The Sustainability of Affordable Fuels in America
by David J. Tippeconnic
President and CEO
CITGO Petroleum Corporation
The gasoline price spikes and supply shortages experienced this summer, particularly in the upper Midwest where prices reached historically high levels, serve as a dramatic illustration of the impact on the nation’s refining industry of three decades of environmental regulation and the lack of a cohesive national energy policy.
High Prices and Angry Consumers
The scenario of price spikes, angry consumers and posturing politicians is one likely to be played out with increasing frequency in the coming years unless U.S. regulatory policies undergo a complete overhaul and a national energy policy is established with the ultimate objective of providing the nation with clean, affordable fuels. Such a policy must support rather than dampen economic growth and serve to enhance the quality of life Americans have come to expect.
Indeed, Americans regard low-priced fuels and their mobile lifestyles as a national birthright — a view supported by the industry’s historic ability to absorb the massive costs of wave after wave of environmental regulations without passing the costs on to the consumer.
Americans have enjoyed a long period of cheap transportation fuels, a fact that has contributed to our overall high standard of living. The oil and gas industry has done an excellent job of providing clean fuels at an affordable price since record keeping began.
In fact, in 1999 dollars, the gasoline price has decreased from $1.16 a gallon in 1918 to 32 cents per gallon in 1999, according to research by Cambridge Energy Research Associates (CERA), one of the world’s leading energy research firms. Clearly, though, our industry’s ability to sustain this is in serious jeopardy.
From the regulatory standpoint, the threat to refiners’ continued ability to provide clean, affordable fuels stems primarily from five areas.
"Boutique" Fuels
A plethora of "boutique" or so-called "designer" fuels has been mandated by state and local governments and endorsed by the Environmental Protection Agency across the nation. Such requirements strain not only our refineries’ ability to produce such a diverse basket of fuels but also the national supply and distribution system’s ability to deliver them to the consumer.
A recent U.S. Energy Information Administration report observed that an Eastern U.S. pipeline operator handles 38 different grades of gasoline (including multiple vapor pressures for each grade), seven grades of kerosene, 16 grades of home heating oil and diesel fuel (including diesel fuel-marine for the U.S. Navy and light-cycle oil) and one grade of transmix (the gasoline/distillate pipeline interface material that needs to be reprocessed). For instance, four different gasoline mixtures are required between Chicago and St. Louis — a 300-mile distance. Of the 62 product codes, 29 are fungible products and 33 are for products that must be shipped on a segregated basis.
The nation’s transportation fuel supply infrastructure was tested when the EPA introduced RFG in 1994, and boutique fuels have increased that burden to a nearly unmanageable level. According to the National Petroleum Council, "Fungible product specifications are critical to the reliability and efficiency of the U.S. product distribution system." Without fungibility, the distribution system loses the flexibility to redirect supplies from one area to cover shortfalls in another area. If state or local government agencies proliferate requirements for unique fuels, including local MTBE restrictions, then the risk of supply disturbances will increase.
During the summer of 2000, 12 different types of gasoline were required (excluding the West Coast). Each of these types of gasoline was available in three octane grades. Each of these 36 gasolines is a blend of several unique streams produced in the refinery process. Therefore, in order to meet the specifications of each gasoline, a particular ratio of these streams must be carefully blended in order to produce finished gasoline that meets the specification for that particular grade.
This explosion of the number of boutique fuels is a recurring theme around our country. Each of these boutique fuels must be manufactured separately, stored separately, shipped separately and handled separately. The net effect is that very few refiners have the ability to make all of these specialty gasolines and, even if they can, they have very limited delivery systems to handle transitions to new fuels or to meet any shortages. The net result is a delicate balance of the supply and demand system that can be upset by the slightest disruption.
The nation’s refineries produce about 97 percent of the fuels needed to meet the nation’s travel and freight movement demands. That includes about 350 million gallons of gasoline per day, 70 million gallons of kerosene and jet fuel and 150 million gallons per day of diesel and heating oil. Clearly, complicating this with dozens of different grades of fuels for very limited areas of the country makes it virtually impossible for any one refinery to make every different grade of fuel required. Refiners need flexibility to remain in operation and to accommodate refinery outages and maintenance turnarounds. Having to manufacture and deliver a myriad of fuels virtually destroys this flexibility.
Unfortunately, boutique fuels offer a politically attractive solution to areas that are in non-attainment with the ozone standard or those that are close to non-attainment and are searching for emission reductions. Alternatives such as vehicle tailpipe tests, speed limit reductions, construction bans during parts of the day, mass transit and car pooling requirements are very unpopular with voters and taxpayers, and state rulemakers are very aware of that.
Consequently, a boutique fuel solution is an easy fix politically because consumers don't pay much attention to the type of gasoline used in an area. Just dropping the Reid Vapor Pressure gains a few tons of reduced evaporative emissions, depending on the number of vehicles in the area. EPA has models that will tell the locality how many tons of pollution certain solutions will provide. The state then submits a revised State Implementation Plan for EPA approval and initiates rulemaking to make these reductions happen.
However, it can be dangerous for individual states to make decisions about changes to their gasoline quality without regard to its source or quality within a region. Gasoline is a commodity and historically has been manufactured and delivered as such. If a state changes the specifications on motor fuels to something that is not readily available, they are assuring themselves of supply interruptions and price spikes at the pump.
EPA Tier 2 Rule
In December 1999, the EPA issued the "Tier 2 Rule" requiring the reduction of sulfur content in most gasolines to 30 parts per million (ppm) average in the 2004-2006 timeframe. Meeting Tier 2 gasoline regulations will be expensive, about $8 billion for the industry, and will present a significant challenge to refiners.
There are a number of factors that could have implications on supply of this product. Because of the high capital costs, it is likely that some refiners will be unable to justify the investments, and will simply shut down. Most others, because of the high cost of conventional desulfurization technology, will use new and unproved technologies to reduce the sulfur content of gasoline. These new technologies, while being less costly, will have limited commercial experience and will likely result in more initial operating problems and increase the risk for supply disruptions.
In order to meet the deadline of 2004-2006 required by the EPA, the industry will face significant hurdles to obtain the necessary permits, engineering and construction resources, and hardware to complete the work on time.
Sulfur in Diesel
It is highly unlikely that the industry will be able to consistently maintain needed supplies of on-highway diesel within the 15 ppm sulfur level cap proposed by the EPA. First of all, with the current distribution system, it will be extremely difficult to deliver on-highway diesel with a 15 ppm cap to consumers because it must share a distribution system with other products that have significantly higher sulfur levels.
Due to the high cost to produce 15 ppm sulfur diesel, many refiners will choose not to participate in the on-highway diesel market or to participate less than they do today. Some will be forced to simply go out of business. This could drastically reduce the supplies of on-highway diesel, with the possibility of supply disruptions and price spikes becoming the norm.
The sulfur level for on-highway diesel being proposed by the EPA is too low and the timing is too soon. Similar benefits can be obtained from a more reasonable 50 ppm sulfur cap. The EPA arbitrarily selected the NOx tail pipe emission standards for the proposed diesel sulfur without the technology to support the standard. The engine manufacturers don’t have the after-treatment technology today to meet the standard, and the oil industry doesn’t have the desulfurization technology to reduce sulfur to the levels being required by proposal in a cost-effective manner.
MTBE Ban
In March of this year, the EPA proposed to significantly reduce or ban altogether the use of MTBE in gasoline, replacing it with a renewable fuel such as ethanol in order to meet 1990 Clean Air Act oxygen content requirements. Eliminating MTBE while maintaining the RFG oxygen requirement would require approximately $4.5 billion in investment.
In addition to the significant investments necessary as a result of the proposed ban, the elimination of MTBE would tend to increase emissions from gasoline. If current levels of toxic emissions performance standards should be required, additional investments of $400 million would be necessary.
This would also add significantly to the volume and octane loss associated with the reduction of sulfur in gasoline proposed in the Tier 2 rule. Compensating for this would severely strain permitting and construction resources with the strong possibility of loss of gasoline production capacity and higher costs.
Reduction of Gasoline Driveability Index
The Alliance of Automobile Manufacturers (AAM) has proposed reducing the gasoline Driveability Index (DI) cap from 1,250° to 1,200°, a move which would prove to be very costly to the industry and, ultimately, to consumers. This would likely require investments of up to $11 billion and a per-gallon cost increase of about seven cents. These costs stem from the significant refinery modifications necessary to compensate for lost production capacity resulting from the reduced DI cap. This could very well mean lost production capacity with resulting price spikes and supply shortages until the necessary refinery modifications are made.
A Course for Disaster
If the EPA does not properly facilitate the permitting process or if other regulations, like the proposed diesel sulfur regulations or a ban on MTBE, overlap the Tier 2 work, then we are on a course for disaster. As discussed, high capital costs could result not only from the regulatory issues mentioned above but other issues on the horizon such as the Kyoto Protocol and alternative fuels technology. Such costs could lead to refinery shutdowns either as investment decisions or from unforeseen problems involving new technologies.
Gasoline supply disruptions could be experienced for long periods of time, leading to fundamentally higher prices at the pump. This scenario is one that the motoring public is unlikely to tolerate for long.
EPA — The Salvation of the Nation’s Refiners?
Ironically, EPA’s current and proposed regulations could, in fact, do what the free market has not done consistently: improve refining margins. West Coast refining margins, for example, fluctuate more than those on the Gulf Coast.
California prices are more variable than others because there are relatively few supply sources of its unique blend of gasoline outside the state. To meet gasoline demand, California refineries have to operate near fullest capacity. If more than one of its refineries experiences operating difficulties at the same time, California’s gasoline supply becomes very tight and the prices soar. In today’s regulatory environment, this will soon be the case for the entire nation.
Although industry rationalization has been threatened for more than a decade, actual refinery closures and shut-in capacity have been rare. Instead, companies have sold off their underperforming facilities to competitors, exacerbating margin pressures. Even the recent wave of mergers and downstream joint ventures has resulted in only minimal capacity shutdowns.
However, the high capital costs associated with the proposed regulations discussed above would certainly force many of the smaller refiners, unable to make the necessary investments, out of the industry. Other companies, under prodding from the shareholders, could well decide to exit the refining segment altogether and invest their capital in higher return areas such as E&P. Consequently, the refiners who stick it out should, over time, see higher margins.
However, I don’t believe this is the correct solution. It’s not a free-market solution and, ultimately, the consumer loses. There are better ways.
National Energy Policy Needed
What these scenarios graphically illustrate is the nation’s desperate need for a comprehensive energy policy that has regulatory reform as a centerpiece. The petroleum-refining sector is grossly over-regulated by an uncoordinated and often counterproductive regimen of federal, state and local laws and regulations.
The unfortunate fact is that this nation’s energy policy is not driven by the Department of Energy but by the Environmental Protection Agency. In reality, it’s not a policy at all but a patchwork quilt of regulations and requirements that has been added to every year since the Clean Air Act was passed in 1970 and amended in 1990.
This hodgepodge of regulations fails to take into consideration this nation’s needs or the refiners’ ability to produce and distribute an increasingly complex range of products. It’s a refiner’s nightmare — one that is now beginning to affect the American people and will continue to do so with increasing frequency.
The coordinated implementation and integration of environmental rules and regulations are absolutely necessary to ensure that U.S. energy needs are met.
Higher energy prices that disrupt the American consumers’ budgets can be avoided with a correction in the direction of regulatory policy.
The current "command and control" regulatory system is ill suited to address the nation’s remaining environmental concerns in a practical way. New rules covering air emissions and fuel formulations are wreaking havoc on the nation’s petroleum refineries. These new rules come on top of the over 120 health and environmental rules that have already been imposed on the refining and marketing industry.
A New Approach
Government agencies at all levels must adopt processes to analyze and prioritize risks, and then subject proposed solutions for the highest risks to a thorough cost/benefit analysis. Comprehensive reform legislation has been under discussion in Congress for several years but no progress has occurred.
Adding regulations that are not cost effective on top of existing rules damages the refining industry’s ability to compete in world markets.
Many major petroleum companies are divesting refining and marketing assets because of their low profitability, while others are merging operations or entering into partnerships to maintain economic viability. The current regulatory direction will cause the U.S. to be dependent on even greater percentages of imported motor fuels.
The government can reduce the potential for market volatility by making environmental regulations more reasonable and workable. Improved regulations would give companies more flexibility to adjust to problems that may have temporary impacts on supply and price. In order to do so, Congress should mandate and police federal agencies’ adoption of the following principles:
• Prioritization. Regulations must address the greatest concerns first.
• Use Current Data: Regulations must be based on sound science and current data.
• Cost/Benefit Analysis: Regulations must carefully balance the total anticipated cost of compliance (capital plus maintenance) over a specified time frame against the total anticipated benefits over the same timeframe.
• Stakeholder Involvement: The regulated community must have a more active role in setting environmental priorities and enforcement.
• Flexibility: Regulations should set performance requirements, but allow for the creation of innovative solutions and lead time to reach those goals.
• Accountability: Each regulation should include an automatic sunset provision that can be overridden, if necessary.
The Benefits of Teamwork
The industry has repeatedly warned of the impact of ill-considered regulations based on "junk" science and political motives. If government and industry work together to implement sound regulations, this nation can have both clean air and adequate supplies of clean fuels.
Such a philosophy would be one that serves the American public and helps promote the economic growth necessary to sustain the American quality of life. It’s vital that the Administration, Congressional and regulatory leaders heed the industry’s warnings and take the appropriate actions.
David J. Tippeconnic joined CITGO Petroleum Corporation as president, chief executive officer and director July 1, 1997. He had previously served two and a half years as president and CEO of The UNO-VEN Company, a petroleum refining and marketing venture between Petróleos de Venezuela, S.A., and Unocal Corporation. Prior to joining UNO-VEN, Tippeconnic served 33 years with Phillips Petroleum Company. During that time he held various operating positions before being named vice president of human resources. He was later named senior vice president of planning and technology, then executive vice president of Phillips Petroleum Company and president of the Phillips 66 Company, the refining, marketing, transportation and chemicals arm of the company. He was also a member of the Phillips Petroleum Company Board of Directors.
A native of Kingman, Ariz., Tippeconnic attended Harvard University’s Advanced Management Program. He holds an M.S. degree in chemical engineering from the University of Arizona and a B.S. degree in chemical engineering from Oklahoma State University.
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