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Another Big Win For Energy Economics 101: Demand Destruction Isn’t Good For New Investment

On Mon­day the Wall Street Jour­nal ran an arti­cle that described the end of the golden era for oil refin­ers. It is a great arti­cle that, unfor­tu­nately, was pub­lished many years too late to be con­sid­ered news. Just as grav­ity is a force that brings all objects to earth, pub­lic pol­icy that destroys the demand for gaso­line will hurt the refin­ery busi­ness. Not sur­pris­ingly, Pres­i­dent Obama’s pub­lic pol­icy ini­tia­tives that increase car and truck fuel effi­ciency have the side effect of hurt­ing oil refin­ery and dis­tri­b­u­tion businesses.

Just to be clear, I am not against the Administration’s effort to increase fuel effi­ciency in the vehi­cle fleet. Quite the con­trary, it is a mat­ter of national and eco­nomic secu­rity that we burn less imported fuel.  Increas­ing trans­porta­tion fuel effi­ciency is a “must” for the United States. How­ever, I don’t think that it is real­is­tic to believe that the energy indus­try is act like an old trusted dog that knows when it it time to walk into the woods and die. And, it isn’t fair to the refin­ery and dis­tri­b­u­tion busi­nesses to ask them to effec­tively sub­si­dize the rest of the economy’s shift to more fuel effi­cient vehi­cles and alter­nate energy with­out compensation.

The Wall Street Jour­nal reported that over the next few years there is going to be global over­ca­pac­ity among oil refin­ers. Not only is demand being reduced for refined prod­ucts (par­tic­u­larly in the U.S.), but there is a lot of new and effi­cient capac­ity that is com­ing on line in Asia and the Mid­dle East. That isn’t a pre­scrip­tion for a lot of new invest­ment in refin­ery capac­ity or for good returns for exist­ing refiners.

I have a cou­ple of news flashes about the future of oil refin­ery and dis­tri­b­u­tion that I am pretty sure are big news scoops (at least for most major media outlets).

  1. As gaso­line demand drops refiner­ies won’t be the only busi­nesses whose invest­ments are under­per­form­ing. There is going to be a lot of excess dis­tri­b­u­tion and retail­ing capac­ity. So far the Wall Street Jour­nal has only reported on excess refin­ery capac­ity. Dis­tri­b­u­tion and retail­ing are the next seg­ments of the indus­try that will expe­ri­ence over­ca­pac­ity and the end of its “golden era” (to the extent that there ever was a golden era). That means that the U.S. will have too many tank farms, too many truck­ers that move refined prod­ucts and too many gas sta­tions that sell gaso­line and diesel to consumers.
  2. The oil refin­ery and dis­tri­b­u­tion indus­try isn’t going to take an assault on their abil­ity to earn prof­its sit­ting down. They are going to hold back on main­te­nance spend­ing until U.S. refin­ery and dis­tri­b­u­tion capac­ity declines and mar­gins are restored. Restor­ing mar­gins means that prices will rise. There will be a pub­lic back­lash against the oil com­pa­nies for earn­ing too much money and maybe even worth­less Con­gres­sional hear­ings where senior indus­try offi­cials are pub­li­cally flogged. If there are hear­ings, some­one who claims to be smart, but really isn’t, will get on TV and announce that no new refiner­ies have been built in the U.S. in more than 30 years and that this is another exam­ple of the U.S. los­ing its global eco­nomic lead­er­ship. Of course, no one will point out that offi­cial gov­ern­ment pol­icy on fuel effi­ciency has the nasty side effect of destroy­ing the indus­try, that the pol­icy is work­ing and only an idiot would build a new oil refin­ery. Sound famil­iar? It reminds me of the sum­mer of 2007 and the hys­te­ria that took place in the media and Con­gress when refin­ery capac­ity was tight.

Over­ca­pac­ity and falling mar­gins reported by the Wall Street Jour­nal on Mon­day were eas­ily pre­dictable. In fact, I know that they were pre­dictable because in Decem­ber, 2008, I pre­dicted that oil refin­ers would face over­ca­pac­ity and falling mar­gins. Back in Decem­ber I wrote two arti­cles on energy pol­icy which can be viewed here and here.

From Three Incon­ve­nient Energy Truths

…while every­one agrees that cars need to get bet­ter gas mileage, vir­tu­ally no one has thought about what hap­pens to the peo­ple and com­pa­nies that make and dis­trib­ute gas for us to use. Bet­ter gas mileage has a side effect of hurt­ing the refin­ers, trans­porters, whole­salers and retail­ers of gaso­line. Bet­ter gas mileage destroys demand for gaso­line and will cre­ate lower prices and over capac­ity. It isn’t sur­pris­ing that vested inter­ests in the oil indus­try are quiet but effec­tive oppo­nents of energy pol­icy pro­pos­als. After all, how many indus­try lead­ers sup­port fed­eral ini­tia­tives that are the equiv­a­lent of eco­nomic suicide?

Of course, for every action there is an equal or greater reac­tion and the refin­ery and dis­tri­b­u­tion story doesn’t end with demand destruc­tion and stranded capac­ity and investment.

…Even worse, it will take years for the U.S. to achieve energy inde­pen­dence. We will need new invest­ment to pre­serve exist­ing infra­struc­ture. For exam­ple, oil refiner­ies need con­stant invest­ment to oper­ate. Dur­ing the sum­mer, with great fan­fare, the media announced that it had been more than 30 years since the last new domes­tic oil refin­ery was built. Politi­cians acted like it was a national crime when the refin­ery indus­try was caught short of capac­ity. But, what ratio­nal investor would put money into a new oil refin­ery know­ing that it is U.S. pol­icy to reduce demand for their prod­ucts and cre­ate over­ca­pac­ity. And, for that mat­ter, why should Saudi Ara­bia invest in pro­duc­tion capac­ity to serve Amer­i­can demand if our stated goal is to leave their infra­struc­ture stranded with­out its best customer.

The con­cerns of exist­ing energy pro­duc­ers are legit­i­mate and need to be addressed. If Obama’s energy pol­icy for­gets to take care of incum­bent energy inter­ests it will fail. Energy pol­icy needs to make sure that invest­ments in prop­erty, plant and equip­ment that are ren­dered obso­lete or made uneco­nomic because of over­ca­pac­ity are paid for through their use­ful eco­nomic lives.

The Admin­is­tra­tion means well but needs to get rid of its sim­plis­tic approach to energy pol­icy which ignores how to tran­si­tion the U.S. from a posi­tion of energy depen­dence to one of energy inde­pen­dence. If the Admin­is­tra­tion con­tin­ues on its cur­rent pol­icy path the indus­try will cut capac­ity until mar­gins are restored. It will seem like the oil indus­try is hold­ing the nation hostage to high prices while in fact they will just be act­ing log­i­cally and pre­dictably. It is naïve to believe that Big Oil will merely stand by and watch hun­dreds of bil­lions of dol­lars of invest­ment that is needed to sup­port the rest of the econ­omy get flushed down the drain before the end of its eco­nomic life and with­out com­pen­sa­tion. We need oil refin­ers, dis­trib­u­tors and retail­ers to main­tain the cur­rent infra­struc­ture for the fore­see­able future and will­ingly engi­neer a smooth tran­si­tion to a dif­fer­ent energy par­a­digm. If energy pol­icy keeps on ignor­ing this incon­ve­nient truth the shift will be very expen­sive and extremely rocky.

The prob­lems of demand destruc­tion, stranded invest­ment and tran­si­tion eco­nom­ics were taught to me in my Energy Eco­nom­ics 101 class 29 years ago. It is just too bad the Admin­is­tra­tion offi­cials didn’t take the class.

Posted in: economy, Energy, Finance, Oil, Politics, Public Policy

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