A harsh winter?

Cover Story

Post-hurricane refinery recovery is moving along, but distillates are in trouble

by Keith Reid

Hurricanes Katrina and Rita screamed ashore with all their fury and left devastation in their paths. The wreckage is still being cleared, and uprooted people remain homeless and often hopeless, and one of America’s great cities will never be the same. But for all of the massive damage generated, the energy sector came through it in pretty good shape, all things considered. That evaluation is, of course, relative.

Katrina immediately resulted in the shutdown of 15 refineries and shut in or reduced about 2 million barrels per day of crude oil refining capacity. At its peak impact, Katrina, shut down over 25 percent of U.S. crude oil production, 20 percent of crude imports and 10 percent of domestic refinery capacity, according to the Energy Information Administration. That translated into approximately 1 million b/d (42 million gallons per day) of gasoline production and represented a loss of approximately 10 percent of U.S. gasoline capacity during the tail end of the summer demand peaks when there is only a few percent of excess supply to spare anyway. By the time the wind died down it was apparent that eight refineries were in need of additional repairs, electricity or both before restarting, while others came back online at reduced capacity.

The Plantation and Colonial product pipelines and the Capline crude oil pipeline suffered some damage, but were soon back to at least partial operation, though suffering from electrical shortages. Product stopped flowing at the start of the Labor Day driving peak, with a particular impact on the Gulf Coast, Midwest and East Coast. Panics set in and lines formed at gasoline stations. Some stations ran dry. In Atlanta, consumer panic and a supply scare led to retail prices that temporarily crested at $6 per gallon. Crude oil passed $70 per barrel and wholesale gasoline prices passed $3 in some markets and was not lagging far behind in most others. For all of the turmoil, however, recovery started to pick up rapidly and only four refineries remained down a week later. And then, on Sept. 24, Hurricane Rita arrived.

For a short period of time, 20 refineries were off-line as 16 refineries from Houston to Lake Charles, La., were shut down in advance of the storm and overlapped the four still down from Katrina. When the winds stopped blowing again, the human toll was far less, but the impact on the oil industry was even greater. Seven refineries received some degree of notable damage, or were left without the electricity to restart following the storm. As of Oct. 11, three refineries remained shut down from Hurricane Katrina and four from Hurricane Rita, amounting for a total of about 1.9 million b/d of refining capacity, according to EIA.

The Gulf of Mexico provides 29 percent of U.S. oil production and 19 percent of U.S. natural gas production, according to the U.S Department of the Interior’s Minerals Management Service. Fortunately, although damage was done, only a very small percentage of production is expected to be permanently lost. Things could have been worse.

‘We see indications that imports are heading this way,” said Ed Murphy, downstream general manager, American Petroleum Institute. ‘The Katrina refineries, other than those that have had severe damage, are back up and running. The pipelines are back up, the power systems are back in place, so for what I would characterize as the largest, most catastrophic interruption in supplies since I’ve been in this industry ‘ which is 30 years ‘ things have started to recover pretty quickly. So that’s the good side. The bad side is that it hit the worst possible place in the country and generated severe economic damage, severe losses and, in a positive sense, it has started to focus people on what can be done to minimize this in the future. Some are good and some are bad, to be perfectly honest, but hopefully we can have something good in the end.”

Estimates are that the upcoming winter holiday season should bring some return to normalcy at the basic infrastructure level.

‘The industry has experienced a number of challenges,” said Bob Slaughter, president of the National Petrochemical and Refiners Association. ‘Certainly these two hurricanes back-to-back have represented a significant challenge for the industry. We’re very proud of our member companies and their personnel having worked to bring refining back as fast as possible and we’ll have to see how long it takes to get the refineries back that are still off-line. Some will certainly be back sooner than others. I would guess we’re going to see refineries that are still not operating well into November, if not December. Not many will be left for December, but there might be one or two.”

Gasoline outlook
The outlook for gasoline prices in the coming months should be fairly positive, according to Energy Information Administration economist, Jake Bournazian.

‘We do expect retail prices to fall as refineries that did not suffered significant damage are able to restart,” he said. ‘Currently…demand is dropping as we move out of the driving season. That’s going to give room for retail prices to come down…and that will continue well into the winter. We expect to see retail gasoline prices after Christmas and New Year’s somewhere down around the $2.50 range.”

That would mark a return to the already high gasoline prices seen before Katrina came into the picture.

Distillates outlook
The outlook for distillate prices moving forward is not nearly as positive as with gasoline.
‘We expect diesel prices to continue to rise,” Bournazian said. ‘Likewise, we’ll probably see kerojet prices remain high because it’s related to the distillate market. There are a couple of factors there. We’re really into the high-demand period with heating oil and the agricultural harvest season. Also, those refineries that were shut down across the Gulf were more geared towards diesel production and heating oil. While the East Coast refiners do their strong heating oil runs, these (Gulf) refineries really maximize their diesel-fuel production. The country consumes about 4.2 million barrels per day on average and the combined loss from those refineries is about 700,000 barrels, so in essence almost 15 percent of diesel production is off-line.”

While gasoline demand has some elasticity when faced with price spikes, diesel transportation fuel is heavily utilized for commercial road and rail transport, which is largely inelastic. Also, while imports have been helpful in dropping gasoline prices, the same is not true for diesel.

‘There’s no extra diesel out there in Asia or Europe to export to the United States,” Bournazian said. ‘So we have strong demand that is not abating and demand is going to continue to increase as cold weather sets in. If you look at those factors combined, it paints a very bleak picture for retail diesel prices that will also impact kerojet and heating oil. Even though there are some refiners geared toward a heating oil slate, they will be tempted to switch over and maximize diesel fuel at the expense of heating oil.”

Bournazian noted that November was a very critical month, because analysts are watching diesel stocks getting drawn down, and how deeply those stocks get drawn down by the time restart comes is going to be a key factor on the tightness of the distillate markets.

‘December is going to stay very tightly balanced well through March, which means the market is not going to be able to absorb any kind of supply shock,” he said.

What’s next
What can be expected once the final tremors from Katrina and Rita settle out? There are a range of educated guesses to consider.

‘Before Katrina, there were credible reports by very intelligent, well-informed analysts that predicted prices were going to go up to $100 per barrel and that prices were going to go down to $20 per barrel,” Murphy said. ‘So, there’s a huge range of uncertainty and probably the best thing to do is look at the New York Mercantile Exchange and see what futures contracts are selling for. That will certainly give you a good indication of what people are willing to put their money on the line for. Since Katrina, I think there’s even more uncertainty.”

Many predictions call for a higher crude price projection moving forward, with demand being a huge factor. The United States leads the world in oil consumption, using more than 20 billion b/d of crude with 44 percent going to gasoline production and growth projection moving forward. China has moved to second place over Japan, consuming 6.5 million b/d of crude and its currently hot economy is expected to use more and more in coming years. On the supply side, both production and refining capacity are strained by current demand with concerns about the ability to meet future demand. Also, more than half of that supply faces potential social and political instability.

However, where small percentages or fractions of percentages can have a huge impact, any number of developments on either the supply or demand side could occur.

‘The question on China is whether or not its expansion is sustainable and if China itself will make internal policy decisions such as putting a greater emphasis on coal as opposed to oil and gas,” Murphy said. ‘We know the Saudis are adding additional capacity and everybody is making sure that you’re able to produce as much as they can in coming years. So I can make a very credible case saying prices are going to collapse well below where they were pre-Katrina, and on the other hand I can make a credible case saying that they’re going to go up further.”

The EIA’s Annual Energy Outlook 2005 with Projections to 2025 outlined a wide variety of potential scenarios for the U.S. energy market between 2005 and 2025. The baseline historical data used for AEO2005 projections comes from EIA’s Annual Energy Review 2003, with considerable additional data and modeling. One of the report’s authors, Paul D. Holtberg, was recently contacted for an opinion as to which of the different models seemed to be more viable following both the pre-Katrina run up and the immediate post-Katrina/Rita reactions. Without over committing, he stated that the ‘High Case B” model seemed to be more viable at this time.

The High B World Oil Price Case hinges on oil prices staying close to where they are today, with continued uncertainty about the size and availability of crude oil resources, particularly conventional resources, investment capital and geopolitical trends. Prices would rise through 2005 to the $44-per-barrel level, gradually fall until 2010 reaching $37 per barrel and then rapidly rise to $48 per barrel by 2025.

This case assumes a strong, cohesive OPEC, as well as the higher prices impacting demand and encouraging crude alternatives that are less viable with lower-priced crude. The report noted that there are a variety of uncertainties with the forecast due to a number of modeling limitations.

A variety of analysts project a higher-priced oil scenario starting at close to $40 per barrel and moving into the $50-per-barrel range. Goldman Sachs has reported that it expects West Texas Intermediate crude to stay above $60 per barrel for the rest of the decade, with the potential of spikes hitting the $100-per-barrel range in the face of a major supply disruption to be followed by a significant deflation. Hedge fund owner Boone Pickens offers similar projections.

And then there is the low end. While the United States still leads the world in consumption, and with much of that focused on gasoline, a shift in consumer behavior can have a significant impact. Anecdotally, marketers noticed that the $3-a-gallon level for gasoline induced significant changes in consumer demand. As Murphy touched on, such a reaction might be a case of sticker shock, or it could be the start of something deeper.

‘I feel we’ve reached some very, very long-term important highs,” said Peter Beutel, president of Cameron Hanover, an energy risk management firm headquartered in New Haven, Conn., and author of Surviving Energy Prices. ‘One thing that is very interesting is that if you look at a price chart for gasoline post-Katrina, the high is $2.92 on the NYMEX, and the post-Rita high is $2.37. It’s clear that there was a lot more damage after Rita than there was after Katrina, so one should have seen new highs after Rita. I think what has happened is we’re now looking at some long-term changes in the way people use energy.”

Even at $3 per gallon, the inflation and productivity adjust cost of gasoline was about the same motorists paid in 1981 with little outrage as a daily fact of life (though without roads filled with SUVs). How does price elasticity play out in the market?

‘If you have a windfall-profits tax you reduce the incentives for people to invest in new supplies,” said Jerry Taylor, director of natural resource studies for the Cato Institute. ‘It’s just as simple as that, and I think we would want to increase the incentives to invest in supply. The idea is to bring prices back down and we don’t want to impose policies that will discourage people from actions that will do that. That’s the first strike against windfall-profit taxes, the second is that it amounts to sort of one-way capitalism. When oil companies are not doing so well the government rarely lifts a finger. When they have an occasional bout in which they make some money, they then threatened to step in and take that money away. Under those circumstances, why invest if you’re only allowed to lose money or break-even.”

The overall economy is a critical component of gasoline demand in the United States and abroad in critical countries like China that are ramping up world demand. Beutel, unfortunately, sees an additional factor encouraging a strong drop in gasoline prices.

‘We have now taken $200 billion in the first three quarters of 2005 out of consumers’ and businesses’ pockets in energy costs as compared to the first three quarters in 2002,” he said. ‘My feeling is you just can’t take that much out without it leading to a recession, and I think we will have one. At that point, once we get into the recession, I believe many of the things that are ongoing now will increase supply. It will be easier to build infrastructure and we will find people in strange and exotic places finding oil. I think we will see gasoline at less than $1.50 again. It’s not going happen right away, but I think we will see it again. And the question is can we learn our lesson this time, because the next time we go on an upside it’s going to be really, really bad.”

Regulations and investment
It is obvious that refining capacity needs to be expanded. At the same time, reactions from the current gasoline crisis have started any number of legislative balls rolling ‘ some with the potential to help investment and some with the potential to hinder it.

A bill that promises more good than bad is House Energy and Commerce Committee Chairman Joe Barton’s, R-Texas, Gasoline for America’s Security Act of 2005. The bill passed the House on Oct. 10 by a narrow margin. It aims to increase refinery capacity for gasoline, heating oil, diesel fuel and jet fuel; reduce environmental and other regulations affecting refineries under the Clean Air Act; and coordinate permitting requirements and other regulations affecting refineries at the federal, state and local levels. It includes an FTC study into price gouging; an amendment to the FTC study provisions directing the FTC to examine credit-card interchange rates and their role in increased gasoline and diesel fuel prices. The boutique fuels issue is similarly addressed.

According to the Society of Independent Gasoline Marketers of America, Republicans decided to drop one of its most contentious provisions from that bill, a change in the Clean Air Act’s NSR provisions that require industries that are upgrading facilities to install modern anti-pollution controls unless the improvements are routine maintenance. House leadership also decided to drop that portion of the FTC study on credit-card interchange fees that would have examined different rates between different channels of trade. Where price gouging is concerned, the FTC must define price gouging within six months and it is permitted to levy an $11,000 per incident fine.

Several bills in particular reflect little understanding of how commodities markets work, the petroleum distribution infrastructure, the recent history of regulated and deregulated markets in the United States and the role investment capital plays in business.

One bill proposed by Sen. Maria Cantwell, D-Wash., would grant the president price-control powers similar to those introduced in 1973 by the late Sen. Henry Jackson that directly resulted in gasoline supply disruptions and higher consumer prices than those enjoyed after deregulation in 1981.

‘Oil barons are making $200 million a day in profits,” Caldwell said in a Seattle Post-Intelligencer interview. ‘There is absolutely no reason for gas to go up in Washington as the result of a hurricane.”

Sen. Byron Dorgan, D-N.D., introduced his Windfall Profits Rebate Act of 2005, which would fund consumer rebates ‘ paid to consumers in a tax-rebate check ‘ through a three-year, 50-percent excise tax on oil company windfall profits. Windfall profits are defined by his legislation as the portion of the price of a barrel of oil that exceeds $40.

Rapidly escalating oil prices have ‘drained billions of dollars” from the nation’s economy ‘in a massive transfer of wealth from average Americans who can’t afford it to big oil companies who already were experiencing all-time record profits,” Dorgan noted in a press release. Rep. Robert Menendez, D-N.J., is drafting similar legislation in the House.

‘You can tax all you want, but that’s not going to encourage a company to increase investment and capacity,” said Mark Cooper, director of research with the Consumer Federation of America. ‘And my point of view, you need to build a surplus capacity cut ‘ we know that’s not true drilling ‘ an increase CAFE standards, strategic product reserves and strategic refining reserves.”

Senator Dick Durbin, D-Ill., has proposed The Strategic Gasoline and Fuel Reserve Act of 2005, which would require the Department of Energy to hold and manage 40 million barrels of unleaded gasoline and 7.5 million barrels of jet fuel to be used in times of shortages that adversely impact the U.S. economy.

While refiners would agree with Cooper on windfall-profit taxes, they would disagree with the strategic reserve proposals, citing practical issues like refined product ‘shelf life” and the potential hindrance of imports that come into play when prices rise.

‘The windfall-profits tax? Who is going to decide what is an acceptable investment and what is not, and what are their credentials?” the NPRA’s Slaughter said. ‘These requirements for product reserves and mandatory inventory ‘ all of these ideas from the 1970s are coming back and we’ve already tried most of them and they didn’t work very well. The reason we went back to the market is that even with all of its flaws it was better than government intervention. Fortunately, there are a lot of people alive today that had the benefit of that lesson and hopefully we won’t have to commit the errors again to learn from them.”

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