Are Refiners Boosting The Pain At The Pump?

They're reluctant to increase production lest profits take a hit

Gasoline prices are near all-time highs even though the peak summer driving season is months away. The national average for regular gasoline was $1.72 a gallon in mid-March -- an 18% hike in just three months. In Los Angeles and San Francisco, the average price was around $2.15, and super went for a supercharged $2.35. Nor is the worst over: On Mar. 17, the Energy Dept. announced that inventories of gasoline had dropped again -- the seventh time in the last eight weeks. That raises the likelihood that prices will go up another dime or so in coming weeks.

What's going on? With global supplies of crude tight and OPEC increasingly willing to flex its muscles, the dominant factor in high gasoline prices is, of course, $38-a-barrel oil. That's where oil prices stood on Mar. 17 -- the highest since Oct. 16, 1990, prior to the Gulf War. But there's another factor: the dysfunctional U.S. refining industry, in which the slightest disturbance sends prices through the roof.

After years of skimpy investment, refineries are chronically overtaxed, running at better than 90% of capacity on average. And differing environmental regulations can make it impossible for refiners in one region to relieve shortages in neighboring areas. Even oil industry honchos say something is wrong. Notes Exxon Mobil Corp. (XOM ) Chairman and CEO Lee R. Raymond: "There are fewer and fewer degrees of flexibility in the system."

Refiners are running near capacity because they have little incentive to build more. For starters, they make more money when supplies are tight. Refining profit margins in the last week of February were $6.74 a barrel, vs. a five-year average of $4, according to data collected by UBS. In California, where refiners have a long history of high profit margins, the late-February refining margin was $13.78 a barrel. That's double the five-year average of $6.76, UBS says, though margins have since come down.

Refining is hardly a model of pure competition. A merger wave has left ownership highly concentrated, and the big players know that any large increase in their output would push down prices and shrink profits. According to an analysis of corporate filings by Public Citizen's Energy Program, a liberal research group, the top five refiners controlled 51% of domestic capacity last year, while the top 10 controlled 77%. That's a sharp increase from 10 years earlier, when the top five had just 33% and the top 10 had 54%.


Even if refiners were eager to build plants, they would face daunting costs -- more than $2 billion per plant, partly the result of strict pollution controls. Then there's the inevitable not-in-my-backyard opposition. After all, refineries are smelly and ugly. Moreover, lots can go wrong. Houston entrepreneur John R. Stanley spent the 1990s trying to modernize a shuttered Louisiana refinery. Cost overruns and operational snafus racked up more than $1 billion in debt before the business entered bankruptcy in 1999. San Antonio-based Valero Energy Corp. (VLO ) bought the refinery last year for $500 million. That, it figures, is just 20% of the total that had been invested in the plant.

Valero is typical in its preference for growth through acquisition of existing refineries, rather than breaking ground for new ones. "We don't have any plans to build a grassroots refinery," says William E. Greehey, the chairman and CEO. To the extent that the industry has boosted capacity, it has come instead through "creep" -- lingo for adding to existing plants. Overall, refining capacity has risen just 8% inside the U.S. since 1996, vs. 13% outside the U.S., according to data compiled by Oil & Gas Journal and brokerage Friedman, Billings, Ramsey & Co. (FBR )

Another reason for the capacity squeeze: The industry is also closing smaller plants. Shell Oil Co. plans to shut one in Bakersfield, Calif., on Oct. 1, even though the state has some of the country's worst supply problems. Shell, which didn't try to find a buyer for the refinery, says not enough oil is available locally to keep it supplied. But in a letter to the Federal Trade Commission, Senator Ron Wyden (D-Ore.) questions that explanation and asks whether the closure will "cause further anticompetitive problems in West Coast gasoline markets, such as raising prices or restricting supply."

Wyden isn't the only lawmaker on the refiners' case. A 400-page report in 2002 by the staff of the Senate's Permanent Subcommittee on Investigations, then chaired by Democrat Carl Levin of Michigan, uncovered several internal memos in which oil-industry execs advocated measures to hold back refinery output to keep gas prices high. That report trumpeted an earlier FTC analysis showing that, according to one method of calculating market concentration, 28 states had "tight oligopolies" in 2000, up from 14 in 1994.

Refining execs argue their business is competitive. But the fact is, the main relief for consumers in recent years has come from imported gasoline, which accounts for around 10% of domestic supply. That's double the 5% of a decade ago. Trouble is, relief isn't instant. With the exception of neighboring Canada, foreign refiners take longer than domestic ones to step up deliveries when supply falls. Earlier this year, in fact, imports actually fell from the level of a year earlier -- possibly because foreign refiners needed time to comply with new federal low-sulfur standards. And some imports come from unreliable sources such as Venezuela.

In contrast with the debate over the industry's structure, there's near unanimity that differing regional blends of gasoline contribute to higher prices by making it harder for refineries to ship gasoline to hard-up regions with incompatible formulations. Many analysts are worried about the possibility of a big price spike in New York and Connecticut because those states began using ethanol as an oxygenate additive this year. June is the deadline for starting to sell the summer blend, which must not evaporate and pollute the air when pumped on hot summer days. Prices could rise 30 cents to 40 cents per gallon if there's a shortage, the Energy Dept. concluded last year.

That's the kind of thing that can happen when an industry is overstretched. Yet as little momentum exists for standardizing environmental regulations as there is for boosting refining capacity. That may be great news for the refinery industry. But U.S. drivers are going to have to get used to those wild upward price swings.

By Peter Coy in New York, with Stephanie Anderson Forest in Dallas and Christopher Palmeri in Los Angeles

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