Why are Gas Prices High? No Single Cause, No Easy Cure

By James R. Halloran
Senior Vice President & Energy Analyst
National City Private Client Group

The tension between the American driving public and the oil and gas industry is reaching a breaking point.

Motorists find it very difficult to curb driving habits in reaction to sharply higher gasoline prices. Oil companies find their explanations of unplanned refinery outages and tight gasoline inventories met with skepticism from consumers and politicians. How did we get here - and where are we going?

Gasoline prices surged more than 25 percent nationally since late March without any significant rise in the cost of crude oil. The media resorted to the usual sound bites, including the obligatory “no new refinery built since 1976.” While technically true, it misses the fact that refinery capacity in the United States has increased 13 percent, or 2 million barrels per day since 1997 through upgrades to existing sites. (A barrel equals 42 gallons of product.)

Refiners Made the Investment
This capacity increase has occurred even though refining assets were a poor investment from 1986 to 2003. New money for refining additions would have done better in government bonds. Refineries operated at less than 70 percent of capacity early in the 1980s, including many small units (“‘pot boilers”) built to take advantage of tax preferences. Owners increased the size of the average refinery, seeking profit improvement through economy of scale.

Crude oil prices were generally stable during 1986-2003, averaging $19 per barrel with (in retrospect) modest price peaks and valleys. On an inflation-adjusted basis, Americans enjoyed the cheapest period of gasoline prices since their love affair with the automobile began in the 1920s.

Cheap Gas Fueled Sprawl
Cheap fuel aided suburban sprawl. In addition, the population shift to the South and West has meant greater driver concentrations in areas of relatively low means of mass transportation. Every driving trend reflects increasing dependence on automobiles: More drivers, more cars per driver, more miles driven per car and bigger vehicles.

During this period, refining became more efficient as an industry. Refiners raised their operations to full utilization (94 percent, including maintenance time) through closing many of the “pot boilers” when they became too expensive to upgrade for evolving EPA requirements. As a result, gasoline production in the United States has lagged demand growth. Our gasoline supply increasingly comes from imports, amounting to 14 percent in May, compared with 6 percent 10 years ago.

A Series of Unfortunate Events
The tight gasoline supply chain encountered an unusually large set of glitches this year, starting in March. Inventories hit seasonal low levels after a series of unplanned refinery outages due to fires and operational issues. This happened with a heavier than normal schedule of planned maintenance on many refining units. At the same time, global demand for gasoline and related products pushed up gas prices from our traditional foreign sources such as Europe. The Midwest, which even in normal times must rely on gasoline brought in from other locations, was particularly affected. The issue was complicated further by the shutdowns occurring during the switchover from winter to summer gasoline, affecting many localized “boutique” blends required by the EPA.

Price is the only tool available to suppliers to ration gas when potential shortages appear. However, consumers have become accustomed to the volatility, even as they complain about price spikes. As a result, it takes an ever higher price to persuade motorists to change their habits and reduce usage. A cynical public sees such price increases only as an effort on the part of refiners to boost profits, and rejects them as being a signal to change demand.

Ethanol Wild Card
Prices will drop as downed refinery units return to service, but the problem is not going away. Oil companies have plans to increase domestic refining capacity by about 10 percent, but it will take years to complete and may not keep pace with demand growth. Worse, not all the planned additions may get built. Oil companies view government efforts to increase ethanol use and improve auto fuel efficiency as major disincentives to put more money into domestic refinery construction. Who knows what the effect of such programs to reduce gasoline use will be on assets meant to last 30 years or more?

Can Build for Less Elsewhere
The rising cost (steel, engineering, etc.) for any new infrastructure is also a negative factor. It costs more than $20,000 per barrel to build a refinery in the United States. The cost is a fraction of that amount in Saudi Arabia, Panama or West Africa, and the permitting process is much easier. Any future overseas refineries will be able to choose among several global gasoline markets and ship accordingly.

So, welcome to the emerging global market for gasoline, wherein a supply problem in Hong Kong or Rotterdam may ripple through to the price at the pump here. An efficient supply chain, extended to a global reach, should lead to better efforts to add capacity, but also provide more chance for price volatility.

This is not likely to sit well with legislators, who may sound off about national security. And it will not find favor with the American driving public, already suspicious of Big Oil.

Editor’s Note: Halloran is senior vice president and energy analyst with National City Private Client Group in Cleveland. The above item appeared in the Cleveland Plain Dealer, Tuesday, June 26, 2007 edition.