Jackson Jambalaya

Wonder why gas prices are so high despite the fact Americans are using less gasoline and there is no oil shortage? Speculators? Weak dollar? Perhaps. Try something more basic: the law of supply and demand. Supply and demand not for oil but for refined gasoline. After this summer 50% of the refining capacity in the Northeast will be cut 50% in the last two years. A February report from the U.S. Energy Information Administration states:

"Since September 2011, two refineries in the Philadelphia area (ConocoPhillips Trainer refinery and Sunoco’s Marcus Hook refinery) and one major Caribbean export refinery supplying the East Coast (HOVENSA’s U.S. Virgin Islands refinery KF note: 500,000 barrels a day.*) have closed. In addition, Sunoco has announced plans to idle its remaining Philadelphia-area refinery (Sunoco Philadelphia) in July 2012 if no buyer is found(KF note: Delta Airlines is purchasing the refinery.). The three Philadelphia-area refineries (Trainer, Marcus Hook, and Philadelphia) taken together represented 50% of total East Coast refining capacity as of August 2011.

Refining capacity is available outside of the East Coast to replace products historically supplied by the capacity that has been or may be idled, including potential production losses from the Sunoco Philadelphia refinery, but transportation constraints may hinder the delivery of products to the Northeast in the short term...

If the Sunoco Philadelphia refinery closes, price impacts are highly uncertain. If areas cannot be adequately supplied in the short term, prices can spike. In the longer run, higher prices and possibly higher price volatility can result from longer supply chains. The potential loss of the Sunoco Philadelphia refinery presents a complex supply challenge, and no single solution has been identified by industry participants that will address all of the logistical hurdles that must be overcome..."

What's the problem, just pipe it in, right? That could be done, if the current pipelines weren't already at capacity: "The pipeline that delivers products from the Gulf Coast to the Northeast is at or near capacity."(p.4). The refineries are old and according the Market Ticker's Karl Denninger, simply not worth the cost of retrofitting to fit EPA regulations. The Gulf Coast refineries can't ship products via shipping thanks to the Jones Act. The Jones Act makes the shipping rates 2-3 times that of foreign rates (thank you, unions), and ensures there is a scarce supply of compliant shipping availablet. The report states only 56 tankers meet Jones Act requirements. ** Environmental regulations also state the Northeast has to use ultra-low sulfur diesel fuel, which can only be obtained from Northeast and Gulf Coast refineries.

A recent story in Forbes confirms the developing bottleneck and its effect on prices:

"Gasoline consumption in the United States has been dropping for years. In the last decade, vehicle fuel efficiency has improved by 20%, and the combination of that shift and a weak economy of late has pushed gasoline demand to its lowest level in a decade.

At the same time, U.S. oil production is at its highest level in a decade. Deepwater wells in the Gulf of Mexico and horizontal fracs in the Bakken shale have turned America’s domestic oil production scene around. After 20 years of declining production, U.S. crude output rates started to climb in 2008 and have increased every year since..."

So why are the prices high at the pump? It's the refining capacity, stupid:

"The U.S. is divided into five oil districts, which were originally designed to ensure energy security during World War II. Things have certainly evolved since then, but the districts remain less connected than you might think. Crude oil cannot necessarily flow from one side of the country to the other or from one producing region to another refining area. The system’s disconnectedness means that refiners in different regions are forced to pay whatever the price may be for the crude oil they can access – and those prices differ significantly.

East-Coast refiners have traditionally relied on imported oil from Europe and West Africa, which means they pay Brent pricing for most of their crude. As such, Brent’s surging price has dealt a blow to East Coast refiners, hitting several so hard that they are shutting down. No fewer than four refineries serving the East Coast are going or have gone offline since 2010, eliminating almost half of the gasoline previously supplied to the U.S. Northeast. Knowing that, high gasoline prices in the Northeast start to make a bit more sense: Refiners’ costs have been sky high, and refinery shutdowns have eliminated a huge chunk of supply.

Similarly, refiners on the West Coast receive some supply from Alaska but depend on internationally priced crude for the bulk of their input. Their need to pay Brent pricing explains why gas prices in California are regularly among the highest in the nation.

At the other end of the spectrum are refiners in the Midwest. The oil hub at Cushing, Oklahoma, is being increasingly inundated with crude oil as production ramps up in North Dakota’s Bakken formation and in Canada’s oil sands. Crude from both of those rapidly-expanding oil regions flows primarily to Cushing, where refineries process as much as they can. Those refiners are able to buy at WTI pricing, which has held a roughly 20% discount to Brent crude for the last year. That helps keep gasoline prices in the Midwest a little lower.

However, Midwest refineries are generally designed to process light, sweet oil, which means they can handle output from the Bakken but are not up to processing heavy oil from the sands. Oil-sands crude needs to go to the Gulf Coast, where an army of sophisticated refineries are thirsty for heavy oil. All that is lacking is a pipeline to connect supply with demand, but at the moment there is no such pipe; thus, the supply glut at Cushing has discounted heavy oil significantly. Western Canada Select, the benchmark crude oil coming out of Canada’s oil sands, closed at $74.73 per barrel on March 5, a 30% discount to WTI and a 40% discount to Brent."

Remember that St. Croix refinery mentioned at the beginning of this post. Forbes explains why its shutdown is a big deal:

"One final element is making matters worse: Refineries are currently starting to shift to producing spring-summer gasoline blends, which are lighter and therefore usually cost about 10¢ more per gallon than fall-winter blends. And this year, the quick refinery shutdowns needed to enact the seasonal shift are creating slight supply gaps because some of the “swing” refineries that usually help bridge the gap are no longer operating. For example, the Hovensa refinery in the U.S. Virgin Islands – a joint venture between Hess Corp. and Petroleos de Venezuela – used to produce extra volume during the seasonal transition, but it was closed down a few weeks ago after losing $1.3 billion over the last three years."

So there you have it. Declining refining capacity and an inability to ship gasoline to other parts of the country as needed. Smaller supply with unchanged demand means higher prices.

*Note from the report: "HOVENSA (a joint venture between Hess and Petróleos de Venezuela), is a large refinery, located in St. Croix, U.S. Virgin Islands, that historically sent most of its output to the United States. In January 2012, HOVENSA announced plans to shut down the St. Croix refinery in mid-February and convert it to a petroleum storage facility. HOVENSA sent most of its product to the U.S. East Coast, but in recent years, it had increased its sales in other markets. In 2007, HOVENSA shipped two-thirds of its output to the East Coast; that share had declined to 55% in 2011 (through August). At the same time, the refinery’s output dropped in 2011 after HOVENSA announced it was reducing its capacity from 500,000 bbl/d to 350,000 bbl/d."

**The report has a specific note on the Jones Act: "The Merchant Marine Act of 1920 (P.L. 66-261) is a U.S. Federal statute that regulates maritime commerce in U.S. waters and between U.S. ports. Section 27 of the statute, also known as the Jones Act, requires that all commercial shipping between U.S. ports, cabotage, must be performed by U.S.-flag ships constructed in the United States, wholly owned by U.S. citizens, and crewed by U.S. citizens and U.S. permanent residents. Steep penalties result from noncompliance. At the end of 2010, 56 tankers met the Jones Act requirements, accounting for less than 1% of both the total number and the total deadweight tonnage of tankers in the world (see table below). At any given time, 35 Jones Act tankers are engaged in trade in U.S. waters."