Thursday, April 11, 2013

Oil, Corn, and the Price of Gasoline

A great energy revolution is said to be taking place. New sources of oil are going to make the US energy independent and we will become a net energy exporter. If we are suddenly producing so much more oil, shouldn’t that allow the price of gasoline to drop? An excellent article in Bloomberg Businessweek by Asjylyn Loder, Mario Parker, and Matthew Philips addresses that issue.
"For the first time since 1995, the U.S. will likely produce more oil than it imports."

A greater supply of domestic oil and a fall in domestic demand for oil might be expected to lead to lower prices for gasoline.

"Even as fuel consumption has fallen to 16 percent below its 2007 peak, gasoline remains about a dollar higher than the average price over the past decade. So far this year, gasoline prices have risen 11 percent nationwide, to $3.65 a gallon."

Prices are being held high by a combination of market competition, logistics difficulties, and perverse effects of government regulation.

"Most of the surge in oil production has happened in places such as North Dakota, Wyoming, Colorado, and Oklahoma, far from refining hubs and big population centers. With competition fierce for limited pipeline capacity, producers have begun moving crude on barges and trains, adding as much as $17 a barrel to the price of domestic oil. That extra cost eventually makes its way to the price at the pump."

Once oil is refined to produce gasoline, it must still make its way from the refineries to the various domestic markets.

"Complicating the equation is a 1920 law called the Jones Act, which requires any cargo shipped between U.S. ports to be carried by vessels that are based in the U.S., made in the U.S., and crewed mostly by U.S. citizens. The law was intended to protect U.S. shipping interests but has made it more costly to move fuel between U.S. ports. This in particular hurts the Northeast, which is struggling to meet its fuel needs after several refineries closed in the last two years. According to Ed Morse, chief commodity analyst at Citigroup, those constraints add between $6 and $8 a barrel to transport costs."

As a result, abundant domestic oil supplies couple with expensive domestic transportation costs to make selling gasoline on the world market more profitable.

"’s often cheaper for a Gulf Coast refiner to send gasoline to Brazil than to New York."

Exports of refined oil products have been growing for a number of years. In 2011 the US became the largest exporter of such products.

"’The tools are in place for the U.S. to become an even bigger exporter of gasoline and diesel,’ says Stephen Schork, president of the Pennsylvania energy consulting firm Schork Group. ‘The U.S. has the most sophisticated network and the most technologically advanced refining system in the world, and it has access to a tremendous amount of domestically produced crude oil in a country where demand is stagnant at best’."

The article provides this chart to describe how these exports have grown over time and where they end up.

The refiners have a right to maximize their profits as they decide where to sell their products. They have that right because society gave it to them. Society is, in effect, agreeing to subsidize the profits by agreeing to pay a higher price for gasoline. Society can at least benefit from the flow of money into our economy from these exports and the lower flow of money out as the need to import crude oil diminishes.

The authors point out that there is one more regulatory cost to be discussed: the ethanol requirement. A law was passed in 2005 (and amended in 2007) that required ethanol to be mixed with gasoline in order to limit our dependence on imported oil.

"This year, the law requires U.S. refiners to blend 13.8 billion gallons of ethanol into the fuel they sell to domestic customers. In their calculations when crafting the bill in 2007, lawmakers assumed gasoline demand would continue to rise and that refiners would need all that ethanol to make up 10 percent of the fuel sold to motorists."

Our visionary legislators could not conceive of a situation in which demand for gasoline would fall.

"As a result, refiners don’t need all the ethanol the government forces them to buy. To make up the roughly 400 million gallon difference between the ethanol the industry needs and the amount the government mandates, refiners must buy credits called Renewable Identification Numbers, or RINs."

The cost of these RINs has been increasing. Therefore the cost of dealing with this excess ethanol problem will be borne by the consumer.

"If sustained, the increase may add as much as 10¢ to the retail price of a gallon of gasoline, says Bill Klesse, chief executive officer of Valero Energy, the world’s largest independent refiner."

The idea to convert plant product into ethanol is not a dumb idea—unless the plant stock chosen is a very inefficient one, and one that is also a critical component of the worldwide food supply. The decision to convert corn into ethanol was not only dumb, it was tragic.

World food prices have about doubled in the past decade. Withdrawing about half our corn production from the world market in order to make ethanol has not helped the situation. The decision to follow this path has raised food prices for everyone, including ourselves. This increase may not mean much to most people in the US, but it means a lot to those around the world for whom the purchase of food consumes the biggest portion of their income.

Now we learn that ethanol production is needlessly raising the price of our gasoline.

"The end result is that refiners have an even greater incentive to sell their fuel abroad, where it isn’t subject to U.S. ethanol requirements."

If politicians are really interested in smaller government and less regulation, this law and the associated regulations provide a good place to start whacking away.

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