TESTIMONY

EDWARD H. MURPHY
GENERAL MANAGER

DOWNSTREAM INDUSTRY SEGMENT
THE AMERICAN PETROLEUM INSTITUTE

BEFORE THE

THE FEDERAL TRADE COMMISSION

AUGUST 2, 2001

 

Mr. Chairman and members of the Commission, I am Edward Murphy, general manager of the downstream industry segment at the American Petroleum Institute. I would like to talk with you today about the present state of the refining industry in the United States and the gasoline price increases that we experienced this spring. But first, I would like to put things into historical perspective and explain how we arrived where we are today.

Recent Refining History

Over the last decade or so, levels of profitability in the refining sector of the oil industry have been historically low. During the 1990s, the rate of return on investment for refineries averaged about 4 percent. That is about a third of the return earned by most American industries. Another way to look at this is that from 1998 to 2000, the whole petroleum industry earnings as a percentage of sales were 4.6 percent while banking had an average rate of return of 12.7 percent, telecommunications 9.4 percent, utilities 6.1 percent and overall manufacturing, 5.6 percent. Those numbers help explain the reluctance of companies to make the investments required to expand refinery capacity.

Why were profits so low? One reason is that during the 1990's the refining industry spent $46.9 billion to make sure it was in compliance with the federal Clean Air Act and other environmental rules. That figure includes $17.9 billion in capital costs and $29 billion in operations and maintenance costs specifically intended to meet requirements for clean air, clean water and waste removal. The environmental costs ranged from $5.9 billion in 1994 to $3.6 billion in 1999 for an annual average of about $4.7 billion. We in the industry fully share the broad political consensus supporting environmental improvement. We will continue to make cleaner-burning fuels that have delivered remarkable improvements in air quality throughout the United States. But these environmental gains come with a large price tag for the industry since most of these costs have not been recovered in the marketplace as you can see in Slide #2. As a result, profit margins were reduced, and new investments were discouraged.

One reason the high environmental costs were not recovered was the excess refining capacity that existed during the 1980s and early 1990s. In 1980, there were more than 300 U.S. refineries producing gasoline and other products for consumers and businesses and refinery utilization averaged 75 percent.

In the event of an operating problem in one refinery during that era, other refining capacity was available to make up any shortfall. Gasoline was largely fungible so supplies could be shifted from one area to another, as the market demanded.

In addition to low rates of return and high environmental costs, refining capacity expansion in the last decade has also been constrained by uncertainty about the extent and timing of the many government regulations that refineries must comply with. In addition, refineries confront a complex and time-consuming permitting process involving federal, state and local authorities with often-conflicting priorities.

Despite high environmental costs and low profitability, refinery capacity has been expanding slowly at a rate of 0.6 percent a year in the last decade as Slide #3 shows. But demand has been expanding more rapidly--at a rate of 1.5 percent per year. As a result, utilization rates of the nation's 152 refineries have been steadily climbing. This year, utilization rates were often at 95 percent or greater. The excess refinery capacity that existed over most of the last 20 years is no longer there as shown in Slide #4.

All this leaves little margin for operating or other problems that might interfere--even temporarily--with the gasoline supply system.

As the number of refineries has sharply declined, the industry has worked hard to keep up with growing demand. Refineries have become much bigger, so that each facility is able to produce more. In 1980, for example, the average U.S. refinery produced just below 60,000 barrels of petroleum products daily. Last year, the average refinery was capable of producing over 110,000 barrels of gasoline, heating oil, diesel oil and other products every day. In part, this improvement is the result of sophisticated technologies as shown in Slide #5 that have been installed in every part of the complex refining process.

An expanding economy needs reliable and growing supplies of energy, and the industry is doing its best to keep up with demand. The demand for petroleum products has risen by 16% over the 1990 to 1999 period, or 1.5% per year as shown in Slide #6. By 1999, demand rose to 19.5 million barrels daily. Government projections of future energy use say there will be a 26 percent growth in U.S. petroleum consumption over the next 20 years.

Developments in 2000 and 2001

Slide #7 shows as winter approached last year, stocks of heating oil and diesel fuel were lower than usual. In October of 2000, distillate stocks were 114 million barrels compared with the previous five-year average of 131 million barrels for the same month. Then, weather that was the coldest in a decade caused demand for heating oil to shoot up. At the same time, natural gas prices rose sharply causing many electric utilities to turn to distillate fuels for fuel to make electricity. Demand for distillates rose by 4.8 percent in the fourth quarter of last year and nearly 12 percent in the first quarter of 2001.

As you can see in Slide #8, refineries responded and produced large amounts of distillate, including heating oil to supply the Northeast and New England heating oil markets. Consumer demand was met, although at a higher price.

Because refineries were producing record amounts of distillate late into the winter season, they were not building inventories of gasoline for the summer. For example, gasoline production in March of 2001 averaged 7.8 million barrels daily compared with 8.1 million barrels a day in 2000 while gasoline consumption in the first quarter had increased by 2.1% or 170 thousand barrels a day. As a result, gasoline stocks totaled 192 million barrels at the end of March 2001, compared to a five-year average of 206 million barrels.

As spring arrived, many refineries also took time off to do badly needed maintenance, some of which may have been delayed as a direct result of government requests to produce more distillate products earlier in the winter. At the end of March, refinery utilization rates averaged 88.6 percent compared to a five-year average of 93.4 percent.

For all these reasons as shown in Slide #10, refiners got a late start in producing the large amounts of gasoline traditionally needed for the summer driving season. Gasoline inventories in March were at their lowest level for that month in 40 years.

As the industry struggled in the face of insufficient refinery production capacity, public statements by traders began to reflect concern about the adequacy of summer gasoline supplies. Resulting as Slide #11 shows, prices for regular grade gasoline surged in the early spring, averaging about $1.75 a gallon nationwide and approaching $2.00 in some areas. Refineries responded and supplied large amounts of gasoline to a ready market and broke all previous production records for the second quarter of 2001. Production soared from about 7.8 million barrels a day in March 2001 to approximately 8.6 million barrels a day in May. The average for the second quarter of the year was 8.56 million barrels of gasoline daily. Gasoline inventories were higher in June than in the past three years for that month.

Besides the shortage of refining capacity, the existence of so many special or "boutique" gasoline blends shown here on Slide #13, in the U.S. decreases the flexibility of the gasoline supply system to compensate for shortfalls in one area by moving gasoline from other areas. In this way, boutique fuels have further limited gasoline supply capability.

The combination of no excess refinery capacity and the proliferation of boutique fuels have led to the kind of price volatility that has disrupted markets over the last few years.

This summer, there were fortunately no major disruptions of supply so refineries currently find themselves with higher inventories after a surge of gasoline production throughout the spring and early summer. The result has been sharply falling prices amid a slowing U.S. economy.

Policy Recommendations

In the announcement for this conference, it was stated that, "…the Commission plans to broaden its focus beyond law enforcement and study in more detail the central factors that can effect the level and violability of refined petroleum prices throughout the U.S."

So, it is appropriate to ask what have we learned through this experience? We know there are ways to improve the production and delivery of gasoline and other fuels to consumers without the dramatic ups and downs in supply and prices.

That can happen if environmental regulations are based on sound science and thorough analysis of the cost effectiveness of any new rules.

New regulations should be predictable and permit enough time for refiners and distributors to make investment decisions that are needed so markets are not disrupted.

Overlapping and cumbersome permitting processes at all levels of government should be streamlined so refiners can expand capacity and produce cleaner-burning fuels needed by consumers.

To cite but one example, EPA has recently promulgated a rule for reducing the sulfur content of diesel fuel. While we fully support the objective of that rule, we are concerned that the implementation process was developed without adequate attention to the costs to consumers and the likely adverse effect on diesel supplies. I am very concerned that if this is not corrected, I will be back here in 2006 explaining why there are shortages of diesel fuel, and outmoded requirements that restrict gasoline supplies without any offsetting benefits, such as the oxygenate requirement in the Clean Air Act, need to be eliminated.

Mr. Chairman, we have tried to give you a clear idea of what the refinery industry has experienced and how that experience impacts the sharp increases in gasoline prices last spring. I hope we have succeeded.