Tuesday, August 31, 2004

Where Will Our Gasoline Come From?
An article in today’s Wall St. Journal highlights an important issue that has received little attention, even in this year of unusually high crude oil and gasoline prices. As the article’s title suggests, “US Relies on Europe For Gasoline”. In additional to all the crude oil this country imports, we also bought over two million barrels per day of petroleum products from foreign refiners last year, with a quarter of that consisting of finished gasoline, and a similar fraction requiring further processing or blending. This dependence will only grow in the years ahead, if US gasoline demand continues to ratchet up.

There are good reasons for our loss of gasoline self-sufficiency. First, as domestic crude oil supplies dry up, US refineries lose some of their competitive advantage against imports. More importantly, the domestic refining industry has been saddled with two decades of high investment to meet increasingly strict environmental regulations, both on the properties of the fuel and on refinery emissions.

Although necessary to stay in business, these investments have yielded very poor financial returns for oil companies, since consumers have not seen the changes as something for which they were willing to paying more. Nor have the government’s regulations provided for any profit-recovery on mandated investment, leaving that to the market. Other regulations make building new refineries in this country virtually unthinkable. The net result has been refinery closures and little investment in new capacity to keep up with demand.

As the Journal points out, this problem has been manageable so far, because Europe is in the midst of a sea-change from gasoline to diesel for its new cars, nudged along by tax and emissions policies that favor the latter. For European refiners, the opportunity to export to the US has provided a dual benefit; not only are they able to sell a high-margin product for which demand in Europe is falling, but they can forego the expensive refinery retooling that would otherwise be required to convert more oil to diesel and less to gasoline. But as the article suggests, there are strong indications that foreign suppliers, especially those in Latin America, are not enthusiastic to invest in refinery upgrades to meet more stringent US gasoline specifications, when other export markets--such as a rapidly growing China--may be just as attractive without additonal investment.

What is the likely outcome of this situation? Clearly US gasoline prices, particularly in regions such as the East Coast that are highly dependent on imports, must rise relative to crude oil. And these higher margins must persist long enough to offer US or foreign refiners the prospect of attractive returns from investment in new capacity, which will take further years to build. So even if crude oil returns to $20 or $25 per barrel, we may not see gasoline prices as low as those of 2001 and early 2002 for a long time to come.

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