Thursday, November 13, 2008

A Growing Imbalance

This spring I reviewed Robert Bryce's book, "Gusher of Lies," a thorough debunking of the notion that America could or should become energy independent any time soon. In a provocative article in Slate, he has connected the dots between our steadily rising ethanol mandates and the current weirdness in the US petroleum products market, in which wholesale gasoline continues to sell for less than light sweet crude oil, while diesel fuel/heating oil commands large premiums over both. In the process, he explains the short-to-medium-term constraints on attempting to reduce crude oil imports by increasing ethanol production. Although these impediments could be overcome in the long run, doing so would require enormous additional investments in the fuels sector, because it would render obsolete the configuration of virtually every current US oil refinery.

Reading Robert's article triggered two related thoughts. The first was that our present ethanol policy, embodied in the Renewable Fuel Standard (RFS) and the decades-old system of ethanol blending credits and import tariffs, reflects an outdated set of assumptions about the nature of the US motor fuels market. These subsidies and mandates arose during a period in which US gasoline demand was growing steadily at 1-3% per year, US refineries were producing as much gasoline as they could, and US imports of finished gasoline and gasoline bending components were growing steadily. None of these factors has survived this summer's price spike and the ensuing financial and economic crisis. Nor are they likely to recover to their former levels when the economy does, because of the growing emphasis on conservation, fuel economy and alternative transportation fuels and vehicle types.

I've commented periodically on the shifting global balance between gasoline and diesel fuel, but without factoring in the influence of US ethanol output--which has more than doubled in the last two years alone--on this relationship. The Slate article identifies the problems created by pushing increasing quantities of ethanol into a stagnating gasoline market, with upstream consequences for refinery operations and the production of other necessary products such as diesel, heating oil and jet fuel, for which long-term demand looks more robust than for gasoline, both domestically and internationally. With US ethanol output currently running at a level equivalent to 7% of US gasoline demand, it compounds the global weakness of gasoline, at the same time ethanol producers are adversely affected by gasoline's slump.

Markets eventually adjust to such disruptions, and I see several paths by which the US refining industry could accommodate a national energy policy aimed at steadily expanding our use of biofuels from 10 billion gallons per year today to 36 billion gallons by 2022, and perhaps to the 60 billion gallons per year envisioned by the President-elect for 2030. But getting there won't be easy or cheap, and that's a big problem for a segment of the energy industry that, with the exception of a brief surge of profitability several years ago, has generally returned no more than the cost of capital.

To see why this would be so expensive and challenging, you need to know a bit about what happens inside a refinery. All oil refineries separate crude oil into its natural fractions of LPG, gasoline, jet fuel, diesel, and heavier oils. The heart of most US refineries, however, is the Fluid Catalytic Cracking Unit, or "cat cracker", a massive device for breaking down and reassembling the molecules found in "vacuum gas oil" and "coker gas oil"--some of those heavier oils I mentioned a moment ago. The result is high-octane gasoline for blending, along with the precursors for making "alkylate", a key constituent of California-type reformulated gasoline. These units also make some low-quality diesel that is typically either processed further or sold into the bunker fuel market.

A refinery with a big cat cracker is fundamentally a gasoline machine, and there's very little you can do to change that, short of shutting the unit down and replacing it with a big, expensive "hydrocracker", which uses hydrogen generated mainly from natural gas to turn those same heavy gas oils into jet fuel and diesel. The other possible end of the ethanol road for US refiners would involve a huge ramp-up in synthetic diesel production, from gas-to-liquids and/or biomass-to-liquids, followed by a wave of refinery closings to end the growing global gasoline surplus. Either route involves hundreds of billions of dollars of investment, in aggregate, and the usual problems in obtaining the necessary permits and environmental offsets.

The energy industry has often attracted unintended consequences, and this one looks like a dandy: We create incentives and mandates for ethanol to substitute for gasoline (and thus imported oil) and end up driving up not just the price of food from which we make ethanol--notwithstanding claims to the contrary in the latest PR and lobbying campaign from the ethanol industry--but also the price of diesel fuel and heating oil, while having much less net impact on oil imports than we imagined. Biofuels will be a fact of life from now on, and along with CNG and electrified vehicles, they are probably a necessity, with oil production looking unlikely to keep up with long-run demand. The oil industry is already getting on this bandwagon. However, the dislocations this creates would be a lot easier to justify, if the biofuels involved were at least produced from feedstocks and processes that didn't consume food and nearly as much energy as the fossil fuels they are intended to displace.

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