TESTIMONY of JOHN C. FELMY
CHIEF ECONOMIST AND DIRECTOR,
POLICY ANALYSIS AND STATISTICS DEPARTMENT
AMERICAN PETROLEUM INSTITUTE
FEDERAL TRADE COMMISSION
AUGUST 2, 2001
Mr. Chairman and members of the Commission, I am John Felmy, Chief Economist and Director, Policy Analysis and Statistics Department of the American Petroleum Institute, a national trade association representing more than 400 companies from all sectors of the U.S. oil and natural gas industry.
I would like to thank the Commission for the opportunity to present our views on what happened to the prices of refined petroleum products over the past two years.
I will review what led to these problems and explain what the industry did to make sure gasoline got to every family who needed it for the 2001 summer driving season. Then, I will discuss the huge challenges we face and suggest actions that need to be taken to avoid the turmoil we have experienced over the past two years.
Right out of the block, however, I would like to say that gasoline prices shot up dramatically starting last March because of supply and demand. Nothing more, nothing less. For a variety of reasons, there were lower-than-usual inventories of gasoline on hand in the spring. In part, that was true because we had a colder winter than most recent winters. That meant refineries supplied large amounts of heating fuel to keep American families warm . And if refineries are producing large amounts of heating oil, they are producing less gasoline. You can only squeeze so much out of any one barrel of crude oil. Meanwhile, the decline in gasoline production was accompanied by a drop in imports of gasoline and a two percent increase in demand. Taken together, those are the immediate causes for the price spikes earlier this year.
For the broader perspective, I will describe our energy situation two decades ago when we experienced our last major price shock. In that era, we paid even more for petroleum products—when measured in today’s dollars—than we do now. The average price of a gallon of gasoline in 1981 was $2.64 and the price of a barrel of crude oil was about $69. In the same year, we produced 45 percent more petroleum and consumed 20 percent less petroleum than we do today. As a result, the U.S. imported only 36 percent of its petroleum compared to the 60 percent we now get from other producing nations. Refinery capacity was over two million barrels a day higher. There were 315 U.S. refineries and capacity utilization was only 69 percent compared to the current 93 percent. Since that time, more than half the refineries have shut down, but surviving refineries are much bigger.
Why have things in the industry changed so much?
The impact of what happened in the late 1970s and early 1980s cannot be overstated. Higher prices of the time, a deep recession and a steep decline in consumption of petroleum products brought about major changes. Between 1978 and 1983, for example, petroleum consumption declined by 19 percent to 15.2 million barrels per day. This decline led to a severe recession in the industry. Thousands of workers were laid off and many expansion projects were cancelled.
Another factor that had a big impact was the Windfall Profits Tax of 1980. That drained $73 billion dollars that otherwise would have been spent on new exploration, refining or marketing. Huge investments required for environmental controls successfully reduced emissions from all facilities but also sharply cut profits in the industry. In the 1990s alone, the industry spent $90 billion on environmental investments. The industry spent almost $2 billion alone on upgrading underground storage tanks. These investments were never recovered and between 1981 and 1998, the rate of return in the refinery sector was just 4 percent.
Because of these regulatory costs, dozens of refineries and storage facilities were closed and thousands of gasoline stations went out of business. This low rate of return forced companies to do everything they could to become more efficient. It also explains many of the mergers that occurred in the industry. By merging, companies eliminated duplicate functions and saved billions in costs. In addition, the larger merged companies had more capital to make the huge investments required to explore and drill for oil. To cite one example, a deepwater offshore drilling rig can cost $1 billion.
By becoming more efficient and developing stunning new technologies, the industry has saved incredible amounts of money. The cost of finding and refining petroleum has gone down despite massive environmental investments that have accompanied all these changes. And these developments—mergers, investments and technological improvements—directly benefit American consumers. The real cost of a gallon of gasoline is now 45 percent lower than it was in 1981.
Despite this good news, we still have a petroleum supply system that is straining to meet consumer needs. Since 1985, demand for petroleum products has exceeded the refinery capacity even though refineries are bigger and more efficient than ever. Storage facilities for crude oil and refined products continue to shrink due to regulations. We now import about 2.5 million barrels of refined petroleum products each day, and that represents 10 percent of demand. And, according to the Department of Energy’s Energy Information Administration, these imports are predicted to grow by 140 percent over the next 20 years.
This would not be a concern except that other countries require different gasoline recipes than we do in the United States. On top of that, different U.S. jurisdictions—federal, state and local— require different kinds of fuels to meet their own environmental needs. The existing refinery, pipeline and terminal systems must supply 16 different types of gasoline. These boutique fuels have hamstrung the delivery system, increasing the possibility that any small change in demand or interruption in supply will set off another explosion of price increases like those we have seen over the last two years.
And the situation could get much worse if still other new regulations are not carefully implemented. New rules lowering sulfur content in gasoline and diesel fuel will limit the availability of imported fuel because most foreign refiners do not yet produce the kind of low sulfur fuel that will be required in the U.S.
All this means that we have reached an important crossroads in our ability to supply American consumers with the fuels they need. Two decades of regulation -- no matter how well intentioned -- have put a tremendous strain on the system. The price spikes for heating oil and gasoline over the last two years are but manifestations of the underlying problems that we face in supplying consumers. We are now lurching from season to season, unable to build up sufficient inventories to provide a comfortable supply buffer of either gasoline or heating oil for the coming season.
The price spikes that occurred for heating oil and gasoline were driven by the interplay between supply and demand for those fuels. Our experience with these spikes reveals that markets for petroleum work. Sharp increases in gasoline prices are caused by shifts in supply and demand partially triggered by unwise regulatory policies and limited refinery capacity. In the spring of 2000, a variety of supply limitations and demand growth drove prices up and then, as markets worked, and more supplies rushed in to meet demand in the Midwest, prices fell.
This year’s sharp increases in gasoline prices were again due to supply and demand factors. We experienced a much colder winter; November and December were the two coldest Novembers and Decembers on record. As a consequence, our refineries supplied large amounts of heating fuel, and because natural gas prices were high, utilities needed larger amounts of residual fuel to make electricity.
Even though the refinery utilization was 2.7 percent above the previous year and at high levels for the season, gasoline production fell by two percent over the previous year.
With the end of the heating season and a fall in natural gas prices, gasoline production expanded greatly. The refinery system set records for gasoline production for 13 straight weeks. Both May and June were record months for gasoline production, as was the entire quarter. In addition, imports of gasoline increased dramatically as prices rose. In recent weeks, the high prices and a slowing economy have driven down demand.
As a result, prices have plummeted. In the spring and early summer, prices increased by 30 cents over a 45-day period and declined by more than they rose over a 60-day period.
Let me close with a plea for a call for adoption of a comprehensive energy policy. Prices of gasoline, natural gas and electricity have declined over the past two months, but we should not be lulled into complacency. No sane homeowner would quit repairing a leaky roof simply because it’s stopped raining. Likewise, it would be foolish for our nation and its leaders to forego seeking long-term solutions to our increasing energy needs simply because gasoline prices have gone down. While the gasoline situation has improved, we are already preparing for the next season. Refineries are operating at a very high level and will require maintenance for safety and environmental investments. We have little breathing room to prepare for the heating season. Inventories of heating oil are about 11 percent below average.
While prices have declined, we still face the same challenges that we faced last winter and spring. Refinery capacity is less than our demand for petroleum products. The Department of Energy says we will need 30 percent more energy over the next 20 years. To meet that demand, we will need 33 percent more petroleum or about six million barrels per day. This is a staggering amount equal to 90 billion gallons. To supply this to consumers, we will need more refinery capacity, more pipeline and terminal capacity, more shipping capacity and more port facilities. We must enact a comprehensive policy that adequately promotes cost-effective energy efficiency and conservation, realistic amounts of renewable energy and more supplies of oil, coal, natural gas and nuclear energy. In addition, regulations need to be streamlined to get supplies to consumers more cheaply. Otherwise, we will be doomed to more frequent and more severe energy disruptions than we have endured in recent years. And with that, Mr. Chairman, I will conclude my testimony.