London, 23 February 2010

US refiners have emerged as the biggest losers from the previous surge in oil and push for cleaner energy. The industry's brief golden age has swiftly given way to a prolonged dark period of adjustment and decline.

What went wrong? Like other sectors, refiners have been hit by the cyclical downturn, which has cut trade volumes and the related demand for transport fuels such as aviation fuel and marine diesel especially hard.

But cyclical factors are compounding a structural decline in consumption that began around 2007 and has continued through the recession, as high prices and legislative responses force greater conservation and a shift towards biofuels.

Even as the economy recovers, U.S. consumption of petroleum- derived gasoline and distillate fuels is unlikely to exceed the record set in 2007. The resulting "demand peak" has left up to 10 percent of total U.S. refining capacity (around 1.8 million barrels per day) surplus to requirements.

Falling Utilisation Rates

No new refineries have been built on greenfield sites since the 1970s because permitting regulations are so strict. But there has been substantial brownfield growth at existing sites as well as increases in potential throughput as a result of debottlenecking and improvements in operations and maintenance.

In fact US refiners have added 1.3 million barrels per day (bpd) of crude processing capacity since 1999 (an increase of 8.4 percent), according to the Energy Information Administration ( EIA), the statistical arm of the U.S. Department of Energy. Much of that investment was predicated on strong growth in gasoline demand that now appears unlikely ever to be realised.

Refinery utilisation rates peaked at 95-100 percent of theoretical capacity just before the turn of the century (a level that was almost certainly unsustainable) and have been trending lower for ten years (Chart 5). But in the past 24 months, operating rates have fallen to as little as 80-90 percent. Extended turnarounds can no longer disguise the fact the industry's capacity base is far too high.

Entrenched Conservation

In 2005-2008, rising prices enforced conservation mostly through market mechanisms, encouraging consumers to cut back on discretionary driving and buy smaller, lighter and more fuel efficient vehicles. But those price responses have now been entrenched in legislation. So the drive for fuel conservation will continue in the next few years even if oil prices stabilise. While market processes can be reversed, legislative responses are much stickier and harder to modify.

The most powerful thrust is coming from ethanol mandates enacted by the Energy Policy Act 2005 (EPACT) and the Energy Independence and Security Act 2007 (EISA). Both laws are progressively tilting the market away from gasoline towards biofuels derived from corn starch and cellulosic feedstock.

The total volume of motor gasoline supplied to the domestic market has held up relatively strongly despite the recession, and is down just 3 percent (293,000 bpd) compared with 2007. But the crude component has fallen twice as fast, by 6.5 percent (580,000 bpd), as the industry is forced to blend in a steadily rising proportion of ethanol into the gasoline supply..

As the authors of the legislation intended, refineries are being displaced by corn fields, in a bid to cut oil imports and somehow improve "energy independence". But the resulting shift in the energy base has left the country with redundant refining capacity.

The price spike's other legacy is the shift towards more fuel-efficient vehicles. After the deepest downturn on record, the number of car journeys has started to recover. But those journeys are increasingly made in vehicles that burn fewer gallons of gasoline per mile.

Despite a small wobble at the height of the fuel crisis in 2008, the trend to larger, heavier and more powerful vehicles has continued. But engine efficiency is improving significantly.

Fuel economy has improved 6 percent in just four years, according to the Environmental Protection Agency.

Economy is set to improve even more quickly in the years ahead. EISA has already stiffened the corporate average fuel economy (CAFE) standard motor manufacturers must meet for all new automobiles. CAFE is set to rise from the current level of 27.5 miles per gallon (mpg) (for passenger cars) and 23.1 mpg (for light trucks) to an average of 35 mpg by 2020. Regulations proposed by the administration would accelerate the process, requiring auto manufacturers to achieve average economy of 35.5 mpg by 2016.

Export or Close

Caught between an economy mandate that will reduce gasoline use significantly, and a blending requirement that displaces crude-derived fuel in favour of ethanol, many refineries will never operate near their full capacity again.

The industry has responded by cutting gasoline imports from Europe and exporting increasing volumes of surplus gasoline and distillate fuels, especially to Mexico, Central and South America. Combined gasoline and diesel exports have doubled from less than 10 million barrels per month in 2004 and 2005 to more than 20 million barrels per month in 2009.

But export markets are not large enough to absorb all the excess refining capacity created by a shrinking domestic market. Besides U.S. refiners struggle to compete with the much cheaper refineries being built in Asia. The only option is to sell or close surplus refineries. But since the industry's problems are structural rather than cyclical, no buyers have emerged. Refiners have begun the painful process of shuttering or dismantling facilities.

Valero closed its 185,000 bpd Delaware City refinery permanently in November 2009. Sunoco announced earlier this month it was permanently closing another 145,000 bpd of capacity at Eagle Point in New Jersey. Two smaller refineries in the western United States have been idled or permanently shut down. More closures seem inevitable over the next 12 months as the industry shrinks itself for a smaller future.

Problems are not confined to North America. As the United States imports less gasoline, European refiners are seeing their own export market shrink, and coming under pressure to rationalise. The strike paralysing six of Total's European refineries today is simply another manifestation of excess refining capacity across the whole of the North Atlantic area.

Plant closures and job losses are the price oil companies and their employees are paying to realise western governments' biofuels and energy independence objectives.

Ends --

EIA Weekly Petroleum Status Report (WPSR):

http://graphics.thomsonreuters.com/ce-insight/EIA-INVENTORIES.pdf

By John Kemp, Reuters columnist ... for Commodities Now

The views expressed are his own.