Where’s the gas? As pump prices test $3, persistent problems, from old plants to a shortage of skilled workers, spur debate on the industry.

Business Week Online

Fires. Explosions. Lightning strikes. This is the new state of affairs for U.S. oil refiners, hobbled in recent months by an unprecedented plague of bad luck and operational setbacks from California to Delaware [see BusinessWeek.com, 4/26/07, “$4 Gas? Fat Chance”]. Facilities of all sizes and age have been struck, leading to supply bottlenecks in various regions.

On May 2 the Energy Dept. reported that refineries are operating at only 88.3% of capacity, barely above the 20-year low notched last week. Not surprisingly, gasoline inventories dropped for the 12th week in a row — the first such three-month stretch since 1993. All that has set gasoline prices on a dramatic bull run, with refiners’ stocks setting all-time highs and U.S. consumers facing average pump prices of $2.98.

Strained System

What’s gone so wrong in refining?

“They’re cursed,” says Phil Flynn, an analyst with Alaron Trading in Chicago. “You can argue that the refineries are old and they’re squeezing more blood from the turnip than ever, but that explanation doesn’t cut it. Maybe Al Gore has cast a spell on the industry.”

Conspiracy theories aside, a number of factors are preventing more supply from flowing into the U.S. market. The overall picture is a system under such strain that any outages or disruptions ricochet quickly into retail prices. Because of high costs and a lack of public support, refiners haven’t built an entirely new plant since 1976. While they’ve been expanding existing plants, the industry isn’t keeping pace with growing demand. Any additional stresses — hurricanes such as Katrina or the persistent power outages — curb output. Add to that a shortage of skilled workers and government rules mandating cleaner fuels, and the reasons behind scarce supplies emerge.

High Margins

But while production hiccups may be an operational curse, refinery shareholders are now pondering a different question: What’s gone so right with refining?

The price difference between a barrel of crude and a barrel of refined gasoline are now the fattest the industry has ever seen. With gasoline for June delivery priced at $93.37 May 2 on the New York Mercantile Exchange, margins have reached $30 per barrel, according to calculations by both Chicago-based consulting firm Oil Analytics and Peter Beutel of Cameron Hanover Associates. That’s 50% higher than last year, when margins at the time hit historic highs of $20 a barrel, according to Oil Analytics. “Refiners are making a bundle now,” says Beutel.

The steep margins led to Valero’s Apr. 26 announcement that first-quarter profits were $1.1 billion, up a stunning 30% over last year; Chevron (CVX) reported first-quarter earnings of $4.7 billion, up 18% from last year. ExxonMobil (XOM) saw a 10% jump in quarterly net income, at $9.3 billion — the company’s best-ever first quarter. For integrated oil companies, the results are from one factor: high refining margins. The segment of Exxon‘s business that includes refining, for example, earned $1.9 billion for the quarter, up $641 million from the year before.

The profits led to all-time closing highs last week for the shares of the two biggest U.S. refiners, San Antonio-based Valero and its cross-town rival, Tesoro (TSO). The stocks of integrated players Marathon Oil (MRO), ExxonMobil, and Chevron also set 52-week highs last week on their robust profits.

Deliberate Shortage?

“It’s true we’re enjoying pretty good margins right now and pretty good profits,” says Bill Day, a spokesman for Valero Energy (VLO). “But that’s in spite of, not because of, the refinery outages. In this environment, with the supply-and-demand balance so tight, this is really when you want your refineries
running full blast. That’s why we get heartburn every time we hear of an outage. You really want everything running full capacity.”

The reports of rich profits alongside higher pump prices have some groups crying foul. “Oil companies that have refused to increase refinery capacity enough to meet population took refineries out of service for longer
[and] refused to import gasoline to make up the difference,” says Judy Dugan, research director of the Foundation for Taxpayer & Consumer Rights in Santa Monica, Calif. “Then they have the gall to behave as though gasoline prices are an act of fate, not the shortage that they created.”

But industry representatives and analysts dispute the notion that the problems are manufactured. “Saying it’s a deliberate shortage is ridiculous,” says Charlie Drevna, executive vice-president of the National Petrochemicals & Refiners Assn. “Especially considering the margins right now, the last thing a refiner wants is to have a planned outage. You may want the other guy to have one, but you sure as heck don’t want one.” Says Lynn Westfall, Tesoro’s chief economist: “It’s the working of Economics 101. Any time supply goes down, margins go up.”

Environmental Issues

Refiners say they aren’t building new facilities because of the soaring costs of steel and concrete and because of “not in my backyard” opposition from communities. Another issue hindering both new construction and output at existing facilities is a shrinking pool of skilled refinery workers, analysts say.

From geologists to engineers to skilled offshore workers, the oil industry is having trouble sourcing labor, and the problem is now becoming acute in the refining business. With excess capacity and falling oil prices in the 1980s and 1990s, refineries cut staff as a wave of consolidation swept the industry. The oil business was considered a volatile, if not dying, industry and has not been a popular career choice for college students.

“The oil industry doesn’t have the glamour or allure of industries like tech; it’s considered a smokestack industry,” says Craig Pirrong, professor of energy at the University of Houston. “Then there’s the uncertainty of the future of carbon-emitting energies. That puts oil companies and refiners at a disadvantage in recruiting.”

Good-Bye to $3

New regulations and quotas to produce new gasoline blends also stress refining. It’s also likely that many refiners have not yet achieved full efficiencies as they integrate new processes, say analysts. Under new rules that took effect in November, 2006, refiners are required to produce low-sulfur gasoline for the retail market nationwide; California law mandates another formulation of cleaner-burning fuel. Differing regional requirements also make it harder to substitute gasoline from one geographic area to another in the case of an outage.

With high costs and fierce civic and environmental opposition, oil companies and refineries like Valero and Marathon are opting to expand existing plants instead of building new ones. But quenching the ever-growing thirst of U.S. consumers will mean more gasoline imports from Western Europe, the Caribbean, and South Korea. The U.S. currently imports about 13% of its gasoline.

If the troubles persist, gasoline prices are likely to creep well beyond $3 nationally. And that will turn the issue toward demand — how much will consumers agree to pay to drive this summer?