The Flip Side of Energy Reform: Destroying Oil Demand

On Monday the Wall Street Journal ran an article that described the end of the golden era for oil refiners. It is a great article that, unfortunately, was published many years too late to be considered news. Just as gravity is a force that brings all objects to earth, public policy that destroys the demand for gasoline will hurt the refinery business. Not surprisingly, President Obama’s public policy initiatives that increase car and truck fuel efficiency have the side effect of hurting oil refinery and distribution businesses.

Just to be clear, I am not against the Administration’s effort to increase fuel efficiency in the vehicle fleet. Quite the contrary, it is a matter of national and economic security that we burn less imported fuel. Increasing transportation fuel efficiency is a “must” for the United States. However, I don’t think that it is realistic to believe that the energy industry will act like an old trusted dog that knows when it it time to walk into the woods and die. And it isn’t fair to the refinery and distribution businesses to ask them to effectively subsidize the rest of the economy’s shift to more fuel efficient vehicles and alternate energy without compensation.

The Wall Street Journal reported that over the next few years there is going to be global overcapacity among oil refiners. Not only is demand being reduced for refined products (particularly in the U.S.), but there is a lot of new and efficient capacity that is coming on line in Asia and the Middle East. That isn’t a prescription for a lot of new investment in refinery capacity or for good returns for existing refiners.

I have a couple of news flashes about the future of oil refinery and distribution that I am pretty sure are big news scoops (at least for most major media outlets).

1. As gasoline demand drops refineries won’t be the only businesses whose investments are underperforming. There is also going to be a lot of excess distribution and retailing capacity. So far the Wall Street Journal has only reported on excess refinery capacity. Distribution and retailing are the next segments of the industry that will experience overcapacity and the end of the “golden era” (to the extent that there ever was a golden era). That means that the U.S. will have too many tank farms, too many truckers that move refined products and too many gas stations that sell gasoline and diesel to consumers.
2. The oil refinery and distribution industry isn’t going to take an assault on its ability to earn profits sitting down. It is going to hold back on maintenance spending until U.S. refinery and distribution capacity declines and margins are restored. Restoring margins means that prices will rise. There will be a public backlash against the oil companies for earning too much money and maybe even worthless Congressional hearings where senior industry officials are publically flogged. If there are hearings, someone who claims to be smart, but really isn’t, will get on TV and announce that no new refineries have been built in the U.S. in more than 30 years and that this is another example of the U.S. losing its global economic leadership. Of course, no one will point out that official government policy on fuel efficiency has the nasty side effect of destroying the industry, that the policy is working and only an idiot would build a new oil refinery. Sound familiar? It reminds me of the summer of 2007 and the hysteria that took place in the media and Congress when refinery capacity was tight.

Overcapacity and falling margins reported by the Wall Street Journal on Monday were easily predictable. In fact, I knew that they were predictable because in December 2008 I predicted that oil refiners would face overcapacity and falling margins. Back in December I wrote two articles on energy policy which can be viewed here and here.

From Three Inconvenient Energy Truths

…while everyone agrees that cars need to get better gas mileage, virtually no one has thought about what happens to the people and companies that make and distribute gas for us to use. Better gas mileage has a side effect of hurting the refiners, transporters, wholesalers and retailers of gasoline. Better gas mileage destroys demand for gasoline and will create lower prices and over capacity. It isn’t surprising that vested interests in the oil industry are quiet but effective opponents of energy policy proposals. After all, how many industry leaders support federal initiatives that are the equivalent of economic suicide?

Of course, for every action there is an equal or greater reaction, and the refinery and distribution story doesn’t end with demand destruction and stranded capacity and investment.

…Even worse, it will take years for the U.S. to achieve energy independence. We will need new investment to preserve existing infrastructure. For example, oil refineries need constant investment to operate. During the summer, with great fanfare, the media announced that it had been more than 30 years since the last new domestic oil refinery was built. Politicians acted like it was a national crime when the refinery industry was caught short of capacity. But what rational investor would put money into a new oil refinery knowing that it is U.S. policy to reduce demand for their products and create overcapacity? And, for that matter, why should Saudi Arabia invest in production capacity to serve American demand if our stated goal is to leave their infrastructure stranded without its best customer?

The concerns of existing energy producers are legitimate and need to be addressed. If Obama’s energy policy forgets to take care of incumbent energy interests it will fail. Energy policy needs to make sure that investments in property, plant and equipment that are rendered obsolete or made uneconomic because of overcapacity are paid for through their useful economic lives.

The Administration means well but needs to get rid of its simplistic approach to energy policy which ignores how to transition the U.S. from a position of energy dependence to one of energy independence. If the Administration continues on its current policy path the industry will cut capacity until margins are restored. It will seem like the oil industry is holding the nation hostage to high prices while in fact they will just be acting logically and predictably.

It is naïve to believe that Big Oil will merely stand by and watch hundreds of billions of dollars of investment that is needed to support the rest of the economy get flushed down the drain before the end of its economic life and without compensation. We need oil refiners, distributors and retailers to maintain the current infrastructure for the foreseeable future and willingly engineer a smooth transition to a different energy paradigm. If energy policy keeps on ignoring this inconvenient truth the shift will be very expensive and extremely rocky.

The problems of demand destruction, stranded investment and transition economics were taught to me in my Energy Economics 101 class 29 years ago. It is just too bad the Administration officials didn’t take the class.

Comments

[Giulio Negrini:]

As my personal strategy I am promoting direct investments in the oil and gas industry to help the transition to different energy sources.
I think I am the only one that understand the real situation I hope that more investors follow me.
negrinioil.net

Oct 21 02:16 PM

[PastTense:]

I disagree with the comments as it applies to gas stations: small, fuel efficient cars means a driver buys less gas when he goes to the gas station, not that he makes a lot fewer visits to gas stations. And at gas stations, gasoline sales are basically a loss-leader or break-even proposition--gas stations make their profits selling beer, cigarettes, and convenience store items.

Oct 21 05:38 PM

[THofler:]

A 1979 Honda Civic got 55 mpg highway, and a new 2009 Civic gets 34 mpg highway. Don't buy the spin on increasing fuel efficiency.

Even the excellent mileage of a Prius is really pathetic when the really sophisticated technology is considered. There are plenty of little diesels in Europe with comparable mileage to the Prius for a small fraction of the cost.

How is this possible? Because the NOx emission standards have been driven from 1.0 gm/mi down to 0.07 gm/mi or a factor of 14 less. Engine efficiency comes directly from high compression and high combustion temperatures and lean burn technology. All of these simple and inexpensive techniques lead directly to higher NOx emissions. Even the purported "silver bullet" for NOx, the 3-stage catalytic converter, depends on the engine burning "rich" for short periods of time to work properly and wasting fuel.

The primary reason gasoline demand is off is high unemployment, particularly in places like California, the land of the 100 mile commute.

Oct 21 10:22 PM

[a. palmer jr.:]

I'll have to agree with the above...if you don't have a job you won't be driving as much. Unemployment compensation in my state isn't enough to pay for vacations and cruising.

Oct 22 09:52 PM