TOM BEARDEN: Last summer, a lot of people in the Midwest got extraordinarily angry over the record high price of gasoline. The oil cartel, OPEC, had reduced production, and the price of crude went up. But when OPEC started pumping more oil, prices stayed high. Some politicians accused the oil industry of gouging consumers. American industry leaders denied that, saying one of the reasons prices went so high, and may shoot up again, is because the nation's refineries are running at full capacity. There is no margin for error. Any interruption in operations could lead to a serious regional shortage and another price spike. Why is there no excess capacity to make such a critical product as gasoline? The head of one of the nation's largest independent refiners says it's because, until recently, there wasn't much money to be made refining oil.
BILL GREEHEY: If you're a major company and you have different lines of business-- exploration, production, chemicals, retail, refining-- what you're going to do is you're going to make the investments where you get the best rate of return. And so what's happened in the last three or four years, the majors have not been spending the money on the refining infrastructure. And, as a result, demand has exceeded capacity growth.
TOM BEARDEN: Look at a refinery from a distance. and nothing much seems to be happening. Get closer, and the apparent calm disappears in the roar of machinery. Thousands of gallons of boiling oil in the soaring, cracking towers literally shakes the ground. The air shimmers with the heat. The place to see what's really happening is the control room. Computer screens show the complex molecules of crude oil being broken apart at high temperatures and pressures, then recombined into finished products. It's a far more complex and refiners say, vulnerable process than decades ago when refineries bought high quality crude and turned it almost directly into gasoline. These days many U.S. refineries-- like Valero Oil's plant in Corpus Christi, Texas-- buy this stuff, a sludgy goo called residual oil.
ROBERT BROADWAY: This is very heavy, very thick oil...
TOM BEARDEN: It's what's left behind after the less sophisticated Middle East refineries skim the easy stuff off the top.
ROBERT BROADWAY: This particular oil has to be heated just to get it into the refinery. We actually take this oil that contains by weight about 3.4% elemental sulfur, and we remove that elemental sulfur. And also we have some contaminants in the oil they're called heavy metals-- such as iron, vanadium, zinc, copper, lead and arsenic-- and we must remove those heavy metals before we can refine the oil into the clean burning gasoline that we produce.
TOM BEARDEN: After removing the contaminates, refiners separate out a series of intermediate ingredients with exotic names like raffinate, xylene, and reformate. Ultimately they're blended together according to a complex recipe that must take into account their individual properties. The blending process all comes down to this room, where quarter-million dollar test devices called "knock engines" continuously meter the octane of the blend, to make sure it'll burn properly. Federal clean air regulations add still another layer of complexity. A new, tougher set of standards, called RFG II, the second phase of reformulated gasoline regulations, went into effect last summer. And finally, a few individual states, like California, have their own, even more stringent clean air laws. These regulations force the industry to produce fuel in smaller batches for different parts of the country. They calls those "boutique gasolines." Robert Broadway, the refinery's service manager, says it's complicated the job considerably.
ROBERT BROADWAY: It is a very difficult process to blend the gasoline from the standpoint-- not the physical standpoint, but the technical standpoint-- to bring the logistics of producing all of these products along with each one of these products having a specific value and tying it all together and making sure that we could produce the most economical gasoline that's required at that point in time.
TOM BEARDEN: The industry says when every plant is running flat out, as they are now, even small outages can have an enormous effect on the market. Sometimes parts of refineries simply break down. Normal maintenance shutdowns also reduce capacity, which can also lead to shortages of finished products. Robert Slaughter is with the Refiners' Trade Association in Washington.
ROBERT SLAUGHTER: What happens when you keep putting more and more burdens on the industry is that, you know, things happen that are unforeseeable. The supply is tighter and from time to time you'll have maybe pipeline or refinery problems or something else unforeseeable, where you'll have a local or perhaps regional supply disruptions with price impacts.
TOM BEARDEN: The industry says all of this, coupled with a temporarily broken pipeline, contributed to the price spikes in the Midwest last summer. And Valero's CEO says reformulated gasoline added yet another layer of complexity.
BILL GREEHEY: RFG Phase II was lower sulfur, lower vapor pressure, which means that refineries had a harder time making this gasoline so you have volume lost.
TOM BEARDEN: But the EPA's clean air chief, Robert Perciasepe, says environmental regulations were not to blame for high prices in the Midwest.
ROBERT PERCIASEPE: RFG II was implemented throughout the entire country and we didn't see any of this kind of effect. They were able to successfully implement it in 97% of the gasoline in the country. You know, what happened in that specific arena and trying to paint a brush to the whole program, is pretty much a disservice to the clean air goals that have been achieved by the oil industry itself in implementing clean burning gasoline.
TOM BEARDEN: Midwest prices eventually came down from their high of over $2 a gallon. But the average price around the country remains in excess of $1.50. California has gone through several price spikes, and fuel prices there are still substantially higher there than the rest of the country. So the state attorney general commissioned a broad-based study of gas prices. He found that the decline in capacity was real, but he also blamed price hikes on lack of competition.
BILL LOCKYER: In California, there are six oil companies and hopefully not fewer, but that may happen. But a handful of companies that control about 92% of the refining and about 92% of the local retail gas stations. Well, there just isn't adequate competition in that sort of a market environment. So with that inelastic demand, with the SUV's and more and more cars and more and more people every year, the demand side keeps going up. The supply side is relatively fixed in our state. And so they just keep raising the prices on us.
TOM BEARDEN: The California report said there were 35 refiners operating in the state in 1980. In those days the biggest six refiners controlled only 68% of production by 1998 there were just 16 refiners in California. And the biggest six controlled 86% of production. But the report also supported some of the refiners' claims. Some task force members believed the state's clean air requirements increased the number and length of refinery disruptions. And it said investments needed to upgrade refineries to produce cleaner gas contributed to the closure of some independent refineries. But the attorney general says regardless of past economic problems, refineries are making a lot of money now.
BILL LOCKYER: If you look at the history of refineries in California, you find that their profit margins jumped dramatically in the last half a dozen years. The local independent gas station owner actually is doing much worse now, less profit than they used to make. Crude oil prices vary, of course, and that's a major factor. But if you factor out those changes, you find that it's refinery profit margins that seem to be the principal factor and cause in the price spikes.
TOM BEARDEN: Even as the argument over what causes high prices continues, refiners are warning of further price and supply problems as they prepare to cope with new clean air regulations. Congress is considering several bills that would outlaw the use of MTBE, an additive used to put oxygen into gasoline to make it burn cleaner. If MTBE is banned, there will be a substantial loss of gasoline volume. Ethanol, an alcohol made from corn, is a viable but more expensive substitute, even though it enjoys several tax subsidies. In addition, the EPA will soon issue a rule requiring a far lower level of sulfur in diesel fuel. Refiners estimate that changeover will cost them $8 billion. EPA's estimate is half that. But engineers say it's only partly a matter of cost. It's also a case of so many new requirements being imposed in a relatively short period of time -- requirements with unknown consequences.
BILL GREEHEY: And that's the biggest problem we have. EPA does everything on a piecemeal basis, and when you're making an investment in a refinery, in the infrastructure, what you're trying to figure out, what are your needs?
ROBERT PERCIEASEPE: Sequencing these things and phasing them and providing adequate lead time is also part of our responsibility to the EPA. So if we can achieve the clean air and technology advancement investments for the American transportation system and sequence these regulations in an appropriate way so that the oil industry can transition in a way that provides the lead time and the flexibility they need, that is the answer.
TOM BEARDEN: Observers warn that there are no quick fixes for the current turmoil in energy markets. In fact, some think price spikes in all kinds of fuels will become uncomfortably familiar for several years to come.