Speeches/Testimony

Written Statement Bob Slaughter of the National Petrochemical & Refiners Association at the House Judiciary Committee Washington, DC June 28, 2000

Overview

The National Petrochemical & Refiners Association represents virtually all of the refining industry, including large, independent and small refiners as well as petrochemical producers. Our members are in the business of manufacturing refined petroleum products needed to transport America's goods and services. We understand your concern about the price and supply problems that are occurring in the Midwest and we will provide the Committee with the best information we have on the situation at this time.

Americans benefit from a highly competitive refining industry that over the years has consistently met environmental and other market challenges while providing high quality, affordable supplies of petroleum products. Prices are affected by many factors that influence supply and demand in the competitive fuels marketplace. Price changes, up or down, are the result of a complex interaction among these factors which often makes identification of a clear cause and effect problematic.

NPRA believes that policy makers must remember that oil refining and marketing is a business that is very sensitive to supply and demand. Our products are commodities which are purchased and exchanged in open trading markets, and behave in those markets as do other commodities.

It has been almost 10 years since the 1990 amendments to the Clean Air Act were signed into law. Since that time the refining industry has had to react to numerous regulations and mandates. Today, we are beginning to see a strain in refiners' ability to provide the many different fuel product specifications and petroleum products to specific markets. The nation's fuels system may be reaching the breaking point. Congressional leaders and Administration policy makers must recognize this fact and the need for a realistic energy policy for the nation's refiners and other fuel supplies. New and emerging environmental requirements, as well as external factors such as the recent sinking of the dry dock in the Calcasieu ship channel, pipeline breakdowns and power outages will also strain the refining industry's ability to deliver fuels to its customers.

We also bring to your attention the recent National Petroleum Council Report and the June 16 Congressional Research Service (CRS) study. Both of these reports provide accurate findings on many of the events affecting price volatility in the Midwest. NPRA agrees with many of the findings of these recent reports and urges this Committee to examine them closely.

The Refining Industry Appreciates and Welcomes Congressional and Administrative Inquiries

NPRA and its members will work with the Federal Trade Commission as it proceeds with its inquiry into gasoline prices in the Midwest. NPRA understands the concerns which have led to the Federal Trade Commission investigation into the gasoline price increase, requested by the Chairman of this Committee, the Department of Energy and the Environmental Protection Agency.

NPRA will work closely and cooperate fully with FTC investigators as they prepare a report. It is our belief that the FTC will find that the situation in the Midwest stems from existing market forces and the "pile on" of new environmental regulations together with shortages caused by external factors such as pipeline breakdowns, refinery outages, extreme weather conditions, and litigation involving RFG patents. Our industry has participated in numerous FTC reviews on previous occasions and industry has always been exonerated in the findings. We have no reason to expect a different conclusion in this instance.

Background on the Reformulated Gasoline Program

The 1990 Clean Air Act Amendments required that reformulated gasoline (RFG) be sold in the nine non-attainment areas for ozone. Other areas have since been designated RFG areas at the request of governors. RFG represents about 30% of the gasoline sold in the United States, the remainder of which is referred to as conventional gasoline. RFG has a 2% oxygenate requirement.

The RFG program has seen its share of controversy. Some refiners entered the RFG program when it was first mandated only to have EPA change its mind about the program, leaving companies with stranded investments. On June 1 of this year, the industry introduced the scheduled Phase II summer RFG gasoline, a more difficult to produce and costly phase of the RFG program. This latest phase of the program requires significant reductions in gasoline sulfur and volatility which must be achieved through additional capital investments and modified operations in existing refineries. With regard to one specification, volatility reduction, the RFG minimum oxygenate requirement for RFG drives volatility in a conflicting direction, resulting in a need to make "overadjustments" in volatility to comply with Phase II requirements. Refiners have had to deal with this situation for several years. But it has become more acute because of the more severe RFG Phase II requirements effective on June 1 of this year.

The new RFG requirements present a greater challenge in Chicago and Milwaukee than other areas. Because of oxygenate supply, the ethanol subsidy and oxygenate mixing considerations, ethanol is essentially the sole source of oxygenate used to satisfy the areas' minimum oxygenate requirements. Unfortunately, the negative volatility blending impact of ethanol is about four times that of oxygenates used elsewhere (largely MTBE). Therefore, the base gasoline blendstock for ethanol blended RFG, called RBOB, is difficult to produce and is typically available from a relatively limited number of refiners.

Concerns have repeatedly been raised about the impact of more restrictive requirements of Phase II RFG on ethanol. Several Illinois Congressmen held a public hearing in July 1999 because of worries that it would be more difficult for refiners to utilize ethanol unless refiners produce expensive, "customized" lower volatility blendstocks. Last August, EPA met with various stakeholders active in the Chicago area to discuss ideas to provide more flexibility in the RFG program. In September 1999, the Governors Ethanol Coalition sent a letter to EPA requesting a regulatory change to the summer Phase II RFG standard to affect problems involved with ethanol use in RFG II. The Governor's Ethanol Coalition again in December 1999 wrote to the Vice President reiterating the problem to EPA and asking him to delay the implementation of the Phase II RFG program until after next summer.

National Petroleum Council Report

The National Petroleum Council, a joint industry-government committee which advises the Secretary of Energy on matters of importance to the oil industry, has just completed a study on the producibility of the new fuels and the viability of the domestic refining industry.

This study underlines the vulnerability of fuel supplies. It reports that the scope and timing of investments necessary to meet new environmental regulations are unprecedented and that all refiners will have to make large investments in a very short period of time. The NPC cautions that during initial implementation of new fuel specifications there may be tight supply conditions with localized supply disturbances and price volatility as industry adjusts to the new requirements.

The NPC recommends that any fuel specification changes be sequenced with minimum overlap to avoid product supply imbalances and the potential for price volatility. The NPC study also states that four years is the minimum time for planning, acquiring environmental permits, financing, constructing, and starting up new facilities for fuel changes.

Congressional Research Service Report

We would also like to call the Committee's attention to the June 16 study by the Congressional Research Service, which finds that the recent price increases in the Midwest are due to higher crude oil prices, use of ethanol in the RFG product, pipeline problems, low inventories, and, to a lesser extent, the RFG blend patented by Unocal. CRS reports that "it can be roughly estimated that 25 cents of the regional (Chicago, Milwaukee) price increase is due to transportation difficulties and another 25 cents, roughly estimated, could be due to the unique RFG situation in Chicago and Milwaukee....The fact that RFG prices are above conventional gas suggest that the difference is due to the supply of RFG uniquely." This report also expands upon the new Phase 2 reformulated gasoline program for the Midwest, the ruptures in the Explorer and Wolverine pipelines, and patent issues surrounding the RFG program.

The report identifies the recent problems with pipeline systems serving the Midwest. Earlier this spring there was a leak in the Explorer Pipeline system which connects the Gulf Coast to Chicago. Repairs have been completed, but the operating pressure in the system has been reduced pending a review of the system's integrity, causing a reduction in capacity. Also, the Wolverine Pipeline, from Illinois to Michigan, had a leak in early June resulting in supply disruptions and consequent gasoline price increases, even though for a period of time supplies were trucked around the leak area. Both of these pipeline problems illustrate that vulnerable and sensitive supplies can be impacted when systems break down, particularly in a system operating close to maximum capacity.

CRS also reports that recent court decisions in the Unocal patent case are also causing uncertainty for many refiners and blenders. Unocal researchers developed a patent for several distinct blends of gasoline based on the special gasoline requirements for California. Several refiners challenged the Unocal patent and its application to reformulated gasoline; however, two courts have upheld the validity of the company's patents. The court decisions would permit Unocal to collect royalties from other companies using their RFG patent. This decision is causing refiners uncertainty, as they decide whether to license the patent or develop blends outside the patent.

According to a Petroleum Industry Research Foundation, Inc. published report, the uncertainty associated with this litigation may be causing U.S. fuel blenders to forgo production of between 200,000 and 300,000 barrels of RFG daily. It is expected that litigating refiners will ask the U.S. Supreme Court to review the case.

Regulatory Challenges before the Industry

In addition to the reformulated gasoline program, the U.S. refining industry is facing a torrent of new and expanded regulatory programs with which the industry must comply. As the U.S. refining industry provides product vital to the movement of goods and services in the United States NPRA believes that Congressional leaders and Administration policy makers must recognize that the refining industry's resources are limited, the cost of upcoming regulatory initiatives is astronomical and additional strains on supplies will result.

The "regulatory blizzard" chart attached to our testimony shows 12 major regulatory actions which the refining industry will be required to comply with over the next ten years. The cost of these programs, which are largely uncoordinated, approaches $20 billion. It is important for this Committee and others to appreciate the upcoming regulatory requirements our industry is facing.

A recent Energy Information Administration report found that an eastern U.S. pipeline operator already handles 38 different grades of gasoline. CITGO Petroleum, an NPRA member, has prepared the attached chart which illustrates the 10 different grades of gasoline which a refiner must currently make in order to serve different markets for summer gasoline in the eastern and central United States. This proliferation of products adds cost to produce and distribute fuels. It reduces flexibility in the supply system and makes it difficult to cope with temporary upsets in supply. The Midwest is one area already experiencing some of the problems encountered in using a "boutique fuel product."

A brief addendum describing these programs is attached.

External Factors Causing Stress to the Fuel Distribution Systems

Since the first of the year, the American public has seen its fuel supply and distribution system under stress. There are the international political problems associated with the price of OPEC oil, the unforeseen weather problems in the Northeast this past winter, the potential surge in power outages during usually warm summer months and the recent drydock sinking in the Calcasieu Ship Channel.

The price of oil also affects the cost and availability of gasoline supplies in the U.S. Production cutbacks by (OPEC) have added to oil price volatility. In February 1999, a barrel of crude oil sold for only $11 (gasoline prices were near $1.00/gallon). Trading prices last week on the New York Mercantile Exchange (NYMEX) for crude oil averaged about $33 per barrel (bbl). The wild price fluctuations in our industry's raw material through the refining and, distribution, and marketing system must be expected to produce fluctuations in product prices. Roughly one-third of gasoline's price reflects the price of its raw materials, crude oil. The CRS estimates that median crude prices are responsible for 48 cents of gasoline price increases.

We are all aware of the shortages which occurred this winter in the Northeast. Last winter in New England, a cold snap caused supply problems and unusual price swings for home heating oil and diesel fuel. NPRA worked closely with the Department of Energy on this matter. Several NPRA members met with the Secretary of Energy and were urged to take any additional steps possible to increase the supply of heating oil and diesel fuel to the region.

Conclusions

NPRA appreciates the interest of this Committee, and we want to work with you to find solutions to these problems. We believe that it is critically important that policy makers begin a review of the our nation's energy policy and provide a realistic energy policy for the U.S. domestic refining industry and other stakeholders. We must recognize the fact that the refining industry and our nation's entire supply infrastructure is operating near its limit and will continue to do so for the foreseeable future. Little flexibility remains to respond to disruptions. Unfortunately, some disruptions are unavoidable and are certain to occur despite our best efforts to prevent them.

The refining industry has a strong commitment to improve the nation's environment, but we caution that environmental goals must be weighed against energy security. We believe for example, that sulfur levels must be reduced in both gasoline and diesel. Refiners have offered reasonable and cost-effective programs to make these reductions. However, they have been totally ignored by EPA, despite our cautions about potentially severe product supply consequences. The pending EPA diesel sulfur proposal is a blueprint for reduced supplies of highway diesel and should not be made final without extensive revisions. However, EPA seems determined to go forward with this radical and extreme proposal, and to ignore the unanimous concerns of the industry about its impact on supply. This indicates to us that we can expect "business as usual" with predictably adverse future impacts unless Congress or the courts intervene to balance environmental and energy supply concerns.

I would be happy to answer any questions.

Addendum A

EPA's Gasoline Sulfur Program - Last December, EPA released the final Tier 2 rule for gasoline sulfur. This new rule will require the refining industry to invest an estimated $8 billion in order to comply with a new 30 ppm gasoline standard between 2004 and 2006. Conservative estimates are that gasoline costs will rise 4-5 cents per gallon as a result. The refining industry suggested an alternative program to EPA that was largely ignored. The refining industry's program was phased and sustainable, and would have protected America's gasoline supplies. However, EPA's final program will result in a logjam of competition for contractors and other suppliers, and will clog the EPA regional and state agencies with permit applications. New technologies for the gasoline sulfur program are not yet proven, and EPA's new directive may cause refiners to invest in expensive and less efficient existing technologies.

EPA's Diesel Sulfur Program - On May 17th EPA released a diesel sulfur reduction plan which calls for refiners to reduce sulfur levels in diesel by 97 percent (from the current 500 ppm to a 15 ppm level) beginning in 2006. The refining industry agrees that sulfur levels must be reduced, but believes that any new program must be reasonable and sustainable. Refiners offered a plan to EPA that would lower the current limit of 500 ppm sulfur in diesel to a limit of 50 ppm - a 90 % reduction. This is a very significant step and will enable diesel engines to meet the particulate matter standards sought by EPA while also achieving significant NOx reductions. Industry's plan is still expensive; it will cost roughly $4 billion to implement, but, unlike EPA's extreme and much more costly proposal, the level of sulfur reduction proposed by industry is both attainable and sustainable. Most refiners would choose to make the investments needed to meet a 50 ppm sulfur limit.

We have told EPA that with the current supply infrastructure, it will be extremely difficult to deliver highway diesel at the 15 ppm level to consumers while maintaining the 15 ppm sulfur level. EPA's rule will be more expensive because 1) the cost to retrofit existing plants and build new capacity has been underestimated (due to the fact that technology to produce ultra low sulfur diesel requires higher investment for retrofits of existing desulfurization plants due to equipment design pressure limitations, more frequent shutdowns for maintenance and catalyst changes, and the costs associated with disposing of spent catalysts); 2) limitations in the distribution system and the high probability of fuels becoming contaminated; and 3) the fact that permitting and engineering resources will be severely constrained by the contemporaneous program to reduce gasoline sulfur. (There are few synergies between the process to reduce sulfur in gasoline and diesel.)

EPA's New Source Review Initiative - Congress enacted the New Source Review (NSR) program in the 1970s to ensure that sources which significantly increase their emissions also install technology to control the increase. NSR is one of the most complicated regulatory programs ever created. Under the Clean Air Act, New Source Review may be triggered by basically any change to existing equipment. Currently, EPA applies NSR to many changes that will never cause emission increases, even to changes that will reduce emissions. The refining industry believes that EPA's New Source Review Program will hinder the refining industry's ability to meet its obligations. NSR should not be retroactively interpreted and current actions by EPA's enforcement office raise concerns about industry's ability to acquire permits for capacity additions and modifications.

EPA's Air Toxics Program - In July EPA will issue new toxics standards as part of its Urban Air Toxics Strategy. Section 202 (l) of the Clean Air Act requires EPA to complete a study of toxic air pollution from mobile sources, including both vehicles and fuels.

EPA's Program To Phase Down MTBE - EPA recently proposed "eliminating or substantially reducing the use of MTBE, replacing the current 2% oxygenate mandate with a renewable fuel content standard, and maintaining current air quality gains." In its announcement to the Congress, EPA did not specify timing or implementation mechanisms, but appears to suggest that a renewable fuels standard is envisioned to increase ethanol use. If so, the costs of replacing MTBE would be much higher. If ethanol is required to replace MTBE on a barrel for barrel basis, current ethanol production would have to quadruple, requiring investment of $10 billion and costing an additional $2.5 billion in ethanol subsidies.

Considering the potential negative impacts on octane and volume loss from MTBE elimination, the scope of diesel sulfur reduction, and gasoline sulfur reduction, NPRA believes that these programs should not be implemented concurrently. We believe that the diesel sulfur reduction program should be more reasonable than EPA has proposed and we oppose any ethanol mandate. Implementing these programs in the time schedules proposed for the next 10 years will most likely result in a domestic fuels shortfall which will impact prices. This is the clear message of the NPC report.

Waivers for the Phase II reformulated gasoline program will not help the situation. The Phase II mandated program which began June lst is a regulatory program based on the requirements of the 1990 Clean Air Act Amendments. Refiners have made investments to meet the requirements mandated by EPA. And waiving those requirements would be unfair and set a bad precedent affecting refiners' reactions to future environmental restrictions.