion new barrels of oil and used 1.5 billion; in 1964, we discovered 48 billion barrels and consumed approximately 12 billion; in 1988, we found 23 billion barrels and used 23 billion barrels; in 2005, we found 5 billion to 6 billion barrels and consumed 30 billion barrels. With countries like China and India now in the mix, worldwide demand is growing by an average of 2 million to 3 million barrels a day every year. The world has to discover a new Saudi Arabia-size oil supplier every five years to meet this demand. But it’s just not going to happen. These overwhelming numbers could produce oil prices above $100 a barrel in short order, which will ultimately have massive consequences for the world’s economy and the way we live our lives. They might well cause a global recession.

This is why I proposed Peak Lite: Demand is growing by 2 to 3 million barrels a day each year, but supply is not keeping pace. And it doesn’t look to keep pace in the foreseeable future, meaning upward pressure on oil prices will remain.

Return to Top

You Go, Hugo

Venezuela Expected to Devalue Currency

The Venezuelan economy, under the direction of President Hugo Chavez, is starting to unravel in the currency market.

While Venezuela earns record proceeds from oil exports, consumers face shortages of meat, flour and cooking oil. Annual inflation has risen to 16 percent, the highest in Latin America, as Chavez tripled government spending in four years.

“This has been the worst-managed oil boom in Venezuela’s history,” said Ricardo Hausmann, a former government planning minister who now teaches economics at Harvard University. “A devaluation is a foregone conclusion. The only question is when.”

Chavez, who is seeking to end presidential term limits, has taken $17 billion of foreign reserves from the central bank and expropriated dozens of farms that he deemed underutilized.

He nationalized Venezuela’s biggest private electric and telephone utilities and took majority stakes in oil projects owned by Exxon and ConocoPhillips. Foreign direct investment was a negative $881 million in the first half as foreign companies pulled out money.

Chavez terminated the broadcast license of the country’s most- watched television network in May, sparking weeks of student protests. He has threatened to take over cement makers, hospitals, banks, supermarkets and butcher shops, saying they were not obeying price controls.

“It’s like our director of marketing, our director of sales, our director of manufacturing is President Chavez,” said Edgar Contreras, who runs international operations at Molinos Nacionales, a Caracas-based food manufacturer that employs 1,500 people. “We can’t go on like this.”

Contreras called the government-set prices on many products “fantasy prices” that are below production costs. Milk, chicken, coffee and flour have disappeared from store shelves in Caracas at times this year.

No comment.

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September 7, 2007 Posted by | Chevron, Hugo Chavez, price gouging, Saudi Arabia | 3 Comments

The Week in Energy – September 7, 2007

Note: This will be my last time to post in this format (a block of stories in one post). Others have commented, and I agree, that this is a bit unwieldly. Besides that, I have been setting on some of these stories for nearly a week. Also, it is taking me more time to link up and format these stories than if I just posted them one at a time as they pop up. By staying out of the comments section and taking my e-mail address offline, I have freed up a lot of the time that I had lost. So, I am just going to post things as I always have, but I still won’t be commenting. Sometimes that may mean I go 10 days without posting a story, and sometimes I may post 3 in a day.

Drilling 5 Miles Deep

Another FTC Investigation, Another Vindication

You Can’t Argue With Doomers

The Energy Emergency

You Go, Hugo

Drilling 5 Miles Deep

When I am cruising along in an airplane at 35,000 feet and I look out the window, sometimes I think about the amazing fact that the distance to the ground is approximately equivalent to the deepest part of the ocean. But it’s even harder to comprehend that some deep-sea rigs could reach from my cruising altitude to the ground:

Pumped Up: Chevron Drills Down 30,000 Feet to Tap Oil-Rich Gulf of Mexico

Today, deep-sea rigs are capable of reaching down 40,000 feet, twice as deep as a decade ago: plunging their drills through 10,000 feet of water and then 30,000 more feet of seabed. One platform sits atop each so-called field, thrusting its tentacles into multiple wells dug into ancient sediment, slurping out oil, and then pumping it back to onshore refineries through underwater pipelines.

It’s a business where huge sums are lost (two years ago, BP suffered a $250 million blow when a hurricane took out one of its platforms) but even more can be made. The mother lode of oil in the deepwater Gulf is so significant that Tahiti and other successful fields in this region are expected to soon produce enough crude to reverse the long-standing decline in US oil production of about 10 percent per year.

Even better, a recent discovery by Chevron has signaled that soon there may be vastly more oil gushing out of the ultradeep seabeds — more than even the optimists were predicting four years ago. In 2004, the company penetrated a 60 million-year-old geological stratum known as the “lower tertiary trend” containing a monster oil patch that holds between 3 billion and 15 billion barrels of crude.

Just as a bit of a reality check, if there actually are 15 billion barrels there, and they could extract it all, that’s less than two years supply for the U.S. It may be a monster field, but we have a monster appetite.

The article also describes life on the rigs:

The galley of the Cajun Express is a prisonlike cafeteria of stainless steel and gray linoleum crammed with engineers in blue coveralls devouring their meals. Today the menu is bratwurst, cheese fries, and twice-baked potatoes. At first glance, it’s hard to believe this is the setting for a proposed Food Network special on the high-caliber cuisine 140 miles offshore. But the grub is lip-smackingly good.

The Cajun is equipped with other perks: an Internet café, a gym, and a movie theater — but these luxuries are hardly used. Few of the men have the energy for entertainment or exercise after working a 12-hour shift on the drilling floor — hauling great vats of mud used for drill lubricant, welding broken iron casings, or repairing robotic submarines that fix problems with seafloor equipment. The living quarters, which house up to 150 workers, are the size of walk-in closets, filled with cot-sized bunk beds that fold out of the walls.

“When you’re here, you’re pretty much working or sleeping,” says Siegele. Stout salaries make up for the extreme conditions: Entry-level tool pushers make about $60,000, and high-level geologists and engineers can earn in the mid six figures. Added bonus: a massive testosterone rush. “This is the best big-boy toy you’ll ever find,” says Chevron spokesperson Mickey Driver.

Return to Top

Another FTC Investigation, Another Vindication

I believe this is now over 30 investigations that have been conducted without finding price-gouging or collusion. What a great use of taxpayer money.

As I have said many times, sure oil companies make more money when prices go up. But they don’t make money by making prices go up. They ride the market up and down just like the speculators who buy oil futures. Because face it, if they could control prices, why would they ever come down?

Big Oil did not manipulate U.S. gasoline prices: FTC

Big oil companies did not conspire to raise U.S. gasoline prices last summer, as it was high crude oil costs and supply problems that caused the spike in pump prices, government investigators said on Thursday.

The Federal Trade Commission said that about 75 percent of the rise in gasoline prices was due to a seasonal increase in summer driving, higher oil costs and more expensive ethanol that was blended into gasoline.

The other 25 percent of the price increase stemmed from lower gasoline production as refiners moved to using ethanol as the main clean-burning fuel additive and lingering damage from hurricanes Katrina and Rita that reduced refining capacity.

“Our targeted examination of major refinery outages revealed no evidence that refiners conspired to restrict supply or otherwise violated antitrust laws,” the FTC said. “We therefore conclude that further investigation of the nationwide 2006 gasoline price spike is not warranted at this time.”

Many lawmakers at the time had accused oil companies, which were raking in billions of dollars in record profits, of overcharging U.S. consumers at the pump.

And they will make those same accusations the next time prices spike, probably next spring. There was a brief dissenting statement by one of the FTC commissioners. The vote was 4-1 that no price-gouging took place, but Commissioner Jon Leibowitz released a statement that read in part:

The oil industry, which posted record profits in 2006, should not view this Report as in any way a vindication of its behavior. Commission staff identified some plausible justifications for the unexpected and dramatic price spikes that bedeviled consumers in the Spring and Summer of 2006, and that raised the average price of gasoline to more than $3.00 per gallon in August of that year.

It was clear that “record profits” got under his skin, and he equated this to bad behavior. I guess Leibowitz prefers “Out of Gas” signs, or gas rationing, instead of allowing prices to dictate demand.

Return to Top

You Can’t Argue With Doomers

My friend Euan Mearns, also a contributor at The Oil Drum, recently published an essay in which he examined Saudi Arabia’s oil reserves:

Saudi Arabia – production forecasts and reserves estimates

I read the essay before he published it, and I warned Euan that despite his scientific approach, he should prepare for mud from the dedicated doomers. And as predicted, they did not disappoint, casting aspersions and accusations his way. As he later wrote to me in frustration, “It’s virtually impossible to debate with them. But it strikes me they are overly defensive of their position which betrays fragile egos.”

Euan also lives in Aberdeen, and we had dinner together a few months ago and discussed how some doomers react when their positions are challenged. Some of them simply lash out, as if their world will end if the world doesn’t end. It is just hard for me to understand.

The gist of the argument revolves around trying to figure out what Saudi Arabia’s oil reserves are. Now, I certainly do not advocate counting on Saudi for our energy security. I think we need to eliminate our dependence on Mideast oil ASAP, as we reduce our overall consumption. But since I don’t expect our government to actually do that, I want to know exactly what’s going on with Saudi’s oil reserves.

Some have latched onto a technique called Hubbert Linearization, which in my opinion is akin to dowsing for water, for information on Saudi’s reserves. They believe this technique shows that Saudi Arabian oil production has peaked, and this is why their oil production is down over the past year. I maintain that they are cutting production to keep prices high. After all, Saudi has cut a lot of production, and yet prices are still where they were a year ago. If their cuts were involuntary, as the HL proponents claim, I would have expected oil prices to skyrocket.

One funny aspect to this argument is that the HL technique is pointing toward a remaining reserve number for Saudi that is impossibly low. If you go back to 1982 when Saudi’s reserves were still open, and merely subtract out the oil that has been produced since then, you end up with 95 billion barrels remaining. This is an argument I made in:

A Different Approach to Calculating Saudi Arabia’s Oil Reserves

But that would presume that Saudi 1). Has not been able to increase the efficiency of their oil extraction, or 2). Has not found any new fields. To put this in perspective, over that same period of time, the U.S. produced 57 billion barrels of oil, but only pulled down reserves by 6 billion barrels because of discoveries and improvements in extracting the oil.

But the HL believers point to the model for Saudi and insist that Saudi only has 65 billion or so barrels left. The model trumps historical measured reserves! And they can be rather nasty about defending this viewpoint, as I found out when I pointed out that the HL technique doesn’t actually predict anything:

Does the Hubbert Linearization Ever Work?

Personally, I don’t put much stock in a model that 1). Doesn’t have a good theoretical basis for why it should work; 2). Can be shown in case after case that it didn’t work. The funny thing is that you can take any random number, increase it by 1% each year, and then do an HL plot on it and get an “answer” for the ultimate amount of oil that should be recovered. The fact that this answer is constantly shifting is hand-waved away by proponents who say “I don’t know why it works, it just does.” You don’t need to know a thing about the oil fields, economics, technology, nothing. It will spit out the answer. Pseudoscience at its best. Think about that: It points to an ultimate recovery rate for the reserve base even if production is increasing at a constant rate. Nonsense. As one person put is succintly:

As it stands, these rationalizations of HL seem to fall in the same category of endless rhetorical arguments. Rhetorical arguments, by definition, are described by the spoken word, so that the only way to keep this up is by producing more rhetoric.

Poor Euan learned the same lesson I learned: You can’t argue with some doomers.

Return to Top

The Energy Emergency

Mort Zuckerman believes we have a problem:

The Energy Emergency

In 1930, we found 10 billion new barrels of oil and used 1.5 billion; in 1964, we discovered 48 billion barrels and consumed approximately 12 billion; in 1988, we found 23 billion barrels and used 23 billion barrels; in 2005, we found 5 billion to 6 billion barrels and consumed 30 billion barrels. With countries like China and India now in the mix, worldwide demand is growing by an average of 2 million to 3 million barrels a day every year. The world has to discover a new Saudi Arabia-size oil supplier every five years to meet this demand. But it’s just not going to happen. These overwhelming numbers could produce oil prices above $100 a barrel in short order, which will ultimately have massive consequences for the world’s economy and the way we live our lives. They might well cause a global recession.

This is why I proposed Peak Lite: Demand is growing by 2 to 3 million barrels a day each year, but supply is not keeping pace. And it doesn’t look to keep pace in the foreseeable future, meaning upward pressure on oil prices will remain.

Return to Top

You Go, Hugo

Venezuela Expected to Devalue Currency

The Venezuelan economy, under the direction of President Hugo Chavez, is starting to unravel in the currency market.

While Venezuela earns record proceeds from oil exports, consumers face shortages of meat, flour and cooking oil. Annual inflation has risen to 16 percent, the highest in Latin America, as Chavez tripled government spending in four years.

“This has been the worst-managed oil boom in Venezuela’s history,” said Ricardo Hausmann, a former government planning minister who now teaches economics at Harvard University. “A devaluation is a foregone conclusion. The only question is when.”

Chavez, who is seeking to end presidential term limits, has taken $17 billion of foreign reserves from the central bank and expropriated dozens of farms that he deemed underutilized.

He nationalized Venezuela’s biggest private electric and telephone utilities and took majority stakes in oil projects owned by Exxon and ConocoPhillips. Foreign direct investment was a negative $881 million in the first half as foreign companies pulled out money.

Chavez terminated the broadcast license of the country’s most- watched television network in May, sparking weeks of student protests. He has threatened to take over cement makers, hospitals, banks, supermarkets and butcher shops, saying they were not obeying price controls.

“It’s like our director of marketing, our director of sales, our director of manufacturing is President Chavez,” said Edgar Contreras, who runs international operations at Molinos Nacionales, a Caracas-based food manufacturer that employs 1,500 people. “We can’t go on like this.”

Contreras called the government-set prices on many products “fantasy prices” that are below production costs. Milk, chicken, coffee and flour have disappeared from store shelves in Caracas at times this year.

No comment.

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September 7, 2007 Posted by | Chevron, Hugo Chavez, price gouging, Saudi Arabia | Comments Off on The Week in Energy – September 7, 2007

Hot Gas is a Bunch of Hot Air

The Owner Operator Independent Drivers Association (OIDA) has launched a new website to “educate” people on the issue of hot gas. And by educate, I mean misinform and obfuscate. I can’t help but wonder about their headline story:

Hot Fuel Costs Consumers More Than 2.3 Billion Dollars Annually

Let’s see, Americans consume 140 billion gallons of gasoline and over 60 billion gallons of diesel each year. That means that even if their headline above was correct, the “rip-off” amounts to just over 1 cent a gallon. And given that pricing is set by supply and demand, what will happen with temperature compensation is that the average gasoline price will go up by just over 1 cent a gallon, plus a bit more as every retailer tries to recoup the cost of temperature compensation equipment. Who wins? The makers of the temperature compensation equipment, and the lawyers. Even in the best case, the average consumer who uses about 600 gallons of fuel a year would win $6 a year if you could suspend the laws of supply and demand.

Their new section on myths and facts is an excellent source of misinformation:

Hot Fuel Myths & Facts

Let’s look at some of their “myths”, and the facts as they see them. And of course the facts as I see them. 🙂

MYTH: Fill up in the morning when it’s cooler.

FACT: 35,000-gallon tanks do not dramatically change temperature in daily cycles.

Well, I agree with this one. 35,000 gallon tanks DO NOT dramatically change temperature in daily cycles. That means when the temperature outside rises to 90 degrees, the temperature of the fuel is about the same as it was in the middle of the night when the temperature was 60 degrees.

MYTH: In-ground tanks at gas stations keep fuel at 60 degrees Fahrenheit.

FACT: The insulated, fiberglass tanks tend to keep fuel at the temperature it was delivered… for a long time. Also, larger retailers turn over fuel supplies very rapidly, greatly reducing the time the fuel spends in the tanks.

And as I showed in an earlier essay, the NIST found that the average annual temperature of fuel stored in those underground tanks was 64.7 degrees.

The fuel temperature data was gathered by the National Institute of Standards and Technology from storage tanks at 1,000 gas stations and truck stops in 48 states and the District of Columbia during a period from 2002 to 2004.

The NIST data revealed that the average temperature of fuel across the country and year-round was 64.7 degrees Fahrenheit — almost 5 degrees higher than the government standard of 60 degrees.

So, how many gallons does the “ripoff” then amount to? The OIDA site discusses that in their next myth:

MYTH: Temperature only causes tablespoons of difference in amount of fuel delivered.

FACT: A 25-gallon fill-up of 75 degree F gasoline equates to a loss of nearly one quart. The same fill-up at 90 degrees F equates to nearly a half gallon.

But we aren’t filling up with gasoline at 75 degrees, are we? The NIST investigation – which started this whole thing – established that. And again, as I showed in the previous essay, the difference between gasoline at 60 degrees F and gasoline at 64.7 degrees F is 0.27%. Therefore, in a 25 gallon fill-up, the difference is 8.6 ounces (17.3 tablespoons). But suggesting that people are regularly getting gasoline at 75 degrees or even 90 degrees is just outright misinformation.

MYTH: 90 percent of fuel retailers are small “mom and pop” operations.

FACT: Several large oil production companies and refiners own 25 percent of the stations that sell their brand fuel.

You have to love this one. The myth is that 90 percent of fuel retailers are small, but the reality is that 25 percent are NOT SMALL. Or, according to them, 75 percent are small, but contrasting 90 to 75 must not have felt impressive enough. But they are wrong anyway, according to a 2007 report:

Who Sells Gas – and For What – May Surprise You

In reality, less than 3 percent of the more than 112,000 convenience stores selling gasoline are owned and operated by major oil companies.

Of course not all gas is sold at convenience stores, so we have to account for the stand-alone gas stations to get the total that are owned by Big Oil. According to the extensive report by the NACS, found here:

It’s estimated that less than 5 percent of the approximately 168,000 retail gasoline facilities in the United States are owned and operated by the major oil companies.

So much for the idea of sticking it to Big Oil. I understand that this is why this issue has taken off, but that’s not who is going to get stuck.

MYTH: The cost to retro-fit the pumps will far outweigh the benefit to the consumers.

FACT: The one-time cost to retro-fit retail pumps is very close to the extra amount consumers already pay annually for hot fuel.

Yet that doesn’t contradict the “myth”, does it? That doesn’t mean that after the retro-fit, consumers won’t be paying even more. And based on the estimates that I have seen, to put temperature compensation on all of these pumps will cost in the range of $6 billion to $12 billion ($3,000-$4,000 per pump times 2-3 million pumps). So even if we accepted the premise of $2 billion extra from consumers each year, I have a hard time accepting that this is “very close” to the cost of the new equipment.

And they close with one supported by nothing by a great big dose of wishful thinking:

MYTH: The cost of retro-fitting the pumps will raise the price of fuel for all consumers.

FACT: Consumers have borne the burden of hot fuel sales for decades. Once the problem is fixed they will reap the benefits for future decades.

Sadly, another story at the OIDA website said that that on July 11, 2007 the National Conference on Weights and Measures failed to approve a measure to approve guidelines for states, should they ever decide that they wanted temperature compensation. Again, they couldn’t even pass a measure for a non-binding guideline. Those voting against must be in the pockets of Big Oil.

Stuff like this really drives me crazy. A waste of time for the parties who are supposed to reap benefits, an annoyance for people trying to run service stations, an issue that allows politicians to pander, while the real beneficiaries are the attorneys.

July 17, 2007 Posted by | gas prices, litigation, price gouging | 11 Comments

Hot Gas is a Bunch of Hot Air

The Owner Operator Independent Drivers Association (OIDA) has launched a new website to “educate” people on the issue of hot gas. And by educate, I mean misinform and obfuscate. I can’t help but wonder about their headline story:

Hot Fuel Costs Consumers More Than 2.3 Billion Dollars Annually

Let’s see, Americans consume 140 billion gallons of gasoline and over 60 billion gallons of diesel each year. That means that even if their headline above was correct, the “rip-off” amounts to just over 1 cent a gallon. And given that pricing is set by supply and demand, what will happen with temperature compensation is that the average gasoline price will go up by just over 1 cent a gallon, plus a bit more as every retailer tries to recoup the cost of temperature compensation equipment. Who wins? The makers of the temperature compensation equipment, and the lawyers. Even in the best case, the average consumer who uses about 600 gallons of fuel a year would win $6 a year if you could suspend the laws of supply and demand.

Their new section on myths and facts is an excellent source of misinformation:

Hot Fuel Myths & Facts

Let’s look at some of their “myths”, and the facts as they see them. And of course the facts as I see them. 🙂

MYTH: Fill up in the morning when it’s cooler.

FACT: 35,000-gallon tanks do not dramatically change temperature in daily cycles.

Well, I agree with this one. 35,000 gallon tanks DO NOT dramatically change temperature in daily cycles. That means when the temperature outside rises to 90 degrees, the temperature of the fuel is about the same as it was in the middle of the night when the temperature was 60 degrees.

MYTH: In-ground tanks at gas stations keep fuel at 60 degrees Fahrenheit.

FACT: The insulated, fiberglass tanks tend to keep fuel at the temperature it was delivered… for a long time. Also, larger retailers turn over fuel supplies very rapidly, greatly reducing the time the fuel spends in the tanks.

And as I showed in an earlier essay, the NIST found that the average annual temperature of fuel stored in those underground tanks was 64.7 degrees.

The fuel temperature data was gathered by the National Institute of Standards and Technology from storage tanks at 1,000 gas stations and truck stops in 48 states and the District of Columbia during a period from 2002 to 2004.

The NIST data revealed that the average temperature of fuel across the country and year-round was 64.7 degrees Fahrenheit — almost 5 degrees higher than the government standard of 60 degrees.

So, how many gallons does the “ripoff” then amount to? The OIDA site discusses that in their next myth:

MYTH: Temperature only causes tablespoons of difference in amount of fuel delivered.

FACT: A 25-gallon fill-up of 75 degree F gasoline equates to a loss of nearly one quart. The same fill-up at 90 degrees F equates to nearly a half gallon.

But we aren’t filling up with gasoline at 75 degrees, are we? The NIST investigation – which started this whole thing – established that. And again, as I showed in the previous essay, the difference between gasoline at 60 degrees F and gasoline at 64.7 degrees F is 0.27%. Therefore, in a 25 gallon fill-up, the difference is 8.6 ounces (17.3 tablespoons). But suggesting that people are regularly getting gasoline at 75 degrees or even 90 degrees is just outright misinformation.

MYTH: 90 percent of fuel retailers are small “mom and pop” operations.

FACT: Several large oil production companies and refiners own 25 percent of the stations that sell their brand fuel.

You have to love this one. The myth is that 90 percent of fuel retailers are small, but the reality is that 25 percent are NOT SMALL. Or, according to them, 75 percent are small, but contrasting 90 to 75 must not have felt impressive enough. But they are wrong anyway, according to a 2007 report:

Who Sells Gas – and For What – May Surprise You

In reality, less than 3 percent of the more than 112,000 convenience stores selling gasoline are owned and operated by major oil companies.

Of course not all gas is sold at convenience stores, so we have to account for the stand-alone gas stations to get the total that are owned by Big Oil. According to the extensive report by the NACS, found here:

It’s estimated that less than 5 percent of the approximately 168,000 retail gasoline facilities in the United States are owned and operated by the major oil companies.

So much for the idea of sticking it to Big Oil. I understand that this is why this issue has taken off, but that’s not who is going to get stuck.

MYTH: The cost to retro-fit the pumps will far outweigh the benefit to the consumers.

FACT: The one-time cost to retro-fit retail pumps is very close to the extra amount consumers already pay annually for hot fuel.

Yet that doesn’t contradict the “myth”, does it? That doesn’t mean that after the retro-fit, consumers won’t be paying even more. And based on the estimates that I have seen, to put temperature compensation on all of these pumps will cost in the range of $6 billion to $12 billion ($3,000-$4,000 per pump times 2-3 million pumps). So even if we accepted the premise of $2 billion extra from consumers each year, I have a hard time accepting that this is “very close” to the cost of the new equipment.

And they close with one supported by nothing by a great big dose of wishful thinking:

MYTH: The cost of retro-fitting the pumps will raise the price of fuel for all consumers.

FACT: Consumers have borne the burden of hot fuel sales for decades. Once the problem is fixed they will reap the benefits for future decades.

Sadly, another story at the OIDA website said that that on July 11, 2007 the National Conference on Weights and Measures failed to approve a measure to approve guidelines for states, should they ever decide that they wanted temperature compensation. Again, they couldn’t even pass a measure for a non-binding guideline. Those voting against must be in the pockets of Big Oil.

Stuff like this really drives me crazy. A waste of time for the parties who are supposed to reap benefits, an annoyance for people trying to run service stations, an issue that allows politicians to pander, while the real beneficiaries are the attorneys.

July 17, 2007 Posted by | gas prices, litigation, price gouging | 12 Comments

Energy Policy Insanity

Just enough quiet time this morning (still suffering jet lag and waking up at 4 a.m.) to knock out an essay. I told my daughter last night that I plan to keep writing, but I don’t plan to do it on their time. I will do it early in the morning, at lunch, or when the rest of the family is occupied with something. But I like writing too much to stop.

I read an article yesterday in The Detroit News:

Energy bill may gouge consumers

The article was written by Mark J. Perry, an economics and finance professor at the University of Michigan, and discusses the pending energy legislation. There was been so much to write about on this issue, but I just haven’t had the free time lately. Professor Perry does a nice job of explaining some of what’s wrong with the pending bill. And believe me, if there was ever an indication that our legislators do not understand energy issues, the pending bills provide concrete evidence (at least to me).

Professor Perry writes:

Despite good intentions, Congress is about to make a huge error in consumer protection and energy security if a House-Senate conference committee ends up approving energy legislation that increases taxes on oil companies and makes gas-price gouging a criminal offense.

I go back and forth on this one. Are their intentions good? Or are they merely pandering to their constituents so they will get reelected? I suppose they may sincerely think they can do both – pass energy legislation that causes no pain to consumers while “punishing” oil companies, and get themselves reelected as a result of their “forward thinking” on energy issues. But it won’t be long before everyone – politicians and citizens – get a great big reality check when these policies drive gas prices up another few dollars per gallon (or cause shortages because price increases are now subject to prosecution).

For Congress to increase taxes on our own investor-owned oil companies and raise royalty rates to pay for a big increase in renewable fuels doesn’t make economic sense.

I agree, but for reasons different than he lays out. As I pointed out in the previous essay, the actual displacement in our fossil fuel consumption would be less than 2% on a net basis if it was even possible to scale up to 35 billion gallons of biofuels per year. And again, I think it is important to reiterate that a substantial portion of that 2% comes in the form of animal feed byproducts (discount the animal feed, and true displacement is a few tenths of a percent). It isn’t like you can burn animal feed in your car.

Perhaps more importantly, the vast majority of that scale up in biofuels is supposed to come from cellulosic ethanol, a technology that has not been able to make it commercially – and shows no imminent signs of doing so even though we have been working on the problem since before man stepped on the moon. But our government seems to think they can legislate technology advances. They hear ethanol evangelists who clearly don’t know the first thing about the technical issues involved, yet tell them that we can scale up and run the country on switchgrass, and so they throw vast amounts of money at the problem.

Professor Perry then points out that private oil companies actually don’t own much in the way of worldwide oil reserves:

In fact, more than three-quarters of the world’s oil reserves are owned by national oil companies from such problematic and potentially unfriendly countries as Saudi Arabia, Venezuela, Russia and Iran.

Only 6 percent of the world’s oil reserves are held by private, investor-owned oil companies like ConocoPhillips and ExxonMobil.

But of course we can always sue OPEC. I mean, have you ever heard of a more idiotic idea? The OPEC countries are not depleting their natural resources fast enough to suit our insatiable demand, so we are going to sue them. Can you imagine if the Japanese passed laws allowing them to sue U.S. timber suppliers, because we aren’t giving them the amount they want at the price they want? How about if Africa sues U.S. corn growers because ethanol demand has driven up corn prices? After all, they are no longer getting corn at the prices they were accustomed to.

It doesn’t make economic sense that our own American privately owned oil companies are so vilified and viewed so differently from other industries. In 2006, the average profits for all manufacturing industries were 8.2 cents per dollar of sales, whereas the average oil-industry earnings were 9.5 cents on each dollar of sales, a penny higher.

More to the point: Oil companies reinvest profits in energy development to support the American economy and make huge capital investments regardless of whether profits are high or low. Between 1992 and 2006, U.S. oil companies invested more than $1 trillion in long-term energy projects.

Those arguments fall on deaf ears. I never understood, if the majority of the public thinks oil companies are making a killing, why more people don’t just invest in oil company stocks. (I guess one reason is that the U.S. savings rate is abysmal). Of course one must wonder, if these companies are really printing money, why they trade at 8 or 10 times earnings. The bottom line is that companies that are investing hundreds of billions to trillions on their business have to make multi-billion profits to justify those investments.

And if you want to know what is really going to happen, and I guarantee you that this is what is going to happen, here it is:

And in the name of supposedly protecting consumers, the Democratic leadership in Congress also wants to empower the Federal Trade Commission (FTC) to prosecute companies and individuals who engage in “price gouging” for gasoline and other petroleum products.

Leaders want this even though a congressionally mandated FTC study of gasoline price increases in the aftermath of hurricanes Katrina and Rita two years ago found no evidence of widespread price gouging or any anti-competitive behavior. The FTC concluded that the price increases were due to the market forces and not to any illegal manipulation by oil companies.

“Price gouging” provisions in the energy legislation could have a chilling effect on the oil market. The severe civil and criminal penalties — substantial fines and possible jail time — would force everyone in the oil industry, from the biggest refiner to the smallest gas station, to reconsider everyday business decisions, including whether they should remain open, particularly in disaster areas.

Gasoline suppliers and wholesalers may choose not to move any additional supplies into affected areas when doing so exposes them to possible fines and jail time if the government finds them guilty of the ambiguous crime of “unconscionable pricing.”

Think about it. You are the owner of a gas station, or a refiner in an area that is about to get hit, or just got hit by a hurricane. Suddenly, either there is a run on supplies as people try to evacuate, or local refineries shut down and your future deliveries will be delayed. Your gasoline inventories start to drop rapidly. Normally, you would raise the price. But now the specter of “unconscionable pricing” and the risk of prosecution hang over your head. What do you do? You have 2 options. You can either run out of gas, or shut your supply down. I would shut my supply down, which would only exacerbate the shortage. And you could thank congress for that.

This Week in Petroleum

Lots of other news to talk about, and hopefully I will get around to those stories before they are stale. One big item to keep an eye on, related to This Week in Petroleum, is that distillate stocks have been coming down rapidly, just as gasoline stocks did this spring. That means we could see a repeat of record high prices in the fall and winter, except this time with heating oil. One could have made a killing in the gasoline futures markets by paying attention to what was happening with inventories back in March. I don’t invest in futures, but if I did I would take a close look at heating oil for winter delivery. A recent OPIS report from a couple of weeks ago laid out the potential problem:

“Heating oil stocks fell by a wintry 2.8 million bbl last week, said the department of Energy, suggesting lively export activity and setting the stage for a big rally once temperatures drop.

It almost seems ridiculous to focus in mid-June on heating oil. But in an otherwise ambiguous DOE report, it is the one product where statistics point to some clear warning signs for the remainder of 2007. Something unusual is happening, and the foundations for a troublesome Winter of 2007-2008 may be in the early construction phase.”

The other thing to note is that gasoline stocks turned back down this week, which was not what analysts had expected. That means gasoline prices may have bottomed out for now, because inventories are still very low heading into the busier driving months of July and August. As I stated in previous essays, historically production draws down in these months. Because we are so thin on supplies, this draw down will likely have a disproportionate effect on gas prices. It is going to be an interesting couple of months.

June 28, 2007 Posted by | EIA, energy policy, heating oil, oil companies, politics, price gouging | 7 Comments

Energy Policy Insanity

Just enough quiet time this morning (still suffering jet lag and waking up at 4 a.m.) to knock out an essay. I told my daughter last night that I plan to keep writing, but I don’t plan to do it on their time. I will do it early in the morning, at lunch, or when the rest of the family is occupied with something. But I like writing too much to stop.

I read an article yesterday in The Detroit News:

Energy bill may gouge consumers

The article was written by Mark J. Perry, an economics and finance professor at the University of Michigan, and discusses the pending energy legislation. There was been so much to write about on this issue, but I just haven’t had the free time lately. Professor Perry does a nice job of explaining some of what’s wrong with the pending bill. And believe me, if there was ever an indication that our legislators do not understand energy issues, the pending bills provide concrete evidence (at least to me).

Professor Perry writes:

Despite good intentions, Congress is about to make a huge error in consumer protection and energy security if a House-Senate conference committee ends up approving energy legislation that increases taxes on oil companies and makes gas-price gouging a criminal offense.

I go back and forth on this one. Are their intentions good? Or are they merely pandering to their constituents so they will get reelected? I suppose they may sincerely think they can do both – pass energy legislation that causes no pain to consumers while “punishing” oil companies, and get themselves reelected as a result of their “forward thinking” on energy issues. But it won’t be long before everyone – politicians and citizens – get a great big reality check when these policies drive gas prices up another few dollars per gallon (or cause shortages because price increases are now subject to prosecution).

For Congress to increase taxes on our own investor-owned oil companies and raise royalty rates to pay for a big increase in renewable fuels doesn’t make economic sense.

I agree, but for reasons different than he lays out. As I pointed out in the previous essay, the actual displacement in our fossil fuel consumption would be less than 2% on a net basis if it was even possible to scale up to 35 billion gallons of biofuels per year. And again, I think it is important to reiterate that a substantial portion of that 2% comes in the form of animal feed byproducts (discount the animal feed, and true displacement is a few tenths of a percent). It isn’t like you can burn animal feed in your car.

Perhaps more importantly, the vast majority of that scale up in biofuels is supposed to come from cellulosic ethanol, a technology that has not been able to make it commercially – and shows no imminent signs of doing so even though we have been working on the problem since before man stepped on the moon. But our government seems to think they can legislate technology advances. They hear ethanol evangelists who clearly don’t know the first thing about the technical issues involved, yet tell them that we can scale up and run the country on switchgrass, and so they throw vast amounts of money at the problem.

Professor Perry then points out that private oil companies actually don’t own much in the way of worldwide oil reserves:

In fact, more than three-quarters of the world’s oil reserves are owned by national oil companies from such problematic and potentially unfriendly countries as Saudi Arabia, Venezuela, Russia and Iran.

Only 6 percent of the world’s oil reserves are held by private, investor-owned oil companies like ConocoPhillips and ExxonMobil.

But of course we can always sue OPEC. I mean, have you ever heard of a more idiotic idea? The OPEC countries are not depleting their natural resources fast enough to suit our insatiable demand, so we are going to sue them. Can you imagine if the Japanese passed laws allowing them to sue U.S. timber suppliers, because we aren’t giving them the amount they want at the price they want? How about if Africa sues U.S. corn growers because ethanol demand has driven up corn prices? After all, they are no longer getting corn at the prices they were accustomed to.

It doesn’t make economic sense that our own American privately owned oil companies are so vilified and viewed so differently from other industries. In 2006, the average profits for all manufacturing industries were 8.2 cents per dollar of sales, whereas the average oil-industry earnings were 9.5 cents on each dollar of sales, a penny higher.

More to the point: Oil companies reinvest profits in energy development to support the American economy and make huge capital investments regardless of whether profits are high or low. Between 1992 and 2006, U.S. oil companies invested more than $1 trillion in long-term energy projects.

Those arguments fall on deaf ears. I never understood, if the majority of the public thinks oil companies are making a killing, why more people don’t just invest in oil company stocks. (I guess one reason is that the U.S. savings rate is abysmal). Of course one must wonder, if these companies are really printing money, why they trade at 8 or 10 times earnings. The bottom line is that companies that are investing hundreds of billions to trillions on their business have to make multi-billion profits to justify those investments.

And if you want to know what is really going to happen, and I guarantee you that this is what is going to happen, here it is:

And in the name of supposedly protecting consumers, the Democratic leadership in Congress also wants to empower the Federal Trade Commission (FTC) to prosecute companies and individuals who engage in “price gouging” for gasoline and other petroleum products.

Leaders want this even though a congressionally mandated FTC study of gasoline price increases in the aftermath of hurricanes Katrina and Rita two years ago found no evidence of widespread price gouging or any anti-competitive behavior. The FTC concluded that the price increases were due to the market forces and not to any illegal manipulation by oil companies.

“Price gouging” provisions in the energy legislation could have a chilling effect on the oil market. The severe civil and criminal penalties — substantial fines and possible jail time — would force everyone in the oil industry, from the biggest refiner to the smallest gas station, to reconsider everyday business decisions, including whether they should remain open, particularly in disaster areas.

Gasoline suppliers and wholesalers may choose not to move any additional supplies into affected areas when doing so exposes them to possible fines and jail time if the government finds them guilty of the ambiguous crime of “unconscionable pricing.”

Think about it. You are the owner of a gas station, or a refiner in an area that is about to get hit, or just got hit by a hurricane. Suddenly, either there is a run on supplies as people try to evacuate, or local refineries shut down and your future deliveries will be delayed. Your gasoline inventories start to drop rapidly. Normally, you would raise the price. But now the specter of “unconscionable pricing” and the risk of prosecution hang over your head. What do you do? You have 2 options. You can either run out of gas, or shut your supply down. I would shut my supply down, which would only exacerbate the shortage. And you could thank congress for that.

This Week in Petroleum

Lots of other news to talk about, and hopefully I will get around to those stories before they are stale. One big item to keep an eye on, related to This Week in Petroleum, is that distillate stocks have been coming down rapidly, just as gasoline stocks did this spring. That means we could see a repeat of record high prices in the fall and winter, except this time with heating oil. One could have made a killing in the gasoline futures markets by paying attention to what was happening with inventories back in March. I don’t invest in futures, but if I did I would take a close look at heating oil for winter delivery. A recent OPIS report from a couple of weeks ago laid out the potential problem:

“Heating oil stocks fell by a wintry 2.8 million bbl last week, said the department of Energy, suggesting lively export activity and setting the stage for a big rally once temperatures drop.

It almost seems ridiculous to focus in mid-June on heating oil. But in an otherwise ambiguous DOE report, it is the one product where statistics point to some clear warning signs for the remainder of 2007. Something unusual is happening, and the foundations for a troublesome Winter of 2007-2008 may be in the early construction phase.”

The other thing to note is that gasoline stocks turned back down this week, which was not what analysts had expected. That means gasoline prices may have bottomed out for now, because inventories are still very low heading into the busier driving months of July and August. As I stated in previous essays, historically production draws down in these months. Because we are so thin on supplies, this draw down will likely have a disproportionate effect on gas prices. It is going to be an interesting couple of months.

June 28, 2007 Posted by | EIA, energy policy, heating oil, oil companies, politics, price gouging | 15 Comments

Gasoline Prices Part II: Long-Term Factors

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.

June 10, 2007 Posted by | energy policy, gas prices, oil refineries, price gouging, price manipulation, profit margins, refining | 6 Comments

Gasoline Prices Part II: Long-Term Factors

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.

June 10, 2007 Posted by | energy policy, gas prices, oil refineries, price gouging, price manipulation, profit margins, refining | 14 Comments