September 11, 2005
The question about refining
Has environmental regulation been responsible for leaving the U.S. with inadequate gasoline refining capacity? The story is not as simple as some have suggested.
Half the nation's refineries have been closed down since 1976, without a single new one in operation. To Reason Foundation's Adrian Moore, this paints a pretty clear picture of the source of our problems:
Just a few new refineries would alleviate the problem and help keep our gas prices lower and steadier.
But getting an oil refinery built is next to impossible, hence the 30-year construction drought. There will always be environmental activists who fight any new proposed refinery, regardless of where it might be located and how environmentally safe it is. And our environmental rules give them the upper hand.
Instapundit, Backcountry Conservative, GOP Bloggers, and Knowledge Problem were among the many who seemed to endorse this conclusion. It's also the reason that President Bush raised the possibility this spring of using old military sites as possible locations for building some new refineries.
One problem with this story was pointed out by Cato Institute's Jerry Taylor and Peter Van Doren (hat tip: Economist's View). As the graph at the right reveals (data source: BP Statistical Review of World Energy June 2005), apart from a brief decline in the early 1980's associated with the drop in energy demand at that time, the total quantity of crude processed by the nation's refineries (known as "throughput") has been steadily rising, despite the loss of half the facilities. Increased scale of operations at the remaining refineries has more than made up for the drop in the total number. It is true that capacity has not grown as fast as throughput, so that there is much less excess capacity in the system now than in 1976. But Taylor and Van Doren argued that it was the earlier period that was unusual:
The explanation resides in the fact that we had a lot of refineries back in 1981 not because of market forces or the lack of environmental regulations, but because the government subsidized the existence of small, inefficient refineries.
And although refinery output has not kept up with U.S. gasoline demand, Taylor and Van Doren weren't worried about that, either:
The increase in gasoline imports since 1976 (from 2 percent of the market then, to 5.8 percent now) is often cited as evidence that "we have a problem." Nonsense. International trade is a good thing. The more globalized the market, the more diversified our supply and the less vulnerable the U.S. market is to disruption. Moreover, the more global the market, the greater the competition.
Although Taylor and Van Doren are making an important point, perhaps they have overstated the case slightly. I would point out first that, although problems with getting a permit to build a refinery are not the only factor, they certainly must be given some weight. Moore noted that the Yuma, Arizona refinery will go on line 15 years after it was first proposed, in large part because of opposition like this. Consider the nature of the effect on your own ability to buy a new car or house if you had to make these decisions 15 years in advance. Environmental concerns appear to have been responsible for preventing the reopening of a refinery in Santa Fe Springs, CA. And interestingly, the Bush proposal to use old military sites had not even gotten out the door before the "not in my backyard" campaigns began. Once the Yuma refinery is in operation, it can look forward to additional lawsuits, like this one or this one or this one.
As for the suggestion that international refineries are more competitive than American, it's usually cheaper to transport crude oil than refined products, which is why refineries tend to be located in the consuming areas rather than producing areas. Insofar as foreign refineries do have a cost advantage over their U.S. counterparts, surely part of that comes from our more stringent environmental regulations. In addition to the litigation liabilities noted above, a study for the Department of Energy estimated that "the share of total U.S. refining capital expenditures for pollution abatement increased from slightly over 10 percent shortly before the Clean Air Act Amendments of 1990 to over 40 percent in recent years".
These trends have also coincided with a proliferation of fuel standards in the U.S. The simultaneous decrease in the number of refineries and increase in the number of separate markets has meant that a far smaller number of suppliers compete in any given community, and makes the system far more vulnerable to local supply and demand disruptions. Having a smaller number of refineries and far less excess capacity in the system also makes us more vulnerable nationally to events such as the damage wrought by Katrina.
If those refineries in Yuma and Santa Fe Springs had been producing gasoline this summer, would it have made any difference? It couldn't have hurt.
Posted by James Hamilton at September 11, 2005 05:12 PMdigg this | reddit
Listed below are links to weblogs that reference The question about refining:
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Tracked on September 12, 2005 10:18 AM
» Rising Commodity Price Prompt Radical Vertical Integration from The Stalwart
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Tracked on September 14, 2005 10:50 AM
» Refining and Environmental Regulations from View From a Height
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Tracked on October 6, 2005 12:09 PM
"stringent environmental regulations" compare to what ? check out Germany or Switzerland for the environmental laws.
US consumers want to drive SUV and use half of all produced in the world energy. I am driving 1.4l Hyundai Getz (when i have one) and should pay for the US by my money.
Now the US consumer paying about half of what i pay (price of gas in Israel is approx $1.2/L not a gal. but liter) complains the most about gas prices.
The whole world cuts and trys to keep environmental damage in check and the US is the only country which is not ready to sign any international agreements.
Frankly it's time for the US consumer to consider some alternatives to his/her Hummer and private swimming pool. May be replacing of that windows in your house can make your bill lower too.
Posted by: larytet at September 12, 2005 05:55 AM
How long can our existing refineries continue to grow? Surely, there must be a point at which the expansion of an existing facility is no longer practical.
Perhaps the real story here is not that we are in the midst of a refining shortage, but that we are approaching one.
And, perhaps, it is time for us to outsource our refining needs, which pretty means outsourcing the pollution burden to other countries. It's hard to make a national security argument against this, considering how we already depend on foreign trade for our crude oil.
Posted by: Mike at September 12, 2005 06:41 AM
In considering the trend of the last quarter century in the concentration of refining capacity it is necessary to recognize that the increasing level of crude imports has resulted in a concentration of refineries either near ports, or pipe lines that can crude from those ports.
Many of the smaller "inefficient" refineries that closed probably shared a reliance on local production that was declining. There is no point in increasing capital investment in a plant that is experiencing supply problems, so th capital re-investment ultimately is allocated to the sites with the most reliable supplies.
An additional factor in concentration of refining capacity is basically a product of the economics of an industry with a high level of pollution exposure. Small companies rely on banks for financing, and banks break into hives from the mention of the letters EPA. Thus, most expansion must be funded through the reinvestment of profits or through attraction of public investment. When the business is only marginally profitable then these sources also shrink.
Posted by: Bill Ellis at September 12, 2005 07:38 AM
Well, I have a completely new theory on what we're seeing. Not a conspiracy theory. Consider: Peaking of world production and depletion is probably inevitable. Substitutes will merely slow depletion. A big miracle--or many small miracles--may arrive to change that (and to make someone very wealthy). But there are good odds that energy will become more dear.
Systemically, thinking about the entire planet, that's a good thing. It starts the regulation proess for human numbers, etc. The transition is the big question. Spoilage of other resources--poor lower EROEI subsitutes--can make lots of little Haitis. So there is the concern that a sustainable world is no nirvana.
But I digress. My theory. If you are an energy company, and you know energy will become more dear, there is no incentive to pull it out of the ground today. The value is appreciating in the ground. It's a great investment. In addition, you know that industrial society will have to start making do with less. Initially, with less production growth. Later, with less absolutely. How do you start this process?
Well, one way is to change your name from British Petroleum to BP and strongly hint that it means Beyond Petroleum. Another is to create PR campaigns like willyoujoinus.com. And another is to allow consumption to run into production. Somewhere. Refining. Pulling it out of the ground. Wherever. Start the process. Allow a lot of conflicting reasons be given: oil depletion? Lack of refining capacity? Etc. etc. The political pressure to do something will be enormous. The politicians will screw it up. So instead let the system run up against the limits. Like Scotty in the engine room of the Star Ship Enterprise, the oil companies can say "we're going as fast as we gan."
Then what happens: demand destruction starts in. The thinking changes. We pass through that window with the public once again considering oil as a limited resource. Suddenly muscle cars and SUVs are no longer possible. And low and behold: oil is more expensive, and that additional production capacity wasn't necessary.
Now isn't that a great way to make a few bucks. No new refining capacity. Higher price for oil in the ground.
Posted by: T.R. Elliott at September 12, 2005 07:42 AM
I suggest you look at some of the financials of refinery firms over the last 20 years.
Yes, regulations and not in my back yard have played a role in the lack or refineries.
But the dominate reason we do not have new refineries is that the industry
was unprofitable. For a couple of decades we have had substantial excess refining capacity and it was a very low return industry because of this. Moreover, it was a consolidating industry as the number of firms has fallen sharply. Over this period Velaro has been buying up many of these firms at rock bottom prices that reflected the poor prospects for these industries.
The poor performance of these refining firms that have fallen by the wayside implies that the dominate reason that no new refineries were built is that the capital markets determined that they were not needed.
Posted by: spencer at September 12, 2005 08:34 AM
I guess I'm with Spencer on this. Otherwise, I would expect to see many large refineries on the Mexican border, pumping up gas instead of oil to the US. There are no stringent environmental laws to complain and people would be glad for the jobs they would provide in their backyards.
Posted by: Cerqueira at September 12, 2005 09:13 AM
Ditto for me. If refineries have been going out of business, that suggests the economic barriers to refining are not EPA or NIMBY.
After all, the alleged EPA and NIMBY barriers apply to the construction of new facilities. But a pre-existing facility would not be affected - indeed, the fact that it was already built and thus largely immune from EPA and NIMBY issues would make it more valuable! While capacity expansion might attract some opposition from NIMBYists and/or New Source Reviews from EPA, every surviving refinery has managed to surmount those obstacles. Assuming that those refineries NEVER expanded, they would have been grandfathered into the Clear Air Act and would NEVER have to worry about the EPA. Ergo, we conclude that those pre-existing refineries which have now been closed weren't shut down because of NIMBY pressures or EPA limits.
If pre-existing refineries that would have been largely immune from the EPA or NIMBYists have shut down, then we should conclude that NIMBY and EPA aren't to blame for the failure to construct new refineries.
Posted by: Silent E at September 12, 2005 09:42 AM
Pre-existing refineries are not at all immune from added environmental costs, as I provide many examples in the original post. Not sure why several of you are dismissing that as a contributing factor in the low profitability of refineries.
The point about Mexico is an interesting one. But a refinery and pipeline would be a classic example of a capital investment that, once made, leaves you at the mercy of the government changing the rules to appropriate all the rent for itself. I think there are all kinds of investments in Mexico which, if you ignored the political risks, would seem to make a lot of economic sense, and yet those investments don't get made.
Posted by: JDH at September 12, 2005 09:59 AM
"I guess I'm with Spencer on this. Otherwise, I would expect to see many large refineries on the Mexican border, pumping up gas instead of oil to the US."
I also think Spencer has a valid point, but am less sure of the argument about Mexican refineries. Not only would the refineries have to be built, but they would have to be tied into the US internal pipeline system. I question whether Texas, to choose an example, would allow the construction of a several-hundred mile pipeline from Mexico so that Mexican refineries could compete with the ones in Texas.
Posted by: Michael Cain at September 12, 2005 10:10 AM
Optimal trade and optimal
environmental protection are tautologically good, but mightn't the specialized
nature of finished petroleum products such as gasoline, jet fuel, etc., pose
extra problems that can't be ignored? Such markets are both relatively small
and unusually critical as chokepoints, inviting all the usual political
mischief of the main crude-oil market, but plus a whole lot more.
Europeans, for example, are ever
eager to export what used to be called Eurosclerosis,
i.e. bizarre self-imposed uneconomic measures (e.g. observer.guardian.co.uk/uk_news/story/0,6903,1567266,00.html).
Today's favored technique is to tell someone else
what to do - see euobserver.com/9/19847,
to say nothing of some comments above. Political Europe might, instead, trim prodigious
and oppressive taxation that engenders protests such as upcoming ones (news.scotsman.com/index.cfm?id=1921402005) by truckers.
But probably not. Now, subjection to their windy lectures is one thing, but is
political blackmail to follow in the near future? That would be a serious
non-monetary cost of insufficient refinery capacity, no matter how that
capacity never came to be.
And, as ever, if oil consumption,
rather than envy and leveling by forcible imposition of economic sclerosis, is
truly the issue, then the ongoing double standard remains curious. On the one
hand, frivolous Hummers and whatnot are excoriated above and elsewhere, but on
the other hand, frivolous, frenetic, ceaseless official and business air travel
jets by unnoticed. I invite the lecturers to make 99+% oil savings by regularly
substituting internet and other communication for air travel, and by scrapping
the book tours and Alpine ski trips entirely. Salubrious example might prove a
more edifying form of instruction than idle yakety-yak.
Otherwise, if we're going to use the oil, we're going to have to get it refined somewhere. Apparently, refinery margins will somehow have to rise somewhere. Higher prices? But the public wants $1 a gallon. Political intervention? But the public can't commute on "no gas". Direct subsidy? Yeah, that has served Indonesia so well. Overseas construction? But the public hates "exporting jobs". Domestic construction? Can you say "NIMBY". Interesting times? Yup.
Posted by: PaulS at September 12, 2005 10:36 AM
Shell was going to close its Bakersfield refinery until the locals protested to save it. A cynic might believe the aim of all this is to direct lawmakers to pass legislation favorable to the industry's purposes. Note how hard they worked on the MTBE liability issue.
Posted by: Lord at September 12, 2005 12:00 PM
The Mexican refinery argument is unnecessarily easy to refute. Try rephrasing it this way:
Why haven't a ton of refineries been built in Texas, where environmental enforcement is negligible?
It really isn't much different here than Mexico, folks. If they aren't being built here in Texas, it isn't because of environmentalist pressure. Even the state's lax laws are rarely enforced.
Posted by: M1EK at September 12, 2005 12:14 PM
I pointed out this conspiracy theory over at the tail end of the comments an another page:
Refinery shortage is because of the evil oil industry deliberately reducing refining capacity through a series of anti-competitive moves:
"An internal 1996 memorandum from Mobil demonstrates the oil company's successful strategies to keep smaller refiner Powerine from reopening its California refinery."
Posted by: Dan at September 12, 2005 12:36 PM
I don't really understand this environmental restriction argument. Clearly, environmental restrictions imposes costs on refineries. But whether or not the refiners can pass those on to consumers has to do with the market power of refiners. As long as there was overcapacity in the industry, they couldn't pass these or any other costs onto consumers, their margins sucked, and they went out of business and consolidated back to the biggest operations with the best economies of scale. Now capacity is very tight, margins are very good, and they'll be able to pass both real and imagined cost increases onto consumers until such time as demand drops or capacity increases.
Seems like a classic business cycle issue to me: alternating over and under capacity in an industry because there are long time lags between getting the price signal to change and actually being able to implement the change. I don't see how the dynamics of the system would have been any different in the absence of environmental restrictions. If anything, we would have expected the balkanization of the market to improve margins by giving refiners more market power. But margins only got decent very recently.
Posted by: Stuart Staniford at September 12, 2005 01:16 PM
The number of refineries has decreased over the last 20 years, but it is not always what it seems. In several cases, refineries next to each other were merged into one operation. That reduced the number of refineries but didn’t take any existing capacity out of production.
The Arizona Clean Fuels refinery wasn’t originally proposed for the Yuma area. Its original proposed location was in a town south of Phoenix, but the NIMBY crowd ran them off. I suspect that a number of folks would like to run them out of the Yuma area.
As I’ve mentioned before, inside the integrated oil companies, exploration and production investments show much higher potential returns than refinery projects do. When you compete for capital dollars, refining loses to E&P.
Further, if you really want to be in the refining business in the US, why not buy an existing refinery rather than build a new one. Arizona Clean Fuels plans to build a 150,000 bpd refinery for $2.5 billion. You can buy an existing refinery a lot cheaper – even if you have to fix it up.
The Shell Bakersfield refinery sold for $130 million and needs $30 to $50 million in capital investment. Its capacity is 70,000 bpd. So you could get about half of what ACF proposes to build for less than a tenth the price.
Posted by: scott at September 12, 2005 08:37 PM
It seems to me that there are multiple issues at play here that together create barriers to entry and impact the number of refineries and their profitability. Some of the major issues are:
1) environmental restrictions: aside from the costs of meeting EPA regulations, the California specific formulations limits the size of the market and the ability to import supplies from outside the state.
2) market power: only 8 firms own the refineries in California and the top 4 firms supply 64% of the market. At a capacity utilization of over 95%, it becomes easier for firms to exercise market power.
3) industry structure: the structure of the industry makes it difficult for a new entrant to enter the market because of not only the large initial investment required to build the plant but also the need to integrate into the existing infrastructure. As a process industry, a continuous supply of crude is required over pipelines that are owned by incumbents, and the refinery will need to deliver its product to the relatively small number of distributors and retailers not controlled by incumbents.
The experience of the past couple of decades in California has been a long period of oversupply and low margins. The industry has worked hard to reduce/remove excess capacity and margins are now good. The question now is whether the necessary adjustments will be made to keep prices at reasonable levels. The adjustments must be some combination of demand reduction, increase in supply, and some relaxation of regulations. Given the dynamics of the market, my guess is that we are in for higher prices, after excluding the impact of events like Katrina.
Posted by: RayJ at September 13, 2005 10:47 AM
Big refinery story in Los Angeles yesterday. An hour-long citywide power outage forced emergency refinery shutdowns. In this situation the refineries are forced to burn off the gas and oil being processed, producing huge flames, towers of black smoke, and terrible air pollution. People near the refineries were rushed to hospitals to be treated for respiratory problems. Emergency phone call systems were activated to notify neighbors to stay indoors. All in all it was a reminder of why people don't like to live near refineries.
Posted by: Hal at September 13, 2005 12:11 PM
A few comments on the downstream business.
Building refinery in Mexico is on the right track but given the state oil company Pemex's monopoly, kind of hard to do. Pemex basically serves as Mexico's treasury so not a whole lot of cash to invest. But oil companies had a even better idea, built it in the Caribbeans where oil tankers can easily dock and by pass all that red tape!
Just as Home Depot killed off regional lumber yards and Walmart drove mom & pop shops out of business, the smaller refineries just did not have the size and scale to invest capital to comply with all the environmnetal regulations while getting squeezed in their margin.
Interestingly, the graph at the top shows that no new refinery built in 20 years was just a myth. Starting around the early '90s, capacity has steadily increased. This is the result of capacity expansion and debottlenecking at existing refineries. It is far easier to expand on a site with existing infrastructures: pipelines, river barges, rail, tank farm, deepwater port, than to start from stratch in something like old airforce base.
Posted by: RoyYoung at September 13, 2005 12:51 PM
No, you can't possibly be right. It HAS to be unreasonable environmentalists. Cheney told me so!
Posted by: M1EK at September 13, 2005 02:40 PM
Well, of course, it might be a biased source, but the American Petroleum Institute (http://api-ep.api.org/industry/index.cfm?objectid=5C1AE70F-0129-449F-A6CEF327E2A0000F&method=display_body&er=1&bitmask=002007004000000000) says: "Increased environmental compliance cost is a major reason that refinery capacity expansion has not kept up with the growth in demand. From 1994 to 2003 the industry spent $47.4 billion to bring refineries into compliance with environmental regulations. That included $15.9 billion in capital costs and $31.4 billion in operations and maintenance costs for compliance with regulations covering air, water and waste rules. With historically low rates of return limiting the refining industryï¿½s ability to attract additional capital, these expenditures have sharply limited refinery expansion."
Now, suppose the API is reporting the truth - then, it would seem at least part of the refining shortage just might be attributed to the costs of environmental compliance...whether reasonable or not is a matter of what should be public debate before the next time we go through another natural or unnatural disaster induced shortage of refiining capacity.
As an aside, don't forget the role that the shut down of a major pipeline system played in raising East Coast gas prices.
Posted by: Eagle1 at September 13, 2005 07:02 PM
It is a matter of both the basic economics being poor and not in my back yard, environmental regulations contributing to the problem.
But what we see is one side of the story.
If we tried to quantify it, would NIMBY and regulations account for 5% of the problem or 50% of the problem. I don't know, but the point is that it is not the only reason.
Remember, a few months ago the same souces were trying to blame all the increase in crude prices on a lack of refining capacity and that just can not be right.
But that is the only reason we see from most sources.
Posted by: spencer at September 14, 2005 02:18 PM
If historically, refining capacity had been a problem we would have seen an increase in the spread between crude and refined product.
But we didn't until Ketrina.
Posted by: spencer at September 14, 2005 02:20 PM