Switch to clean fuel could pump up prices
The oil refining industry is keenly aware of how expensive it is to curb air pollution.
Consumers are about to find out.
A nationwide transition to cleaner gasoline that begins in 2004 is expected to cause modest supply constraints that could trigger sporadic price increases at the pump. So while refiners must spend billions to comply with the strict federal low-sulfur standards for gasoline and diesel, executives and analysts believe the upcoming switch -- lauded by environmentalists -- might actually boost industry profits.
"A significant portion of these costs may ultimately be passed along to the end consumers through higher prices," Brian Caviness, a Chicago-based analyst for Fitch Ratings, said in a recent report. Caviness said he expects "U.S. refiners to ultimately benefit from the increasingly stringent regulations as refined product supply is removed from the market."
How will that happen?
Taken together, these changes could disrupt supplies enough to create "spikes in prices, rather than customers not being able to get the product," said Christine Stackpole, an associate director at Cambridge Energy Research Associates in Cambridge, Mass.
To be sure, there is no expectation of gasoline shortages or a prolonged runup in prices once the low-sulfur rules go into effect.
Yet coupled with other industry trends, such as the emphasis on minimizing storage levels and the difficulty refiners already are having making summer-grade gasoline, executives and analysts say the shift will exacerbate existing supply tightness and price volatility.
Gene Edwards, senior vice president of supply and trading at San Antonio-based Valero Energy Corp., said the shift to cleaner fuel could result in a supply deficit of "a couple hundred thousand barrels per day next year." While roughly 9 million barrels a day of gasoline are consumed in the United States, Edwards noted "it's the last 100,000 barrels per day that sets the price."
Not everyone is as confident there will be a supply deficit. Some analysts believe regularly occurring refinery expansions will make up for supply lost to desulfurization, refinery shutdowns and reduced imports. Any remaining supply shortfall will be cured by market forces.
Cal Hodge, a former Valero executive who runs a Houston-based consultancy specializing in clean fuel issues, said the new low-sulfur rules are "not that big of a problem."
"If the prices get out of whack in one place, it won't be long until product starts coming in," he said.
Other analysts, meanwhile, are concerned about refiners' balance sheets as spending on new, low-sulfur equipment accelerates in the years ahead.
John Thieroff, a director at New York-based debt-rating agency Standard & Poor's, said cost estimates for low-sulfur equipment have crept higher and that "the whole sector is coming off a very bad year" because high oil prices squeezing profit margins.
From an environmental standpoint, the new rules are considered a major step toward reducing air pollution. Lowering the sulfur content in gasoline and diesel is critical to making pollution-control technology in cars, buses and trucks much more effective at reducing smog-causing emissions.
Richard Kassel, a senior attorney at the Natural Resources Defense Council in New York, called the regulations, adopted several years ago under the auspices of the Clean Air Act, "arguably the most important step toward cleaner vehicles since lead was taken out of gasoline."
The EPA estimates the new low-sulfur gasoline and diesel standards, when fully implemented, will prevent nearly 12,500 premature deaths from respiratory and cardiovascular illness, as well as 6,000 cases of bronchitis each year.
With the exception of seven Western states and about 10 small refineries that have been granted extra time to comply, the industry must cut the average sulfur content in gasoline nationwide to 120 parts per million in 2004, with a final goal of just 30 parts per million by 2006. The average sulfur content in today's gasoline is about 270 million parts per million.
The new rules also mandate a 97 percent reduction in the sulfur content of most diesel fuel used in buses and trucks. By mid-2006, the maximum allowable sulfur content for 80 percent of "on-road" diesel will drop to 15 parts per million, down from 500 parts per million today. The remaining 20 percent must comply by mid-2010.
Refiners typically remove sulfur from gasoline through a process known as hydrotreating. By adding hydrogen and heat to finished motor fuel, the sulfur can be pulled out as hydrogen sulfide. Refiners then isolate the sulfur and sell it to fertilizer manufacturers.
The purchase of new hydrotreating units and other refinery modifications will cost the industry more than $10 billion, according to Fitch Ratings. With new units costing as much as $75 million apiece, some of the nation's smallest refineries will be reluctant to make the investment, according to Fitch.
Premcor Inc., a refiner based in Old Greenwich, Conn., that is trying to strengthen its balance sheet, cited low-sulfur requirements as the reason for ceasing operations at two facilities -- one in Illinois, one in Connecticut -- that produced a combined 145,000 barrels of gasoline per day. And Crown Central Petroleum Corp. of Baltimore has been trying for several years to sell two Texas refineries with combined production capacity of 152,000 barrels a day.
"There's a number of them on the endangered species list," said Jim Taylor, senior vice president of manufacturing at Tesoro Petroleum, a San Antonio-based refinery.
Even Valero, whose Tier 2-related expenses could approach $1 billion, said that it might not upgrade all its facilities.