Gas Prices: High and Going Higher?

Published August 1, 2000

As early as March, the Department of Energy predicted summer gasoline shortages and soaring prices. Department officials warned that new Environmental Protection Agency regulations could make matters worse, particularly if supply interruptions occurred, as happened this spring in the upper Midwest.

In June, EPA Administrator Carol Browner and Energy Secretary Bill Richardson began criss-crossing the country, claiming to be searching for answers to soaring gasoline prices.

They needed to have looked only as far as John Cook, director of DOE’s Energy Information Administration’s Petroleum Division, who predicted the pending shortages in testimony before the House Subcommittee on Energy and Power on March 9.

“We are now facing a very tight gasoline market,” Cook testified. “U.S. crude oil and gasoline inventories are at alarmingly low levels not seen for decades. On top of low stocks, refineries need to increase crude inputs over 1 million barrels per day during March and April, within a market short of crude oil–creating an environment ripe for gasoline price volatility this spring.

“But even after we get through spring,” predicted Cook, “expected high refinery utilization rates on top of precariously low gasoline stocks set the stage for volatility during the summer as well.” At the time Cook testified, U.S. refineries were operating at 95 percent of capacity nationwide, and 99 percent of capacity in the Midwest. Their output has remained at that level throughout the supply shortage.

Cook predicted prices for regular unleaded gasoline would be near $1.80 nationwide. That prediction did not take into account the added cost and shortages caused by the June 1 effective date for EPA’s mandated Phase II reformulated gasoline. Nor did Cook take into account temporary interruptions in supply that might occur.

Blame OPEC and EPA

Gasoline prices nationwide have risen due to two principal causes. OPEC members agreed last year to reduce output in order to raise prices. Their plan worked all too well: Crude oil prices have nearly tripled, from $12 per barrel early last year to $32 per barrel today. That increase translates into about $0.45 a gallon.

The second factor contributing to higher gasoline prices is the Environmental Protection Agency’s (EPA) decision to require a new type of reformulated fuel at the very moment demand was rapidly increasing with the arrival of the spring travel season.

New requirements under Phase II of the 1990 Clean Air Act Amendments impose stringent new performance standards for gasoline. Avoiding accidental mixing of old and new fuels required a complex process of emptying existing tanks and rescheduling pipelines that further depleted inventories.

The Energy Information Agency warned in its April report, Summer 2000 Motor Gasoline Outlook,

About a third of gasoline in the U.S. must meet Phase II reformulated specifications [mandated by EPA]. This gasoline must be in place at distribution terminals by May 1 and at retail outlets by June 1. While supply should be sufficient, low gasoline inventories raise the risk of localized shortages. The new requirements for reformulated gasoline may slow the response time for delivery of emergency supplies and reduce the availability of imported gasoline.

Implementation of the Phase II regulations, which require oxygenates in gasoline, comes approximately six months after the respected National Research Council determined that oxygenates do nothing to improve air quality.

The Congressional Research Service, in a report to House Science Committee Chairman James Sensenbrenner, concluded that the new reformulated gas mandate is responsible for at least 25 cents of the higher costs facing gas consumers.

More problems in the Midwest

Other factors explain why prices are especially high in the Midwest. The Midwest depends on the national supply and distribution system for about 25 percent of the fuel used here. That system was designed to handle a half-dozen different grades of gasoline, but is now being asked to handle over a dozen, plus specifications varying by season and geography to meet government air quality regulations.

The growing number of gasoline varieties means shortages in one area can no longer be addressed by moving excess inventories from another area. It also means pipelines and barges cannot simply or easily be rescheduled to transport fuel to one region from another. Evidence that this is contributing to short supplies in the Midwest can be found in the fact that gasoline inventories have been rising on the Gulf Coast while falling in the Midwest.

Another reason for higher prices in Midwest states is a break on the largest Midwest supply pipeline, the Explorer Pipeline, in early March. That break resulted in a week-long shutdown which delayed delivery of over 8 million barrels of oil, depleting inventories in the region. Today, the pipeline is still operating at only 80 percent of its capacity due to regulatory constraints.

Another major pipeline in the Midwest, the TEPPCO Pipeline, is already operating at full capacity and cannot pick up the shortfall caused by the Explorer shut-down. The West Shore Pipeline, which runs from Chicago to Green Bay, Wisconsin, was closed for three days of testing in early June. The Wolverine Pipeline, which normally provides about half of Michigan’s supply, ruptured on June 7 and was returned to service on June 16. As with the Explorer Pipeline, Wolverine is now operating at 80 percent of capacity.

Several refineries in the region were closed for maintenance or other reasons in early spring and some have closed more recently due to accidents.

In the end, those infrastructure issues have resulted in inventories of gasoline stocks and blending components that are the lowest since 1981, some 15 percent lower than the five-year average, and more than 11 million barrels lower than a year ago. Reformulated inventory is slightly higher than last year, but it accounts for less than 5 percent of the total gasoline supply.

While some observers have suggested that requiring inventories to be kept at some government-mandated level would have addressed the Midwest’s supply problem, industry analysts disagree. Had inventory targets been in place, they note, prices likely would have gone higher to choke off demand in order to keep inventories at the mandated level.

Additionally, gasoline bound for the Chicago market on the Explorer Pipeline was diverted to St. Louis when EPA granted a waiver on the use of reformulated gasoline in that market. The waiver was in effect between March 17 and June 5, encouraging suppliers to divert conventional gasoline from the upper Midwest to the St. Louis area. In effect, the waiver gave consumers in St. Louis access to less- expensive gasoline by reducing supplies and escalating gasoline prices in Chicago, Milwaukee, and the markets served from these areas, including northern Indiana, northern and central Ohio, and Michigan.

Further supply problems on the horizon?

“The current predicament,” Bob Slaughter, director of public policy for the National Petrochemical and Refiners Association said in the March 9 hearing, “again reminds us that the U.S. either deliberately or inadvertently has followed a national policy which, at times, doesn’t pay sufficient attention to the question of supply. This is most often true in the area of environmental policy.

“The U.S. frequently pursues overly expensive environmental restrictions without looking for equally effective but less costly alternatives.”

Slaughter pointed to several new EPA regulations that may cause future price increases and, possibly, supply shortages. “NSR [New Source Review] is one of the most complicated regulatory programs ever created,” Slaughter said. The way EPA has interpreted the Clean Air Act, NSR requires EPA permitting every time a refinery makes any change in its plant or method of operation.

Moreover, Slaughter said, new Tier II standards set to go into effect between 2004 and 2006 will cost the petroleum industry approximately $8 billion and, he predicted, add another 5 cents per gallon to the pump price.

Taxes under attack

High taxes on motor fuels have helped fuel rising prices and consumer anger. Chicago, which reports some of the highest gasoline prices in the country, also has the nation’s highest taxes on gasoline and diesel fuels.

Some states, such as Illinois, impose a general sales tax on motor fuels on top of excise taxes, a classic “tax on a tax” that makes worse any underlying increase in fuel prices.

Governors and legislatures in Illinois, Minnesota, and Wisconsin are considering suspending part of their taxes on motor fuels for a limited amount of time, and Indiana has done so. Support is building for repeal of the 4.3 cents/gallon tax on motor fuels passed in 1997, dubbed the “Gore tax” because the Vice President cast the deciding vote.

Environmentalists, including Gore, who are usually vocal proponents of higher, not lower, taxes on motor fuels, have been shaken by the strength of public sentiment against them. The popularity of proposals to reduce taxes also suggests that EPA’s effort to demonize oil companies has been unsuccessful.

When will prices fall?

Will prices of crude oil return to historic levels? OPEC members each have a strong economic incentive to “cheat” on their partners by increasing oil production, so the cartel’s effort to keep prices high will eventually collapse.

The bigger problem is improving the nation’s supply and distribution system so that problems such as the Explorer Pipeline breakdown do not cripple oil supplies in the future. Opposition to new pipelines by environmentalists, politicians, and local property owners (often called NIMBY, for Not In My Backyard) makes upgrading the system slow and expensive. Proposals to build new refineries in the region face the same opposition.

Greater public support for new pipelines and refineries and less support for government mandates for cleaner fuels on unrealistic timelines would lower gas prices. So long as it isn’t overly handicapped by taxes and regulations, markets respond efficiently to supply interruptions and changes in demand.

Lee Alan Lerner is director of public affairs of The Heartland Institute, publisher of Environment & Climate News, and Tom Randall is managing editor.