California: A case study on overbuilding capacity

March 15, 1999
An ideal case study on the refining industry's compulsion to overbuild can be gleaned from the CARB (California Air Resources Board) gasoline saga of the early 1990s. All of the major drivers of overbuilding played a hand (see related story, p. 17): from incremental-barrel economics to overly optimistic margin forecasts; from dreams of future inadequate supply to the fear of being left out and losing control.

An ideal case study on the refining industry's compulsion to overbuild can be gleaned from the CARB (California Air Resources Board) gasoline saga of the early 1990s.

All of the major drivers of overbuilding played a hand (see related story, p. 17): from incremental-barrel economics to overly optimistic margin forecasts; from dreams of future inadequate supply to the fear of being left out and losing control.

Background

When California authorities mandated a new formulation for gasoline, they started a free-for-all in the refining industry. Forecasts predicted that refiners would not be able to afford the investments necessary to fund plant upgrades, leaving the state without enough CARB-specification gasoline to meet demand.

The margin differential between conventional gas and the new CARB formulation was predicted to be substantial, perhaps as high as 15¢/gal. The hefty margins were based on higher production costs of 3-10¢/gal (additional operating costs, Reid vapor pressure reduction costs, methyl tertiary butyl ether and

alkylate costs, etc.) and import transportation costs of 6-8¢/gal. All told, a return on capital of 5-10¢/gal was forecast by industry analysts.

A second "California gold rush" quickly ensued, with California refiners using the margin forecasts to justify heavy investments in new and upgraded plants to make the new gasoline.

The building craze resulted in overcapacity-not only did the refiners invest to produce the necessary CARB gasoline, but nearly every refiner that pursued CARB improvements also used the occasion to increase capacity for total gasoline production.

So much extra capacity was added that the margin between conventional and CARB gasoline never came close to the forecast levels (except for a very brief time as the market adjusted to the new specifications).

Inadequate returns

During 1997-98, the spot pipeline price differential between conventional and CARB gasoline in Los Angeles averaged about 4¢/gal-hardly enough to return the millions of dollars of capital invested in CARB-provoked plant
upgrades.

Interestingly, a handful of California refiners clearly did not believe the margin forecasts, but elected to invest in new CARB gasoline capacity, anyway. Their rationale seemed to be that, if their competitors were getting on the CARB gasoline bandwagon, then they could not risk being left behind.

Most of these refiners had retail operations in California and would need CARB gasoline after new regulations took effect in spring 1996.

Long-term agreements could have guaranteed a steady supply of CARB gasoline to their retail outlets, but setting these agreements up several years in advance constituted a substantial gamble. Imagine negotiating such a contract when margins of 15¢/gal were being used to justify plant upgrades and expansions.

In the end, refiners were caught in a squeeze that made capacity upgrades look like the smart course. If margins ended up high, capital investments to produce CARB gasoline would pay off. If margins ended up low, no one wanted to be locked into a high-cost supply agreement.

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