Speeches/Testimony

STATEMENT OF

BOB SLAUGHTER
GENERAL COUNSEL
NATIONAL PETROCHEMICAL & REFINERS ASSOCIATION

BEFORE THE

SENATE ENERGY AND NATURAL RESOURCES COMMITTEE

CONCERNING

U.S. GASOLINE SUPPLY ISSUES & THEIR RELATIONSHIP TO
REGIONAL PRICE PROBLEMS

JULY 13, 2000
WASHINGTON, DC

Overview

The National Petrochemical & Refiners Association (NPRA) 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 petrochemicals and 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.

We also will discuss the broader implications of the seemingly divergent goals of current US energy and environmental policy. There is a disturbing lack of coordination between our energy and environmental policy objectives. The pursuit of a number of individual environmental programs in a "piecemeal" fashion has stretched the US fuel refining and distribution system to its limit -- resulting in greater potential for tighter supplies and increased market volatility. The current experience in the Midwest may only be an omen for the future. As the Energy Information Administration (EIA) stated recently: "Today, the U.S. refinery system has little excess capacity, and the growth in the number of distinct gasoline types that must be delivered to different locations increases the potential for temporary supply disruptions and increased volatility." And EIA has already begun expressing concerns about supplies and cost of heating oil and natural gas for next winter.

NPRA believes it is possible to enjoy reliable and affordable fuel supplies while preserving, and improving upon, our environmental progress. However, this can only be achieved if energy and environmental policymaking is integrated and if the costs and benefits of new regulatory requirements are carefully weighed in the context of the impact on energy supplies. This is particularly important now, given the host of new fuel requirements that EPA is poised to impose in the next 5-7 years, including reductions in gasoline sulfur content, reductions in on-road diesel sulfur, potential phasing out of the use of certain oxygenates like MTBE and decisions on the role of renewables such as ethanol.

In short, the regulatory "blizzard" is in danger of creating "avalanche" conditions. Absent a comprehensive and integrated approach, energy policy will be just the de facto result of environmental policy. American consumers and our economy will suffer the consequences in terms of supply uncertainties, higher costs and lower economic growth.

Current Market Volatility in the Midwest has been Influenced by a Number of Factors
Americans benefit from a highly competitive refining industry that over the years has consistently met environmental requirements 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 many of the problems we are now experiencing are due to readily understandable factors: the cost of our major input, crude oil, has increased by 300% in the last 18 months; we just introduced a new grade of environmental gasoline covering one-third of U.S. gasoline supply, which is more expensive to produce and requires more oil in the refining process; we have experienced regional supply disruptions due to distributional problems; and inventories of crude and product are at very low levels.

Experts who have looked at the situation seem to agree with our assessment. For example, a recent analysis by the Congressional Research Service identified several key influences:

higher crude oil prices;
use of ethanol in reformulated gasoline;
pipeline problems (reduction in capacity due to ruptures in Explorer pipeline from Gulf Coast to Chicago and Wolverine pipeline from Illinois to Michigan);
low inventories; and
reduced blending flexibility due to a patented RFG process (known as the Unocal patent).

And, as PIRINC's new study, "Gasoline 101: A Politically Explosive Topic" states:

"None of the individual problems contributing the national, and especially local, gasoline price run-ups were major in and of themselves. However, they came together in the context of a tight global oil market. This condition may persist for some time¼The regulatory system currently in place adds significantly to national and local vulnerabilities."

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." CRS also reports that recent court decisions in the Unocal patent case are also causing uncertainty for many refiners and blenders, especially those producing special gasoline blendstock for ethanol RFG. 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 imposed infringement penalties and 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 the PIRINC 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.

The Reformulated Gasoline Program has Contributed to Market Volatility
The 1990 Clean Air Act Amendments required that reformulated gasoline (RFG) be sold in the nine worst 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% oxygen content 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, which is more difficult and costly to produce. 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.

The new RFG requirements present a greater challenge in Chicago and Milwaukee than other areas. Because of oxygenate supply, the ethanol subsidies and oxygenate mixing limitations, ethanol is essentially the sole source of oxygenate used to satisfy the areas' minimum oxygen requirements. Since ethanol increases the volatility, and consequently the evaporative emissions of the finished gasoline, a special lower volatility blendstock is needed. This blendstock for ethanol blended RFG, called RBOB, is expensive and difficult to produce, and is typically available from a relatively limited number of refiners. It is also not widely available in areas outside the Midwest, thus limiting the ability to seek alternate supplies if there are production problems at Midwest refineries.

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 alleviate problems involved with ethanol use in RFG II. The Governors Ethanol Coalition again in December 1999 wrote to the Vice President reiterating the problem asking him to delay the implementation of the Phase II RFG program until after next summer. Only after the market volatility set in this June, did EPA issue a proposed rule seeking to address some of these concerns - an action too late to impact supplies for this summer's driving season.

The Refining Industry Appreciates and Welcomes Congressional and Administrative Inquiries
NPRA and its members will work with the Federal Trade Commission (FTC) as it proceeds with its inquiry into gasoline prices in the Midwest. NPRA understands the concerns which have led to the FTC investigation into the gasoline price increase. 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, and litigation involving RFG patents as noted by CRS. 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.

No More Energy Policy By Default
We strongly urge this committee to consider a more comprehensive review of US energy needs and the implications of future regulatory requirements on energy markets. The National Petroleum Council (NPC), a joint industry-government advisory body, just issued a report explaining why the same or similar situations that we have encountered recently can be expected to recur if we persist in pushing the edge of the envelope on environmental improvements while taking continued energy supplies for granted. The NPC study noted that: "The timing and size of the necessary refinery and distribution investments to reduce sulfur in gasoline and diesel, eliminate MTBE, and make other product specification changes such as reducing toxic emissions from vehicles are unprecedented in the petroleum industry." And, the NPC cautioned that "¼there will be an increased likelihood of localized supply disturbances as product quality specifications are tightened, particularly during the initial implementation of new specifications."

Additionally, the refining industry has been coping with difficult times. According to the NPC report, the refining industry's return on invested capital over almost the past two decades (1981-98) averaged 5%, roughly the passbook savings rate at the local bank. During the past decade alone, refiners were called upon to invest about $20 billion in environmentally-related expenditures. An earlier NPC study determined that those expenditures were likely to exceed the book value of the entire refining industry. In short, few investors looking to make any significant returns on their money put it in refining stocks. It is no surprise that no new refinery has been built in the U.S. in almost thirty years.

Probably as a result of this situation, the refining industry has been going through a period of great change. Roughly one-third of the industry's assets have changed ownership in the past five years. Some refineries have been sold (a few more than once) others have been merged into new companies or they have become part of joint ventures, often under the operating control of a different company than before. Some refineries have closed their doors. Generally, however, refiners have invested to maintain their plants, kept up with expanding demand for products, and met new environmental specifications. The May 2000, Cambridge Energy Research Associates (CERA) study, "Gasoline and the American People," recognizes that, as a result, refiners have become more efficient and flexible in their operations because competitive pressures have forced them to identify ways to bring down costs to compensate for additional environmental expenditures. Given the experience of the past ten years, this really represents a triumph of hope over experience. Especially since, as Dr. Yergin of CERA highlights "¼the long-term trend in gasoline prices is down." $0.30 per gallon gasoline in the 1960's would be the equivalent of $1.75 today, and $1.25 per gallon in the 1980s would be equivalent to $2.50 today.

Substantial New Regulatory Challenges Face the Industry
In addition to the reformulated gasoline program, the U.S. refining industry is facing a torrent of new and expanded regulatory programs. 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. A brief addendum describing these programs is attached.

The Regulatory Blizzard
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. Some, like gasoline sulfur reduction, have passed through the regulatory process and are being implemented. Others, like diesel fuel reductions, have been proposed by EPA with the intent to finalize them this year. Others, like MTBE related regulation, are high-cost and high-impact items which are still taking shape, but are certain to require substantial investment and have negative supply effects in the near future.

These initiatives are largely uncoordinated and, if history is any guide, their impact on energy supplies will be downplayed. They are also very expensive. The gasoline sulfur reduction program will cost the refining industry $8 billion according to the NPC report. Diesel sulfur reduction, if done in conformity with EPA's proposal, will cost around $10 billion. And the cost of responding to MTBE-related problems will take the combined total above $20 billion - and this is for just three of the programs on this chart. And these three programs must be implemented in roughly the same timeframe. It is important for this Committee and others to appreciate the upcoming regulatory requirements our industry is facing, and their likely impact on future supply and pricing.

In light of these concerns, the NPC recommended 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 reiterated that four years is the minimum time for planning, acquiring environmental permits, financing, constructing and starting up new facilities for fuel changes. Due to these timing concerns, the NPC warned that "There is a significant risk of inadequate diesel supplies if EPA's proposal for 15 ppm maximum sulfur on-highway diesel beginning April 1, 2006 is implemented."

And, it is not just refiners who face challenges. The complexities for the nation's fuel distribution system are enormous. A recent EIA 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." The PIRINC study cites the "island" effect whereby areas such as California, Chicago and Milwaukee are isolated due to their dependence on boutique fuels. As PIRINC notes "¼ the problem is that regulatory developments have made gasoline less uniform, or fungible, and more difficult to transport, thereby reducing the ability of the supply system to respond quickly to threats of shortage."

External Factors Also Can Cause Stress to the Fuel Supply and Distribution Systems
Since the first of the year, the American public has seen its fuel supply and distribution system under stress. There were 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 in June on the New York Mercantile Exchange (NYMEX) for crude oil hit a week's average of about $33 per barrel (bbl). The extreme price fluctuations in our industry's raw material through the refining, 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 material 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 in the Northeast. Last winter a cold snap in New England 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. EIA is already expressing concerns about next winter's fuel supplies.

The Refining Industry Is Committed to Providing Cleaner Fuels
The refining industry is committed to providing cleaner, more environmentally acceptable products to consumers. We have spent billions in recent years to meet environmental requirements. We will spend as much, or more, in coming years to achieve the same result. We need to do this because it is right and our customers want and need these products.

But investments of this magnitude will have impacts on the refining industry. Some facilities will close, other refineries, probably many, will change hands. Probably none will be built. Refiners have tried to keep up with demand by making investments in new capacity at existing sites. Meanwhile, EPA is trying to exact huge penalties from the entire refining industry by retroactively claiming that the industry failed to obtain permits for the extra capacity needed to keep up with consumer demand. Our members believe that EPA's claims are without merit, but this issue has diverted attention and scarce resources which could be better used to provide consumers with gasoline, diesel and other products.

Experience tells us, and the NPC study confirms, that refiners will continue to invest to provide petroleum products to consumers. The magnitude of the investments, as well as their timing, will determine which and how many refiners choose to stay in the industry. Also, the NPC study tells us that supply disruptions will occur more frequently as we implement environmentally-driven fuel specification changes. This means that situations like the recent one in the Midwest will occur more often. The refining system is already stretched to the breaking point in producing and distributing a multitude of products, some seasonal, some not.

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 policymakers begin a review of 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 set in the context of our overall energy goals if we are to maintain our 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. Unfortunately, EPA seems determined to go forward with this radical and extreme proposal this year, and has ignored 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.

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 very difficult to maintain and deliver highway diesel at the 15 ppm level to consumers. The low sulfur product will be affected by higher sulfur products carried in the same pipelines, resulting in "off spec" product with greater than 15 ppm sulfur content. EPA's rule will also be very expensive. The cost to retrofit existing plants and build new capacity has been underestimated (technology to produce ultra low sulfur diesel means more investment to retrofit existing desulfurization plants because of equipment design pressure limitations, more frequent shutdowns for maintenance and catalyst changes, and the costs associated with disposing of spent catalysts). There are also limitations in the distribution system and the high probability of fuels becoming contaminated. Permitting and engineering resources also 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 mandate, 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 mandate 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 cannot and 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 such 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.