The website for WCCO-TV has a "Good Question" feature. They ask, "Why not build more oil refineries?"
Average gas prices in the Twin Cities are flirting with $3 per gallon again. They have already topped that in other states and hit a new national average record of $3.07 per gallon. Experts said it's a supply problem. We're paying more because our refineries can't pump out enough gas to meet our demand. So why don't we just build more of them?
"We're dealing with the same spigot," said Dr. Akshay Rao, a business professor at the University of Minnesota.
He said the last refinery built in the United States was in 1976 and many have since closed. In fact, in 1985 there were 254 operating refineries. Today, there are approximately 142.
"There were marginal refineries that weren't making enough money closed," said Rao.
I would imagine that many of those were just too costly to maintain.
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A new refinery would cost $2 billion to $3 billion. Today's environmental regulations help keep our air clean but also make it much more expensive to run a refinery. Finding land is tough because nobody wants to live near a refinery.
Indeed. It is not the cost that is the barrier. $2 billion to $3 billion is the price tag for an offshore oil platform too, and those are being built. Finding a suitable location is certainly a problem. Environmental regulations probably increase the initial outlay somewhat, but mostly affect the operating cost over time. Those two factors are probably enough to discourage that sort of investment.
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There's also no doubt that current gas prices are making oil companies and refiners gallons of money. So some speculate that they don't want to build more refineries because that would increase supply and depress prices. That would cost them money.
"They would be in effect be depressing prices and margins and hurting themselves," said Rao.
If they have market power, this is certainly the case. Of course, the Balkanization of the U.S. gasoline market into geographic regions with different fuel requirements contributes to the market power of the remaining refineries in different geographic regions. If the U.S. gasoline market was really one large market with 142 refineries, would it be profitable for a firm (probably an existing one) to build a new refinery? Talk about a "good question"... that's the one they should have asked.
Yes, the firms have market power. Is it due to market failure, government failure, or both? My vote is for both, and the government failure here is not trivial.
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However, not all American refineries are owned by oil companies. Some are owned by refining companies and that business isn't as good as it used to be. In fact, the energy department said refineries' profit margins peaked in the 1980s.
That actually doesn't surprise me.
As for the present situation, spring maintenance will finish up and we'll be switched to the summer blend of gasoline. This too shall pass, at least in the short run. But the refinery situation isn't going to change anytime soon, except that with each passing year it is only going to get worse. Given the way that gasoline markets are divided up, one or two refineries wouldn't be the solution (even if they could be built). Reversing the tide of geographical restrictions on various types of gasoline is probably not going to happen. The price system will provide the right signals and incentives to explore alternative fuels and so forth. But no one said it would be easy.
While the factor you point out do increase the cost of building refineries the dominant reason no one has built a new refineries in years is that the market said we did not need new ones. If the market determined we need new ones, refining margins would rise, refining would switch from being one of the countries most unprofitable industries to a highly profitable business, and someone would build new ones. Guess what, that process is now starting to happen. We finally absorbed all the excess capacity and for the first time in decades the spread between crude oil and refined product prices are rising and refining is becoming a very profitable industry. If we are not careful someone will respond to the new market signals and build a new refinery.
Of course, if the analysis that we just passed the world peak in oil production and face a future of ever higher real oil prices and flat, and maybe even falling demand for gasoline maybe we will never need any more refining capacity. In this case the poor firm that decides to build a new refinery may end up losing their shirt.
Interesting post. I have a recent real-life example of a refiner's behavior for you. It's called "creating a product squeeze".
http://tinyurl.com/344xb6
Happily, another company offered to buy (for $130 million) the refinery that Shell at first intended to destroy.
My question is why do you think there is a problem here?
Isn't this the way markets always work -- overshooting first in one direction and reversing and overshooting in the other direction?
Academic economists like to think that it is normal for markets to be in equilibrium. But in reality the only time this ever happens is when they pass trough that point as they swing from one extreme to the other.
Come on, spencer, you know me better than that by now!
Where in this post do I say anything about this market being "in equilibrium"? By the way, when I teach supply and demand, I make that precise point about markets not always being "in equilibrium".
In fact, when I said, "The price system will provide the right signals and incentives to explore alternative fuels and so forth. But no one said it would be easy", that was specifically a reference to the fact that it will take some time and some adjustment. If it was instantaneous, it would be easy (or at least easier). My point when I teach supply and demand is that the price system is always pushing things in the right direction by providing signals and incentives, but it's not always a direct route.
It takes time for a refinery to be built, even once the decision is made that it is profitable. It takes time for automakers and consumers to shift towards hybrids, and so forth. In the meantime, people complain about high gas prices. On other words, no one said it would be easy. This is certainly not the problem. Not a problem at all. (Usually when I say things like that, I get criticized for not being sensitive to people's concerns about high prices...so your criticism is, I hope, just a misunderstanding.)
But there is one place in this post where I am clear about where there is a problem--a government failure. The hodgepodge of fuel requirements (see the map in the link) does a good job of segmenting the market and giving the remaining refiners more market power than if there were one national market for good ol' 87 octane unleaded so that gas in Chicago was the same as gas in St. Louis. With a segmented market, it is more likely (how likely I'm not sure, but certainly more likely) that one new refinery would have a measurable impact on price in that market segment.
I mean there has got to be some specialization going on with refineries producing gas for specific regional formulations. If there is any reason why market power is going to get concentrated, I would think this is the likely candidate.
And yes, I do think that is a problem. Though at the same time, the knee-jerk solution of moving everyone to one formula may not be practical or desirable. I would like to hear your thoughts on this.
Update on the 'unprofitable' refinery that Shell Oil intended to shut down and raze. New owners have proposed doubling the capacity.
It seems the big playas in the refining biz and the little ones have different goals.
http://www.bakersfield.com/137/story/49880.html
More on the refinery margin issue over at Angrybear. Seems the EIA data yesterday when I made my follow-up post only went through March. But it does show how volatile the refinery margin component is.
Price escalation is another source for a grassroots refinery's hefty price tag. Since 2003, increases in global demand for materials (like steel) and equipment have been driving up prices.
Another source of problems is that there is a shortage for construction labor and experienced engineering staff. With no one monitoring contractors, refinery projects become costly and out of control.
the free market is constrained and sometimes steered by political agenda and policy. rather than waiting for the market to be so off center for a sustained period of time that it's incentive enough on it own to build, some reasonable incentives to encourage building would solve the problem sooner. of course then politicians wouldn't be able reappear on this issue every time gas prices spike and screeh about needing to lessen dependence on oil. there are better sound bites the way it is