Refinery Capacity and Gasoline Prices

As I was reading the Economic Report of the President, I figured it was time to revisit the issue of gasoline prices and the role played by refinery margins. Our graph shows the retail price per gallon relative to the consumer price index (January 2006 = 1.00) from January 2000 – when the real gasoline prices were $1.51 per gallon – to January 2006 when gasoline prices were $2.32 per gallon. Back in April of last year, real gasoline prices had increased to around $2.30 with Robert Novak blaming the environmentalists for discouraging the building of new refineries over the past 30 years. This argument was weird on several levels including the fact that the refinery margin has averaged less than 16% of the price of a gallon of gasoline over the past 6 years. It is true that the contribution from the refinery margin shows a few spikes – such as the one following Katrina, but the contribution has not only averaged only $0.30 per gallon but also shows little upward trend.

The Economic Report of the President makes the following points:

Another related factor is that surplus refining capacity has declined substantially during the last 25 years. In the early 1980s, U.S. petroleum refiners were producing at only about 70 percent of their total potential production capacity. In contrast, total refiner output has been over 90 percent of capacity for the last decade. Several factors explain this trend. First, many small, inefficient refineries exited the industry in the early 1980s following the removal of poorly conceived Federal petroleum price and allocation controls that had favored such refineries. Without these controls, inefficient refineries were no longer profitable, and total U.S. refining capacity fell by 19 percent from roughly 19 million barrels per day at its peak in 1981 to about 15 million barrels per day in 1994. Second, low profitability in the refining sector during the early to mid 1990s did not provide the necessary incentive to expand total refining capacity … Refinery profitability increased in the late 1990s, however. As a result, domestic refining capacity rose 12 percent from 1994 to 17 million barrels per day in 2004 … Rising refinery costs and profits explain roughly one-quarter of the increase in average gasoline prices between 2000 and 2005 … Efficiency improvements and restructuring in the refining industry have led to lower operating costs per barrel. Excluding oil and other energy inputs, refinery operating costs fell roughly 20 percent between the early 1980s and 2003. These cost reductions tend to reduce the price of gasoline for consumers. Lower surplus capacity may, however, increase the sensitivity of gasoline prices to temporary disruptions in production at particular refineries … Although U.S. refining capacity and utilization have increased since the early 1990s, these increases in production have not kept pace with U.S. demand for gasoline and other refined products. As a consequence, U.S. imports of refined petroleum products, including gasoline, have grown from 11 percent of total refined product consumption in 1993 to 15 percent in 2004. Demand for various types of petroleum products within a country and the configuration of its domestic refining capacity drive much of this international trade … Transport costs for refined petroleum products are sufficiently low that international trading can moderate the effects of regional price spikes. For example, when supplies of gasoline and other refined petroleum products ran short in the United States following Hurricane Katrina, and prices began to rise quickly, importers responded to this price incentive by delivering significantly more product to the United States.

Robert Novak’s disdain for tree huggers is only exceed by his disdain for President Carter – so I find it odd that he longs for the late 1970’s situation where petroleum refineries where producing at only 70% of their capacity. Note the emphasis on the fact that low gasoline prices and low refinery margins were the main reason why companies did not build new refineries. Also note that efficiency gains have increased the production capacity of existing refineries as well as lowered the cost of refining oil into products such as gasoline. I also found quite interesting the international trade aspects of this discussion – especially how trade can mitigate the effects of regional price spikes. Finally, the discussion suggests that if the rising profitability of refineries is expected to continue, then market forces will create the incentives for production of more refineries even without some Cheney-style corporate welfare for the petroleum refineries. While I suspect most true conservatives would prefer the normal workings of the market place over Cheney-style corporate welfare, Mr. Novak has been advocating the Cheney energy plan for the past 5 years.