Refining survivors of regulatory juggernaut to enjoy strong market

There is a rough row to hoe coming up for US refiners on the environmental regulatory front, but the survivors likely will enjoy the benefits of a tighter market-namely higher margins.

Another wave of big changes in transportation fuel specifications is coming in the US. While US refiners have been scrambling to keep their their heads above water in the dismal swamp that was 1998-99, the US Environmental Protection Agency has been busy as beavers erecting a new dam of regulatory barriers to producing economic gasoline and diesel.

Water-logged metaphors aside, the US Department of Energy estimates that the compliance costs for EPA's latest flurry of regulations meant to improve the environmental quality of just gasoline alone will total as much as $8 billion.

Essentially, EPA wants to require the entire US to adopt gasoline specs along the lines of California's brutally draconian CARB (California Air Resources Board) II specs. Among these changes is a proposed rule to slash sulfur content in gasoline to only 30 ppm from the current average of more than 300 ppm.

In a typical game of regulatory oneupsmanship, CARB now wants to up the ante by tightening sulfur standards even more, reducing sulfur levels in gasoline to 15 ppm by January 2003. And EPA now wants to cut the level of sulfur in diesel fuels to 15 ppm from the current level of more than 500 ppm by 2006. The American Petroleum Institute reckons that these rules could cost the US refining industry another $10-12 billion.

Meanwhile, Canada is getting into the act was well. Ottawa is looking at cutting sulfur levels in two stages: to 150 ppm by May 2002 and to 30 ppm by January 2005.

All of this is playing out against the backdrop of a continuing controversy over methyl tertiary butyl ether and the Clean Air Act Amendments' 2.1 wt % mandate for oxygen levels in gasoline. Falling victim to the latest Chicken Little trend is MTBE, long the favored oxygenate among refiners for economic and performance reasons. But the occasional occurrence of the smelly-but nontoxic-stuff in groundwater has led to a hue and cry for its removal from the fuel supply in California by 2003. Other states are joining the bandwagon and pressing EPA to drop the CAAA oxygenate rule. But EPA instead wants to phase out MTBE and replace it with an ethanol requirement. This will cost refiners yet another $2.4 billion for ethanol production capacity-not to mention almost $1 billion/year in taxpayer subsidies for ethanol.-that does not include added outlays for new pipelines and tankage for ethanol.

Capacity affected

All of this adds up to a growing pressure on US refining capacity. There is ample precedent for this view: The ramp-up to CARB fuels during 1990-96 in California cost refiners there $4 billion-and that includes sulfur levels cut just to 30 ppm; the drop to 15 ppm will probably be much more expensive, given the usual pattern of striving for zero-effect emissions levels. It also resulted in the closure of nine refineries in the state (Is it any wonder that California has by far the most expensive fuels in North America?).

It is a certainty that some refiners will not be able to keep their plants running if they have to justify such enormous investments in such a slim-margin business. So even as demand for refined products continues to climb, US refining capacity creep-the small incremental capacity increases that result from debottlenecking and upgrading that calls for replacement of less-efficient units-will fail to keep up, because it will be more than offset by the closure of a number of refineries that will be inevitable under the tightening regulatory regime.

Merrill Lynch sees some price spikes caused by environmental regulatory changes as soon as this summer. With the second phase of reformulated gasoline specs (RFG 2) being implemented this year-with its drop to 150 ppm in sulfur especially tough for summer-grade gasoline-the analyst contends that there will be a shortfall in RFG gasoline. Estimates are that this shortfall could be anywhere from 36,000 b/d to 150,000 b/d. This represents 2% of the RFG market outside of California.

As bad as RFG 2 is, CAAA Tier 2 will be even worse.

Merrill Lynch said, "A similar impact could result as the industry is required to produce gasoline with sulfur limits of 30 ppm, for Tier 2. Implementation is envisioned by the EPA is the 2004-06 timeframe, and we expect this summer will provide an intriguing preview of what that process will mean for markets and consumers."

And then there are the new proposed diesel sulfur limits, which could cost even more than the gasoline sulfur changes. Coming on top of the gasoline sulfur changes, it is likely that many refiners-especially the independents-will not have the cash available to undertake both programs.

Regarding oxygenates, ethanol is anything but a cure-all replacement for MTBE, even irrespective of its lousy economics. It does not have the blending flexibility that MTBE has, and, absent a reasonably protracted phase-down period for MTBE (or all oxygenates), the loss of MTBE will mean a sizeable volume of the gasoline pool removed.

As was the case in California, a number of smaller refineries-even with their various exemptions and special considerations delaying the inevitable-are likely to be shuttered in the wake of this regulatory juggernaut.

For consumers, the upshot will be cleaner fuels but at a hefty price at the pump. And with EPA in effect axing some of the competition, the bigger and more-modern, more efficient refineries (not to mention those with sweetheart equity-for-crude supply deals with foreign crude exporters) will be able to enjoy the strong margins that come with higher refined product prices and reduced domestic supply.

I guess Al Gore may eventually have his wish of outlawing the internal combusion engine, anyway; if this keeps up, no one will be able to afford gasoline or diesel, and if they could, engines probably won't be able to run on what eventually is extruded from this regulatory press. Anyone who owns, as I do, a vintage auto designed to run on leaded fuel can attest that it has never run the same since lead was phased out of US gasoline.

So refiners need to make hay while the sun shines. At the rate the Clinton administration is going, they may soon go the way of the buggy whip manufacturers.