How fuel prices are being affected by the current boom in domestic oil production

Senate 113-71. July 16, 2013. Gas Prices Hearing on how U.S. gasoline and fuel prices are being affected by the current boom in domestic oil production and the restructuring of the U.S. refining industry and distribution system. Senate Hearing.

[ Below are excerpts from the transcript of this hearing ]

Today, the committee is going to look at the changes taking place in the U.S. petroleum industry and their impact, not only on the oil industry, but more importantly, on the prices that our people pay at the pump.

Unlike the immediate benefits that American consumers and businesses have seen from low natural gas prices, at the gasoline pump, it’s been pretty much business as usual. While the U.S. economy may be benefiting from declining oil imports, prices at the pump have remained consistently high. For years, a number of representatives in the oil industry have told the American people that U.S. gasoline prices are at the mercy of world oil prices. That was basically the case because of our dependence on imported oil. New oil supplies from America have turned that dynamic on its head. Some regions of the country like the Midwest that have access to the lowest price crude oil have some of the highest refining margins in the Nation. Our committee is going to explore on a bipartisan basis why so many consumers have not benefited from these new lower cost sources of crude oil.

The U.S. refining industry clearly has a major competitive advantage over other overseas suppliers, especially for markets in North, South, and Central America, but many of our people want to know why prices are so high here at home when there is so much extra gas and diesel fuel that it can actually be exported. Our people want to know why the flood of new domestic crude hasn’t been lowering prices at the pump. Instead, refiners in the middle of the country with the greatest access to the cheapest crudes have had the highest margins with the difference between the cost of the oil they buy and the gasoline and diesel fuel they sell often exceeding $40 or $50 a barrel. In many cases, these refining margins are now at record or near-record levels; some, as I say, over a substantial amount a gallon. What’s been good for refiners hasn’t necessarily been good for the consumer.

Another important development in the U.S. oil and gas industry are the structural changes that have taken place. The largest refinery in the United States is no longer a major integrated oil company; it’s an independent refiner, Valero, who will be testifying here this morning. Refiners often don’t own their own distribution terminals. Oil companies no longer own their own service stations. The number of oil refineries in the country has also declined, though total refining capacity is up, making our Nation more dependent on a smaller number of larger, more complex refineries. An outage at one of these refineries, whether planned or accidental, is now a major factor in the price at the pump. Last October, a minor electric power outage in a major refinery in California raised wholesale gasoline prices over 80 cents a gallon in a matter of hours. In the upper Midwest last month, the prices shot up almost—again, a substantial amount, in a week as a result of refinery outages.

Senator MURKOWSKI. I was home in the State over the Fourth of July recess and had the opportunity to spend a little bit of time on the Kuskokwim River. I was going out looking at, talking to individuals in their fish camps about what’s happening with fishing, price of fuel, and what that means to them in their villages, and it was just after the spring barge had come and delivered fuel. If you live on the Kuskokwim, you get 2 fuel deliveries a year; you get one in the spring, which is June, and you get one in September, provided that you can get upriver. Sometimes, you can only get one barge in, but basically, your price for fuel is set when those purchases are made, and everyone in the village—it’s not like there’s any competition out there; it is what it is—and when you’re in Bethel, which is the big hub community, paying over $5 a gallon for your fuel, when the barge comes in, you’re hoping that it’s going to go down. The prices didn’t go down, they went up 20 cents, so on Monday, you’re sitting at $5.15 and on Tuesday, you’re sitting at $5.35 for the balance of the summer with no relief in sight. You go upriver to Aniak and they were hit with a 20-cent increase in their fuel for the summer. You go 10 miles upriver to Chuathbaluk and there’s no fuel; there is just no fuel. You want fuel for your boat, you borrow some fuel from your neighbor and you go downriver to Aniak and it’s about a $50 run for that 10 miles.

Adam Sieminski, Administrator of the Energy Information Administration at the Department of Energy

Currently, transportation constraints are limiting the full impact of increased domestic crude production, but these constraints are expected to ease in the coming years. Historically, about 90 percent of the crude oil and petroleum products in the United States have been transported by pipeline. However, shipments of crude oil by rail from North Dakota’s Bakken Shale formation have increased dramatically over the past year, reflecting both lags in adding pipeline infrastructure to transport growing volumes of crude and the ability of rail shipments to serve east coast refineries in the United States and Canada and U.S. west coast refineries, where Bakken crude has its greatest economic value as a replacement for seaborne imports of light sweet crude oil. Crude oil and petroleum products shipments by rail averaged 1.37 million barrels per day during the first half of 2013. (Up 48 percent from 927,000 bpd in same period in 2012) according to the Association of American Railroads (AAR), which tracks movement of commodities by rail. Crude oil accounted for an estimated 50 percent of the combined deliveries in the oil and petroleum products, up from 3 percent in 2009. This topic was discussed in the EIA This Week in Petroleum article of July 11 (See Attachment 1*)

Because truck and rail are less cost-effective options for moving crude, they typically have accounted for a very small portion of refinery crude receipts, averaging just 1 percent of total receipts from 2000 to 2010. Starting in 2011, this truck and rail volume increased, and in 2012 it represented 3 percent of refinery receipts. Additionally, domestic barge receipts also increased, and now account for close to 3 percent (Figure 2*). Expanding existing pipelines or building entirely new ones is costly and requires lengthy regulatory review.

Jeffrey B. Hume, Vice Chairman of Strategic Growth Initiatives for Continental Resources

Just to clear one thing up before we get started, I noticed in the purpose statement for this oversight meeting that the word ‘‘boom’’ is used to describe the current growth in U.S. domestic oil production. Indeed, total petroleum liquids production in our country has accelerated tremendously in recent years. In fact, the U.S. has recently surpassed Russia and is running neck to neck with Saudi Arabia in the rankings as the world’s largest producer of petroleum liquids. However, often times when I hear the word ‘‘boom,’’ it’s used in reference to an era like the dot-com bubble or some other wild business cycle that inevitably ended in a ‘‘bust.’’ This just is not the case with respect to the recent gains in U.S. oil production. A much more accurate way to describe the current rise in domestic production would be to use the word ‘‘renaissance,’’ as this remarkable ‘‘re-birth’’ of the U.S. onshore oil industry is being driven by sustainable technological developments such as horizontal drilling. These revolutionary advancements have enabled companies 1 Source: EIA International Energy Statistics. Production of Crude Oil, NGPL, and Other Liquids in 2012. iedindex3.cfm?tid=5&pid=55&aid=1&cid=regions&syid=2012&eyid=2012&unit=TBPD. like Continental Resources to unlock vast resource plays located deep underground, and produce oil from formations that were previously inaccessible using traditional methods. And, the best news of all is that this 21st century ‘‘renaissance’’ is moving us closer to the goal of North American energy independence. When we reach this goal—and are no longer an energy ‘‘debtor’’ nation—we will have bolstered national security, fortified our leadership position at the global negotiating table, and provided Americans with much-needed relief in the form of high-paying job opportunities and savings at the pump.

In today’s environment, two good ways to lower the prices Americans pay for gasoline and fuels are to support additional domestic production on both private and government lands

It’s worth noting, however, that the energy business is very capital intensive, and these figures just mentioned are predicated upon the maintaining of current legislation. Without current law regarding intangible drilling costs (IDCs) and percentage depletion, producers would not be able to generate the capital necessary for the continued growth in domestic drilling and production activity. A recent study by Woods Mackenzie suggests that repealing producers’ deduction for IDCs in 2014 could result in a 15-20 percent drop in annual domestic drilling, meanwhile curtailing over $400 billion of investment from 2014 to 2023. Consequently, 65,000 jobs per year would be lost in the oil and gas industry. To me, those figures provide powerful evidence for the need to maintain support of the oil and gas industry as a very positive contributor to our economy and American way of life.

Wilian R. Klesse, Chairman and CEO of Valero

Valero is a Fortune 500 company based in San Antonio, Texas. We are the world’s largest independent petroleum refiner, with assets that include 13 U.S. refineries with a combined throughput capacity of approximately 2.3 million barrels per day, ethanol, renewable and wind energy facilities, a network of pipelines, terminals and branded and unbranded independent wholesale customers.

The U.S. is the largest, most sophisticated market for refined petroleum products in the world with New York Harbor being a pricing point and the U.S. Gulf Coast a huge physical supply market. The modern oil and gas industry has been providing energy for Americans for nearly 150 years. During this time, the industry has proved cyclical and seasonal. No new refinery with significant operating capacity has been constructed since the 1980s, while the total number of refineries has decreased by half, overall capacity has increased from 16,859,000 barrels-per-calendar- day then to 17,823,659 barrels-per-calendar-day with an annual utilization rate of about 89 percent today.1 As the number of U.S. refineries has declined, the operating capacity complexity of the remaining refineries has been increased to keep up with worldwide demand. Imports and exports also influence market prices and prices are very visible in the commodity exchanges around the world where anyone can buy and sell benchmark crude oil, natural gas, and refined products. The refining industry was hit hard by the recent recession. Much of the financial news regarding U.S. refining was uniformly negative since the beginning of the recession in 2008 through last year. Rising crude oil prices, declining demand and ever-changing regulations led to weak margins for refiners, even causing several East Coast refineries to shut down.2 While crude prices remain high, and demand is still down about 10 percent today compared to pre-recession levels, the outlook for refiners has improved significantly due to the increase in North American natural gas and crude oil production which are giving the industry competitive advantages in the global market.

Refining is energy intensive, and Valero consumes about 700 million cubic feet a day of natural gas. In fact, energy is the largest component of a refinery’s variable operation costs. Additionally, natural gas liquids are an important ingredient in creating finished products from crude oil, and the current supply dynamics have reduced the costs of these feedstocks. As shale oil production has increased, larger volumes of crude oil from highly productive basins like the Bakken and Eagle Ford have replaced imports for the domestic refining industry.

Despite the recent rise in domestic crude oil production, oil prices overall have not fallen significantly. The U.S. remains a net crude oil importer, so crude prices clearly reflect movements in the global marketplace as the prices paid must be high enough to attract the imported crude supply to America.

There are other factors affecting retail product prices, some of which can be affected by government policy. According to the Energy Information3Administration (EIA), the wide range of factors that combine with the price of crude to set the retail price for gasoline include: Different gasoline formulations required in different parts of the country Over the years, federal and state governments have required that refiners produce a range of specialized gasoline blends. Neutral third parties such as the Government Accountability Office (GAO) have long recognized that the rising number of required fuel blends results in a variety of additional costs for refiners that increase the retail price of gasoline.5 As the GAO has explained: Many experts have concluded that the proliferation of these special gasoline blends has caused gasoline prices to rise and/or become more volatile, especially in regions such as California that use unique blends of gasoline, because the fuels have increased the complexity and costs associated with supplying gasoline to all the different markets.6 Transportation, distribution, and marketing costs A major variable impacting retail gasoline prices are the costs associated with transportation and distribution of crude oil and gasoline. The product supply infrastructure involves virtually all aspects of transportation infrastructure, touching on pipelines, barges, ships, terminals, rail, trucking, and storage tanks. Permitting and siting delays connected to the construction of new pipelines and other Energy structure can drive up retail prices and make gasoline prices more volatile because of inevitable supply disruptions related to equipment problems, weather events, or other unpredictable and uncontrollable events.8

The specific location of individual retail outlets

Gasoline prices are highly variable based upon specific location. As the GAO has explained, ‘‘Retail gasoline prices can vary from one region of the United States to another, between and within states and cities, and even within neighborhoods.’’9 Proximity to refineries, regulation by all levels of government, and competition in local markets all combine to have significant impacts on retail prices in ways that cannot be controlled by refiners. Most retail outlets are operated by independent business people. They set their retail price.


One of the most important variables related to retail gasoline prices are taxes imposed by federal, state and in some cases, local governments. The GAO has reported that ‘‘differences in gasoline taxes help explain why gasoline prices vary from place to place in the United States.’’

The market for non-gasoline products

Refineries cannot produce only gasoline and diesel. The refining process results in a significant portion of each barrel of crude oil becoming products other than transportation fuels.11

The actual yield of refined products depends on refinery processes and type of crude processed. The production and marketing of these products, which typically sell at a gross margin loss compared with the price of crude oil, has to be offset by the sales of profitable products. While low-cost natural gas has benefited refiners operating and feedstock cost, it has also resulted in lower margins on natural gas liquids and petrochemical feedstocks that the refinery produces. However, the net benefit is positive.

Most importantly, as U.S. gasoline demand declined from 2007 and as the renewable fuels mandate volumes increase, some U.S. refiners—those that are large merchants and wholesale, spot sellers—find themselves in an unintended predicament of either reducing gasoline production, exporting more gasoline at discounted prices, or buying renewable fuel credits (RINs), which soon may not even be available because the market is going infeasible. If the option of buying RINs doesn’t exist because none are available or because of very high pricing, the domestic supply will be reduced. It’s hard to believe that when Congress passed the Energy Independence and Security Act of 2007, a possible outcome was to reduce U.S. gasoline supplies and increase gasoline prices. However, as a refiner and an ethanol producer, that is exactly the potential outcome we find ourselves in today. No one expects that U.S. gasoline demand will rebound strongly and to begin to grow again, and there are physical constraints on using higher blends of ethanol in gasoline including the lack of car warranties to approve those blends. As a result, there simply aren’t enough gallons of gasoline in which to put all of the required gallons of ethanol— and that has driven the price of corn ethanol RINs from $0.05 in late 2012 to as high as $1.16 recently. Also, there is no cellulosic ethanol and advanced ethanol has to be imported.

At Valero alone, we anticipate cost increases of some $500 to $750 million this year just as a result of volatility in the market for RINs. Unfortunately, this cost will not add one more gallon of fuel into the market. It is nothing more than a federally mandated cost to each gallon of transportation fuel that may be passed on to the consumer. At the outset of the RFS, EPA found in its regulatory preamble that RIN’s cost would be negligible. This estimate has turned out to be profoundly incorrect as the program approaches an infeasible situation, expected in 2014.

Some have suggested, including the EPA, that the refining sector should move the percentage of ethanol blended from 10 percent to as high as 15 percent, a blend called E-15. While Valero supports ethanol and is a leading producer, experts have repeatedly noted that the E-15 blend is not warranted for use by 95 percent of cars on the road today. E-15 reduces engine life and prompts fuel pump failures and consumer misfuelings. American Automobile Association (AAA) even called on EPA ‘‘to suspend the sale of E-15 until motorists are better protected.’’24 There are also issues with boats, lawn mowers, motorcycles and other small engines. Greater reliance on higher ethanol blends is not the way to go, and would likely undermine consumer confidence in alternative fuels. Plus, we must all consider the effect corn ethanol in fuel has had on world food prices.

Implications of Outages

Some observers, particularly in the West, have questioned the role of refinery outages in consumer prices. For environmental and safety reasons, it is necessary every few years to shut down an operating unit for a ‘‘turnaround.’’ Generally, turnarounds are scheduled for low demand seasons with weather considered for efficient turnaround execution. Supply arrangements are made to cover for lost production, and there is currently surplus refining capacity in the United States. But unforeseen problems can complicate even the best plans, resulting in localized supply concerns. Clearly, as refineries have become larger, unplanned outages because of mechanical problems have caused increased priced volatility seen by the consumer. The Federal Trade Commission has monitored the petroleum industry for years, including during the aftermath of Hurricane Katrina, for possible collusion and market manipulation. They found: no evidence to suggest that refiners manipulated prices through any of these means. Instead, the evidence indicated that refiners responded to market prices by trying to produce as much higher-valued products as possible, taking into account crude oil costs and physical characteristics. The evidence also indicated that refiners did not reject profitable capacity expansion opportunities in order to raise prices.26 The bottom line is that refiners take measures to limit the effect of unit outages on inventory and supply. These include increased production of alternate units, continued production from partially shut down units, import of alternate supply, and stockpiling of inventory leading up to a turnaround or outage. These steps are crucial to avoiding a major disruption in supply from a single outage. When there are regional shortages caused by hurricanes or other factors affecting refinery production, one area where regulators can help is by quickly providing Jones Act waivers that would increase the number of available ships, so that fuel supplies can quickly be moved from unaffected parts of the country.

Bradley Olson. Drivers risk $13B gas-price hike as ethanol charge grows. Bloomberg. March 19, 2013. http:// 24 See AAA CEO Urges Suspension of E15 Gasoline Sales in Testimony to Congress, AAA Public Relations. February 26, 2013. e15-gasoline-sales-in-testimonyto- congress/

There has been much written and said about E15, but you need to know that E15 cannot meaningfully help solve the blend wall problem in the short term. We estimate there are 700,000 gasoline dispensers in use in the U.S. and only 5,000 have been approved for E15, and I’m only talking dispensers. There are also underground tanks and underground lines that have not been approved for E15. It will require many years and lots of money to upgrade 160,000 gas stations to handle E15; one estimate I saw was $3 billion.

A few months ago, a major investment bank on Wall Street predicted ethanol RINs will go to $3 next year, and that will likely significantly increase gasoline prices over what they would normally be. We are urging the EPA administrator to adjust the ethanol mandate as needed to ease potential economic harm.

In April 2007, several refineries in the Midwest, all serving the same region, were closed for maintenance. The price shocks in Minnesota, South Dakota and North Dakota were so severe, Senator Dorgan authored an amendment to the 2007 energy bill for EIA to have a coordinator to improve communications. It is now 6 years later and Congress has not appropriated funds for that position. Ironically, just 2 months ago, the same region was hit with a similar situation. For most of May, motorists in North Dakota, South Dakota, Minnesota paid 40 to 80 cents a gallon more as a result of the refinery problems. We hope you will support funding.

Last, I have to mention credit card fees. Interchange fees imposed on gas stations is not a cents per gallon charge, but a percentage of the total. When Minnesotans were paying $4.50 a gallon in May, if they were using their Visa credit card, they were likely paying 11 cents a gallon to Visa. Now the Federal gasoline tax is 18.4 cents, but you’ve got to build and maintain roads with that. Visa gets 11 cents a gallon for what? To make matters worse, Visa charges interchange fees on Federal excise taxes, so they get a cut on that as well. We continually believe credit card fees need to be addressed.

Mr. Gilligan, President of Petroleum Marketers Association.

PMAA is a federation of 48 state and regional trade associations representing more than 8000 petroleum marketing companies nationwide, the majority of which are small businesses as defined by SBA. These companies are very diverse but all have one thing in common, they all bring to market liquid fuels such as gasoline, diesel, heating oil, ethanol, biodiesel, jet fuel and kerosene. Our member companies are engaged in the transport, storage and sale of petroleum products on both the wholesale and retail levels. They supply gasoline to convenience stores, diesel to truck stops, lubricants to industry and heating oil to millions of customers. Not only are these companies primary suppliers of fuels they also own and/or operate over 80,000 retail facilities in the U.S. They also are often specialists serving farmers, railroads, marinas and airports with the fuels they need.

Over the past 12 years, the major integrated oil companies have dramatically reduced their direct retail operations and have sold those businesses to petroleum marketing companies. Of the 160,000 U.S. retail gasoline locations, over 94 percent are now owned by independent businesses. When I joined PMAA in 1998, 70 percent of the Shell stations in the U.S were owned by Shell. Today nearly all Shell stations are owned by independent petroleum marketing companies.

Petroleum marketing companies do not benefit from high gasoline or diesel prices. Because they operate in such a transparently competitive environment, higher wholesale prices must be absorbed by retailers until street prices catch up. Thus, rising gasoline prices not only burden motorists, but petroleum marketers as well. In order to remain competitive, retailers usually offer the lowest price for gasoline to generate volumes sold and customer traffic inside the convenience store. When gasoline prices are unusually high, customers often reduce their purchases of convenience items. Additionally when prices are high, some retailers struggle with credit line limits.

Another factor most PMAA member companies have in common is most are ‘‘rack buyers’’. In the industry, wholesale product is loaded at ‘‘terminal racks’’ and there are approximately 1200 terminals in the U.S. Access to the terminal racks is quite restricted. Companies permitted to load product at terminals must have a plethora of state, local and federal licenses and permits. Also, they must have credit terms with refiners which is crucial for trade to function.

Because PMAA member companies are ‘‘rack buyers’’, I will focus most of my testimony on what factors influence wholesale rack prices and how they impact petroleum marketers and consumers.

The Price of Crude Oil is the primary driver of wholesale gasoline and diesel prices accounting for 67 percent of the price per gallon in May 2013. A recent phenomenon in the oil markets is the price spread between the Brent crude oil contract and the light sweet WTI crude oil contract. Historically, the West Texas Intermediate (WTI) contract was the dominate price benchmark for the world, but since 2011, the North Sea Brent crude oil contract has taken over as the dominate benchmark. The sweeter, light crude WTI oil contract delivered in Cushing, Oklahoma was $2—$3 higher compared to the Brent contact and now it’s common to see the Brent contract price $10—$20 above the WTI contract, although, in recent days that spread has narrowed to less than $5. Because Bakken and Eagle Ford oil shale developments are delivered to Cushing, Oklahoma, they put downward price pressure on the WTI contract, but only have a modest impact on the world’s oil prices because the WTI crude oil is landlocked and doesn’t have an outlet to the world oil market. However, this doesn’t take away from the fact that the U.S. must continue to pursue domestic oil production to prevent future oil price shocks and limit OPEC’s power to dictate price.

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