Gasoline Prices

An excellent piece on gasoline prices from the NY Times on Oil Price ‘Gouging’: A Phantom Menace?:

THE average price of gasoline in the United States set a record last week — $3.10 a gallon, according to the Energy Information Administration — up a nickel from the week before and 15 cents from a year ago.

Like night follows day, politicians in Washington immediately vented their outrage.
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It goes without saying that gasoline retailers and oil companies will seek to maximize their profit, which usually means charging the highest price markets can bear.

But is that price gouging?

Because the demand for gasoline is what economists call inelastic, which means that people cannot quickly reduce their consumption when prices rise sharply, abrupt supply shortages lead to steep price increases without any immediate decline in sales.

The most common reason for such increases in gasoline prices is a steep increase in the price of crude oil. But crude oil prices are set in global markets, and even the biggest American or European oil companies are modest players compared with state-controlled oil companies in the Persian Gulf, Russia and Latin America.
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It seems hard to believe today, but world oil prices briefly drifted below $11 a barrel in 1998. Not surprisingly, few lawmakers in Congress took that opportunity to denounce “unconscionably excessive” price declines.

The Federal Trade Commission has been skeptical about accusations of price-gouging on gasoline prices. In 2004, the agency studied price changes in gasoline from 1991 through late 2003. It concluded that about 85 percent of the price variability — both up and down — reflected changes in crude oil prices.
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INDUSTRY executives say the anomaly reflects a temporary drop-off in refinery activity, partly because of scheduled maintenance and partly because of unscheduled interruptions. On top of that come ethanol prices, which have soared, because refiners now blend a small percentage of ethanol into standard gasoline.

The broader issue is that refinery capacity has not kept up with American demand for gasoline. Oil companies, caught with vast amounts of excess refining capacity in the early 1980s, systematically reduced capacity during the long lean years when energy prices and profit margins were the pity of Wall Street.
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But Congress could face an entirely new quandary in its desire to expand the use of renewable fuels. President Bush has called for producing 35 billion gallons a year of alternative fuels — from cellulosic ethanol to coal-based diesel — by 2017. Congressional Democrats might be even more aggressive.

If that’s the plan, will oil companies want to invest in more refineries? “You’ve got to ask whether the demand will be there,” Mr. Felmy said.

See my previous post on Alternate fuels make new refineries unlikely:

A top Chevron Corp. executive said Tuesday the push to displace as much as a fifth of the country's gasoline with ethanol will make it less likely the industry will build new domestic refineries.

UPDATE: More thoughts here:

Congress can help by making it easier to build refineries in this country. The United States has a serious supply-and-demand problem due in part to this nation’s insufficient refining capacity.

Investors are reluctant to put their money into U.S. refineries due to a thicket of government regulations. Add the uncertainty that Congress could change the regulations after the refinery investments were made.

Most refinery investments now are made in other countries. No new refineries have been built in the United States in more than 30 years.

On Tuesday, the Senate Energy Committee was warned by oil analyst Paul Sankey that the lack of refining capacity in the United States leaves the nation’s 20-day gasoline inventory vulnerable to storms, accidents, equipment failures and foreign supply disruptions, according to a Cox News Service story by Marilyn Geewax.

Sankey said Congress should be prepared for emergency measures, including tossing out environmental rules and drawing down strategic reserves.

“The underlying problem is the U.S. petroleum industry’s infrastructure is just unable to cope with increasing demand,” he said.

Congress also should investigate how it can help promote refinery construction in this country. That’s a start.

Market forces, anyone? The Law of Unintended Consequences is being felt in the impact of prior governmental activity to "solve" the energy crises.

Refinery capacity? As it achieves great efficiency, it also reaches max capacity, leaving little wiggle room for refinery shutdowns, the Energy Information Agency says:

U.S. refining capacity, as measured by daily processing capacity of crude oil distillation units alone, has appeared relatively stable in recent years, at about 16 million barrels per day of operable capacity (graph). While the level is a reduction from the capacity of twenty years ago, the first refineries that were shut down as demand fell in the early 1980's were those that had little downstream processing capability. Limited to simple distillation, these small facilities were only economically viable while receiving subsidies under the Federal price control system that ended in 1981. Some additional refineries were shut down in the late 1980's and during the 1990's, always, of course, those at the least profitable end of a company's asset portfolio. At the same time, refiners improved the efficiency of the crude oil distillation units that remained in service by "debottlenecking" to improve the flow and to match capacity among different units and by turning more and more to computer control of the processing. Furthermore, following government mandates for environmentally more benign products as well as commercial economics, refiners enhanced their upgrading (downstream processing) capacity. As a result, the capacity of the downstream units ceased to be the constraining factor on the amount of crude oil processed (or "run") through the crude oil distillation system. Thus crude oil inputs to refineries ("runs") have continued to rise, and along with them -- given the stability of crude oil distillation capacity -- capacity "utilization" rose throughout much of the 1990's (again, see graph). Utilization -- the share of capacity filled with crude oil -- reached truly record levels in the last half of the decade, nominally exceeding 100 percent for brief periods.

The graph referred to follows:


Refinery profitablity issues from the past haunt us today:

In general, refining has been significantly less profitable than other industry segments during the 1990's, as shown in the accompanying graph. Gross refinery margins -- the difference between the cost of the input and the price of the output -- have been squeezed at the same time that operating costs and the need for additional investment to meet environmental mandates has grown, thus reducing the net margin even further. In addition, much of the investment made during the 1980's was designed to take advantage of the differential between the dwindling supply of higher quality crude oils and the growing supply of heavier and higher sulfur crudes. When that differential narrowed, however, the financial return on those investments declined. Refining margins peaked in the late 1980's.

In short, in the past, when any new refinery capacity that might be needed today could have been started, there was no incentive for the refining companies to build them, because there was little or no profit in the industry.

See also here.

TANSTAAFL.

UPDATE2: Corn based ethanol problems covered here:

Policymakers and legislators often fail to consider the law of unintended consequences. The latest example is their attempt to reduce the United States' dependence on imported oil by shifting a big share of the nation's largest crop – corn – to the production of ethanol for fueling automobiles.

Good goal, bad policy. In fact, ethanol will do little to reduce the large percentage of our fuel that is imported (more than 60 percent), and the ethanol policy will have ripple effects on other markets. Corn farmers and ethanol refiners are ecstatic about the ethanol boom and are enjoying the windfall of artificially enhanced demand. But it will be an expensive and dangerous experiment for the rest of us.

Thanks, Congress.