– John Kemp is a Reuters columnist. The opinions expressed are his own –

U.S. oil refiners have relied heavily on exporting surplus gasoline and especially distillates to help offset plunging domestic demand over the last eighteen months.

Record product exports have averted a much deeper crisis within the industry, an even bigger collapse in gross margins and a huge inventory build.

But as the spreading slowdown cuts demand in key export markets across Europe, Asia and Latin America, the export window is set to close. Refiners look set to respond with unseasonal run cuts over the next two months to prevent a massive stock build before spring.

The total volume of gasoline supplied to the U.S. domestic market has fallen 80 million barrels (3.1 percent) from 2.539 billion barrels in January-September 2007 to 2.459 billion barrels in January-September 2008.

Distillate supplied has fallen 70 million barrels (6.1 percent) from 1.148 billion barrels in 2007 to 1.079 billion in 2008.

Refiners have responded with deep run cuts, supplemented with process adjustments to increase the yield to distillates, and heavy exporting to try to limit the build up of unwanted stocks and provide support for pressured margins.

Distillate exports have risen by 94 million barrels in the first nine months of the year to a record 146 million barrels (+181 percent). Gasoline exports are up by a more modest 12 million barrels to 50 million barrels (+32 percent) (see https://customers.reuters.com/d/graphics/US_GSDSEX1208.gif).

Strong overseas demand for motor diesel as well as heating oils for on-grid generation and back-up power generators during H1 2008 provided a useful and generally profitable way of disposing of excess diesel production. Diesel exports have offset all the decline in domestic demand and even provided a useful fillip to total marketable output.

Overseas demand for gasoline has been weaker, limiting product placement.

Contrasting international demand explains why U.S. gasoline margins have collapsed this year while diesel margins, though under pressure, have stayed positive.

Without profitable diesel exports, U.S. refiners would have had to cut throughput much more severely during the summer months.

Overseas diesel markets have provided a crucial source of support for the U.S. refining industry this year. Diesel sales (including record exports) have cross-subsidized loss-making gasoline production.
But as overseas diesel demand falls, that prop is being taken away.

Gasoline inventories have already begun their normal year-end build (refiners produce excess gasoline as a by-product of winter heating-oil runs). Gasoline stocks normally draw down during the February-April maintenance season. But this year the gasoline build has started earlier and is occurring more aggressively than normal.

Refiners are under pressure to react with early run cuts, or start the maintenance season earlier and take more capacity offline for longer after the turn of the year.

In either event, refinery demand for crude oil looks to soften even more than usual as the northern heating season ends. Prospective run cuts heighten the risk of a very large build up in crude oil inventories in Q2 2009, adding to the downside price risks in the near term.

– John Kemp is a Reuters columnist. The views expressed are his own –

Even by the standards of a deep-cyclical industry, the “golden age” of oil refining has proved remarkably brief, lasting no more than three years, before giving way to a new dark age.

Particularly in the United States, refiners have returned to the state of chronic unprofitability that plagued the industry before 2005.

U.S. refiners now have too much capacity and produce the wrong products (gasoline) in a fuel economy increasingly dominated by ethanol and diesel. Capacity cuts of as much as 0.5-1.0 million bpd (equivalent to 4-8 average refineries) and expensive investment to reconfigure the system to increase the diesel yield seem inevitable.

EVAPORATING PROFIT MARGINS

In May 2007, U.S. refiners paid an average of about $64 a barrel to acquire high quality West Texas Intermediate (WTI) crude (less for other grades) and sold gasoline for $97 per barrel - a margin of $33 per barrel or 52 percent.

By November 2008, U.S. refiners were paying $62 to acquire WTI but selling gasoline at a loss for just $52 - a negative margin of $10 or 16 percent.

Other outputs are still profitable (notably diesel and heating oil) and many refineries will have acquired lower-quality crudes for less than the WTI price. The overall gross margin was still (just) positive.

But the NYMEX benchmark 3-2-1 crude oil-gasoline-heating oil has shrunk from $30 per barrel to just $3. Once operating costs (including natural gas, electricity, water and catalysts) as well as capital expenditures (building, maintaining and upgrading refineries) are taken into account, the industry is making little or no profit.

DEMAND DESTRUCTION

Demand for gasoline and other refined products has been falling for more than a year, initially in response to high prices and now as a result of a weakening economy, leaving refiners with a huge overhang of unused capacity.

The total volume of refined products supplied to the domestic market averaged just 19.2 million barrels per day (bpd) in the four weeks ending Nov. 21, down 1.7 million bpd (8 percent) from 20.9 million bpd in the same period last year. The volume of motor gasoline supplied (9.0 million bpd) was down 300,000 bpd (3.3 percent) compared with last year (9.3 million bpd).

Refiners have responded with run cuts and record exports of both gasoline and distillates to avoid flooding the domestic market and collapsing prices further.

Operating rates have been below year-ago levels since the start of 2008 (https://customers.reuters.com/d/graphics/US_RFRT1208.gif).

Refineries processed 15.2 million bpd of crude and other inputs in the week ending Nov. 21 - using just 86.2 percent of their 17.6 million bpd maximum capacity, and leaving more than 2 million bpd of crude distillation capacity idle.

Refiners also sent increasing volumes of refined products abroad to avoid flooding the domestic market. Refiners and merchants ramped up gasoline exports from 38 million barrels in Jan-Sep 2007 to 50 million in Jan-Sep 2008 (+32 percent) and distillate exports from 52 million barrels to 146 million (a massive increase of +182 percent).

It has not been enough. By Nov. 21, reported gasoline inventories stood at 200 million barrels (22.3 days of supply) up from 197 million barrels (21.2 days cover) in 2007.

ETHANOL DISPLACEMENT

Refinery gasoline is increasingly squeezed out by ethanol. U.S. ethanol production has tripled from 260,000 bpd in Sep 2005 to 640,000 bpd in Sep 2008, with another 80,000 bpd of ethanol imported. As a result, ethanol is cutting almost 750,000 bpd of demand for fossil-fuel refinery-derived gasoline (https://customers.reuters.com/d/graphics/US_GSETH1208.gif).

In Sep 2005, some 8.9 million bpd of gasoline was supplied to the domestic market, of which 8.7 million bpd came from refineries and just 0.3 million bpd was sourced from ethanol distilleries.

Three years later, in Sep 2008, the volume of gasoline supplied had fallen 400,000 bpd to 8.5 million bpd. But while the volume of ethanol sourced from distilleries had risen by 0.5 million bpd to 0.7 million bpd, the volume of gasoline sourced from refineries was down by a massive 1 million bpd to 7.7 million bpd.

Roughly half the refinery demand lost over the last three years is due to increased ethanol (500,000 bpd), while the remainder is due to cyclical factors (400,000 bpd).

The displacement of refinery gasoline is an explicit objective of federal policy to reduce U.S. oil imports. It has been accelerated by the surge in crude oil prices during 2007-2008, encouraging widespread voluntary blending of cheaper ethanol into the domestic fuel supply.

But increased blending volumes threaten to strand many U.S. oil refineries as white elephants with no long-term future. Refinery utilisation rates have been trending down since the start of the decade, but the loss of demand has accelerated notably since widespread ethanol blending commenced in 2005 (https://customers.reuters.com/d/graphics/US_RFRTA1208.gif).

As a result, there is an increasingly wide gap between system capacity and actual throughput. More than 2.0 million bpd of crude distillation capacity is sitting idle. The last time the refining system had more than 1 million bpd of spare capacity was in the early 1990s, when refiners responded by mothballing facilities and closing plants, cutting capacity by more than 500,000 bpd between 1992 and 1994 (https://customers.reuters.com/d/graphics/US_RFRTB1208.gif).

Even with refinery shutdowns, the long-term outlook is bleak. The Energy Information Administration (EIA) projects gasoline consumption will increase from around 142 billion gallons in 2006 to 151 billion gallons in 2030 (based on an increasing population and rising car use, partly offset by improved fuel efficiency).

But the fossil-fuel content of that gasoline is scheduled to drop from 136 billion gallons to just 125 billion gallons as the ethanol content rises from 5.5 billion gallons to 25.8 billion gallons to comply with Renewable Fuel Standard (RFS) targets.

GASOLINE-DIESEL MIX

As if falling demand and the increasing challenge for ethanol were not enough, U.S. refiners face a deeper structural problem.

Most of the world relies on diesel rather than gasoline for transportation fuel and heating demand. According to the International Energy Agency (IEA) the world consumed just 0.75 gallons of gasoline for every gallon of diesel in 2005, and the refinery system was configured to produce the two fuels in roughly the same proportion (https://customers.reuters.com/d/graphics/FL_CNSP1208.gif).

The U.S. petroleum economy is highly unusual in that it is tilted towards consumption and production of gasoline. The United States consumes almost two gallons of gasoline (1.97) for every gallon of diesel; the European Union consumes only 0.40 gallons and China consumes 0.48 gallons.

Until recently, that led to a mutually beneficial trade, with the United States exporting surplus diesel, while Europe and China exported surplus gasoline (https://customers.reuters.com/d/graphics/REFINEPRDS1208.htm).

But U.S. refiners now face the problem that in the fastest-growing parts of the petroleum economy (China, Asia, the Middle East and Africa) the marginal demand is for diesel, while their marginal supply is gasoline, for which demand is stagnating.

The global economy now faces a structural surplus of gasoline and a structural shortfall of diesel. By implication, the world has too much capacity for producing gasoline (much of it concentrated in the United States) and not enough capacity for producing diesel (especially in Asia).

As a result, U.S. refiners face increased competition in their domestic market from imported gasoline, while they struggle to produce enough diesel to sell abroad. This mismatch explains why U.S. diesel exports have risen much faster in the past year than gasoline, even though it is the domestic gasoline market which is most oversupplied.

The United States now has too many refineries for its increasingly ethanol-based economy, and they produce the wrong product mix for a dieselised global economy.

U.S. refiners have begun to reduce gasoline production (https://customers.reuters.com/d/graphics/EIA_REFGS1208.gif) and prioritise distillates (https://customers.reuters.com/d/graphics/EIA_REF1208.gif). But yield changes have been marginal (1-2 percentage points), reflecting the technical limitations of the existing refinery units.

In the short to medium term (12-24 months), it seems virtually certain U.S. refiners will have to cut total capacity sharply, perhaps as much as 0.5-1.0 million bpd, 4-8 average refineries. In the longer term, they have no choice but to undertake substantial capital expenditures to shift the system towards more diesel.

– John Kemp is a Reuters columnist. The opinions expressed are his own –

Despite a promising start, the U.S. experiment with renewable fuels is facing a serious challenge next year. Falling gasoline consumption, lower pump prices and contradictions within the federal government program are intensifying existing pressures on ethanol distillers and farmers already struggling to cope with over-capacity and collapsing margins.

ETHANOL ENTHUSIASM

Between 2000 and 2007, production of fuel ethanol quadrupled from 1.6 billion to 6.5 billion gallons, and the industry is on course to distill a record 9.3 billion gallons in 2008.

Ethanol production is not really economic at oil prices below about $60-70 per barrel (prices of grains and fats for ethanol conversion and processing costs are too high relative to oil). So the original boost to ethanol came from its use as an oxygenating additive in reformulated gasoline, rather than as fuel in its own right, when a number of states banned the use of MTBE.

As oil prices breached $50 in late 2004 and continued to climb steadily higher over the next four years, ethanol’s properties as a fuel suddenly became more attractive.  Blenders began to use ethanol as a cheaper (partial) substitute for conventional oil-derived blendstocks in making gasoline.

Prompted by national security concerns and encouraged by lobbyists for the farm sector, U.S. legislators tried to accelerate the use of ethanol by mandating a minimum ethanol content for all gasoline produced or imported into the United States.

The centerpiece of the government’s intervention is the Renewable Fuel Standard (RFS) which sets a steadily increasing minimum volume of ethanol that must be blended into the nationwide gasoline supply each year.

The original RFS set out in the 2005 Energy Policy Act was relatively modest — requiring blenders to incorporate 4 billion gallons of ethanol into the fuel supply in 2006, rising to 5.4 billion gallons in 2008 and 7.5 billion gallons by 2012.

But as soaring crude oil prices intensified concerns about energy dependence, the 2007 Energy Security and Independence Act imposed a set of much more ambitious targets. The RFS blending target for 2008 was almost doubled to 9 billion gallons, rising to almost 13 billion gallons in 2010 and to an extraordinary 36 billion gallons in 2022 (see chart https://customers.reuters.com/d/graphics/US_ETH1108.gif).

WORSENING ECONOMICS

Most attention has focused on the role of the RFS, but surging oil prices were probably more important in supporting ethanol.

RFS is designed to stimulate investment in the production facilities and distribution infrastructure needed for ethanol by guaranteeing a minimum level of demand for the fuel irrespective of oil prices.  But over the last three years, RFS has never been binding.

On a purely voluntary basis, gasoline blenders have always used more ethanol than the required minimum because increasingly high oil prices made ethanol an attractive fuel in its own right.

RFS mandated 4 billion gallons of ethanol in 2006, but blenders actually used 4.9 billion. It mandated 4.7 billion in 2007, when blenders actually used 5.7 billion (an extra billion gallons or 22 percent).

The apparent success of the ethanol industry on a voluntary basis because of favorable economics was one reason why legislators felt comfortable about amending the RFS to include more ambitious targets in 2007.

But as oil has tumbled below $70 per barrel, ethanol no longer looks competitive. On current trends, blenders will use 9.26 billion gallons of ethanol in 2008, just 260 million gallons or 3 percent above the RFS-mandated minimum of 9 billion gallons.

Unless oil prices rise substantially from current levels, the RFS is set to become binding for the first time in 2009. Gasoline blenders will have to use 11.1 billion gallons of ethanol because that is what the law tells them, not because it makes economic sense.

OBLIGATIONS AND CREDITS

In practice, RFS is expressed as a percentage requirement imposed on each gasoline refiner and importer to buy a specified volume of ethanol (or tradable credits) in proportion to their production/import volume - thereby ensuring the total quantity of ethanol used each year meets the mandated target.

The Environmental Protection Agency (EPA) uses total forecast gasoline consumption in the United States for the coming year (sourced from the October edition of the Energy Information Administration’s Short Term Energy Outlook) and adjusts it for gasoline consumption in Alaska (not currently included in the RFS requirement); production by small refineries and refiners (not subject to RFS until 2011); and the quantity of ethanol that has to be incorporated into the gasoline mix (there is no requirement to blend ethanol into itself).

EPA divides the total mandated ethanol volume into the adjusted gasoline supply to publish the percentage RFS requirement for the coming year. Each gasoline refiner and importer must purchase sufficient ethanol (or tradable credits from others blending more than the minimum) to meet this ratio.
So far, ethanol credits have been cheap (trading at around 3-6 cents per gallon in 2008). However, if oil prices fall further, and RFS becomes binding, the price of credits will have to rise to give blenders an incentive to use at least the mandated minimum volume.

THE BLENDING WALL

Ethanol is a good but not perfect substitute for gasoline.

It has around 66 percent of the energy content of regular gasoline. Almost all ethanol is sold is sold in a 90-10 gasoline-ethanol blend known as E10 and is the limit that can be used in regular motor vehicles under existing manufacturer warranties. A tiny percentage is sold in a 15-85 blend known as E85 that can only be used in vehicles with specially designed engines.

As a practical matter, the amount of ethanol that can be blended into the general gasoline supply is capped at around 10 percent of the total or about 10-14 billion gallons per year - known as the “blending wall”.

For 2008, EPA set the RFS obligation for refiners and importers at 7.76 percent, based on the need to blend 9 billion gallons of ethanol into forecast gasoline consumption of 144.5 billion gallons or 116 billion gallons after adjustments.

In the event, gasoline demand has proved much weaker than forecast. Without voluntary blending above the required amount in the first half of the year owing to high oil prices, the 7.76 percent blending requirement would not have been high enough to ensure 9 billion gallons were used.

On Nov. 14, EPA published an RFS for 2009 of 10.21 percent, based on the need to blend an even higher volume of ethanol (11.1 billion gallons) into a diminished amount of gasoline consumption (139 billion gallons, or 109 billion gallons after adjustments).

The industry is now very close to hitting the blending wall.

This was always going to happen, given the much more ambitious RFS volume obligations in the 2007 law. It was never going to be possible to blend 20.5 billion gallons into the gasoline supply by 2015 without much wider uptake of E85 vehicles or other modifications of the U.S car fleet. But the unprecedented cyclical reduction in gasoline demand has brought the blending wall much closer.

CONSTRAINTS BITE

In fact, the gasoline industry is now trapped in a vice.

Low oil prices are discouraging ethanol blending (RFS becomes binding) while slumping gasoline demand is tightening the technological constraints (the blending wall approaches faster).

Blending credits look set to become more expensive, as gasoline refiners and importers have to start paying far more to make it worthwhile to blend 11.1 billion gallons into the fuel supply next year at low oil prices.

Meanwhile, the limits of the system could prevent any more ethanol being blended for technological reasons. The RFS requirement for 2009 looks achievable, but 13 billion gallons in 2010 and 14 billion gallons in 2011 may be impractical unless the car fleet changes.

The looming wall explains why ethanol advocates are pushing the incoming Obama administration to set a much higher blend rate than E10, reaching E15 or E20, and require motor manufacturers to start redesigning cars to take much higher blends and produce a higher proportion of E85-enabled Flex Fuel Vehicles (FFVs) as a condition of any financial rescue package.

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