MT: There is a great deal of volatility in fuel pricing these days. The volatility in the price of crude obviously has an impact on this but I understand there is also volatility at the refiner level that adds to it. Can you explain the trends found at the refiner level that are making for more volatile conditions?

Ervin: Perhaps the single biggest trend that we’ve seen in the last 20 or 25 years is a significant decline in the number of refineries in North America. In the United States, for example, 20 years ago there were roughly 300 refineries and now there is only about 150. Similarly in Canada 20 years ago there were about 40 refineries and we are now down to 17. That seems fairly alarming given all the talk about higher demand. The refinery closings were in reaction to declining demand for fuel during the 70s. But in the last 15 years we’ve seen demand start to go up again as a result of overall economic prosperity and different driving habits (people buying minivans). If we look at the effect in terms of refinery utilization rates we see that a typical refinery in 2006 is basically operating at 100% capacity. There is a very, very small gap between demand for gasoline and diesel fuel right now and available supply due to a drop in refineries and the lack of interest on the part of refineries to really improve capacity. Situations like that produce price spikes. Price volatility at the rack becomes very typical.

MT: All right, so 20-25 years ago there were demand issues that led to the closing of many refineries and the decision to not invest in new capacity. But, with the rise in demand we’ve seen the last 10-15 years and pricing at levels that probably makes it worthwhile to invest in new capacity, did refiners not miss the boat? It would seem their miscalculation is not only hurting Canadian businesses but also refiners themselves who are missing out on today’s market opportunities.

Ervin: In a way they did miss the boat and it’s too late to hop back on board now. But I think this missing of the boat wasn’t really foreseeable. When we went through the Arab oil embargo back in the 70s, that really was a milestone occasion in terms of North American fuel production. That was a point in time where the industry woke up and realized that demand was going down and the necessity of shedding a whole bunch of surplus assets. Before that point in time, the industry, government, consumers were all perceiving fuel to be a product whose demand was going to increase every year, year over year, ad infinitum. Then when the Arab oil embargo hit, we got into smaller cars, into fuel efficiency standards in the United States and lower speed limits in order to economize on fuel. And that worked to reduce fuel demand until about the start of the 90s when our economies started to grow and consumers discovered SUVs and minivans. That was a consumer trend that nobody saw coming. All of a sudden demand started going up just at a time when refineries were starting to feel comfortable with what they had done in terms of closing operations.

The question now is, why don’t we build new refineries? A couple of key reasons: Number one is the NIMBY (not-in-my-backyard) syndrome. Nobody really wants to see a refinery built in their backyard. As big a continent as this is, that is a real factor. Number two is that to build a new refinery – let’s say a three or four hundred thousand barrel per day refinery – would represent an investment of about $3-4 billion dollars. That is not an investment to be taken lightly; it has to justify itself not over the next 2 or 3 years but over the next 25 years. When refiners look back at the history of margins for refined products, as good as profits are now, historically they haven’t been. So there’s a real reluctance to repeat the mistakes that had been made in the past. The third key element is that while there have been investments in improving capacity, most of the capital that has gone into refineries the last five years has had more to do with complying with regulatory standards – taking lead out, taking benzene out, taking sulphur out. All of these kinds of government mandates have had the effect of basically diverting a great deal of capital – tens of billions of dollars – away from improving capacity.

MT: If refiners, for the reasons you noted, are reluctant to add capacity, does the government have a role to play in improving the situation?

Ervin: I think government does have a role, although not in terms of they themselves becoming refiners – they just don’t have a good track record of playing in the industry. The government can perhaps have some effect in terms of bringing up refining capacity by declaring a moratorium on changes in product specifications. As much as we’ve seen of changes in Canada, it’s far worse in the United States where there is not only the evolution of product specifications but specifications that differ from one region to the other for the same product. For example, there are 18 or 20 different varieties of gasoline in the United States now and I am not talking about the difference between regular, mid grade, and premium. This causes a great deal of difficulty on the part of refiners and shippers of petroleum to get the right product with the right specifications into the markets that mandate those specifications. It also creates the potential for regular pricing volatility in those areas where a refinery serving a specific market has a problem, a fire for example. Buyers of the product simply can’t go next door to ask a neighbouring refinery to ship product to them to make up the difference because that neighbouring refinery in a different jurisdiction simply may not be making product with these specifications.

MT: The 2007 engines require ultra-low sulphur diesel. Historically, every time we’ve had to move to a new formulation of fuel, there have been supply and demand imbalances. Do you see the transition to ultra-low sulphur diesel significantly decreasing available capacity of diesel?

Ervin: No, I don’t think the transition is going to significantly decrease the capacity to produce diesel, but what it will do is create some issues on a localized basis. A lot of refineries have basically met the targets set to bring in the new diesel but typically in any transition there are glitches either in terms of the refinery not being able to cope with production or in the shipping of the product. As the product is moved through the supply chain it can become contaminated. These are general issues that are not going to continue ad infinitum but certainly during the initial phase-in period we are going to see problems of that nature, and typically governments have not granted waivers or pardons for product not being up to spec.

MT: As I understand it, if ultra low-sulphur diesel is contaminated by coming into contact with a higher-sulphur grade anywhere along the supply chain, it cannot be sold as ultra low-sulphur diesel. Does that mean we could be in for localized shortages and, as a result, localized price spikes?

Ervin: Exactly, and that’s been very well established in terms of other transitions we’ve seen come through. During the transition to low sulphur gasoline we saw some spikes and diesel is not going to be any different.

MT: With gasoline when there is pressure on supply we bring in reserves from Europe. Can we not do the same with diesel to relieve potential shortages?

Ervin: Gasoline is an example of a product which is routinely imported in the summer time in the United States, when refineries are operating at 100% but demand goes above that. Over the last 5 years gasoline imports from Europe have been pretty routine. North Americans have been able to import gasoline from Europe because, unlike the case in North America, gasoline is not the highest demand product in Europe and there
is surplus gasoline to bring in to North America.

The situation is different with diesel because diesel is the most important product refined in Europe. More people drive diesel cars in Europe than they do here and there is not that luxury to import surplus diesel from Europe to meet our requirements. This is why we see more volatility in the diesel price.

MT: In addition to the price of crude and factors at the refinery level we’ve touched on, there are also unforeseen external issues such as wars and natural disasters – Hurricane Katrina is the perfect example – which have an impact on crude or refined product supplies and therefore price. Just how bleak does this picture get? How high can prices go and how long can the price volatility we’ve been experiencing continue?

Ervin: To answer the question about where prices will go we have to look at the two most important elements of that: the price of crude and the “crack spread”, which relates to the refined wholesale prices of fuel. On the crude oil side, the predictions that are out there right now run the range of as low as $40 to a doubling of current prices over the next year. Who’s right I don’t know, and frankly I don’t think the level of pricing matters so much as the volatility of pricing. Crude oil and the refined product are basically faced with the same problem: there is a very narrow gap between supply and demand and this will result in more volatility.

This is second and concluding installment of a two-part series of excerpts from the Let’s Talk about Volatile Fuel Prices series of cross-country seminars, conducted recently by Transportation Media (Motortruck’s parent company) in partnership with Markel Insurance.