Paul Sancya/AP Photo
Storage tanks at the Marathon Petroleum refinery in Detroit, April 21, 2020
At this point, it is hard to disentangle overall inflation from surging gas prices. Last week, the national average rose above $5 a gallon for the first time in U.S. history, and it should only increase, given the summer driving season. Gasoline alone accounted for about 20 percent of inflation in May, and fuel also factors into the transportation costs of virtually every good.
Many explanations can be offered for the spike, from generalized inflation to post-pandemic supply disruptions to Russia’s invasion of Ukraine to the unwillingness of Wall Street to invest in domestic production after severe losses in the past. But President Biden has now correctly pointed out a different driver: a lack of refinery capacity.
Yesterday, the president sent a letter to seven leading oil refiners, stressing how their profit margins have tripled in 2022 to a record high, and urging that they take steps to reverse the loss of 800,000 barrels per day of U.S. refining capacity in 2020, the last year for which we have statistics. Globally, the reduction is closer to three million barrels per day.
The refinery theory has a lot of evidentiary power. You can generally predict the price of a gallon of gas by the price of a barrel of oil. But that relationship has broken, with gas prices at least 61 cents per gallon higher than expectations. Biden noted in his letter that in March, the last time oil prices hit the current price of $120 a barrel, gasoline cost $4.25 a gallon; it’s now over $5.
“Usually when crude oil goes up, refinery margins go down,” said Severin Borenstein, who directs the Energy Institute at the UC Berkeley Haas School of Business, because it means higher prices and hence lower sales. But the go-to illustration of short-term refinery profit margins, known as the “crack spread” (that is, the difference between the price of crude and that of refined products like gasoline), shows the opposite dynamic. Going back five years, the crack spread sits within a very narrow range of around $20, until this February, when it starts spiking to triple that amount. (The crack spread has come down off its highs; on June 15, it was at around $54.80.)
This is a global phenomenon, with refinery profit margins rising this year just about everywhere. Companies with significant refining operations, like Valero and Marathon Petroleum, are seeing their highest profit margins in a decade or more; Biden himself noted in a recent speech that Exxon “made more money than God” this year. And refining is the second-largest input into overall gas prices.
The question, then, is what has driven refinery capacity down, and therefore profit margins and gas prices up?
The multifaceted story involves inaccurate predictions of demand, extreme weather events, disinvestment in new capacity, and yes, refineries taken offline in Russia during the war. But the ongoing story in refineries, according to Diana Moss of the American Antitrust Institute, is one of rampant consolidation.
“There has been a dramatic loss of numbers in physical refineries since the early 1980s,” Moss explained, pointing to Energy Information Administration statistics. Operable refineries narrowed from 301 in 1982 to 129 in 2021, and the reductions were even more pronounced in the diesel heating oil–reliant Northeast, with a 74 percent reduction over the same time frame. An Oil & Gas Journal article from 2015 demonstrates 20 years of consolidation, from 26 major refinery players to 11. In California, two firms control half the refinery capacity.
As these consolidations occurred, not a single major new refinery was built between 1977 and 2020.
This is made worse by how refineries operate. Nearly 20 years ago, the Government Accountability Office found that petroleum industry mergers led to something called “networking,” where refiners establish relationships with large retailers, rather than operating as independents. In some cases, refineries make handshake deals to produce certain supplies for one another, which looks suspiciously like cooperative agreements with rivals.
This vertical control means that the same companies engage in oil exploration, refining, and in some cases retail sales. Indeed, one of the largest global refinery owners is Saudi Aramco, the state-owned oil company, which also owns the biggest refinery in North America.
As these consolidations occurred, not a single major new refinery was built between 1977 and 2020. Nor did the Federal Trade Commission, which had jurisdiction over refinery mergers, act to stop many of them. “The FTC is very fond, as they are in pharma mergers, of approving deals with consent orders where they take divestitures,” said Moss. “We have a rapidly expanding record of failed divestitures. We’re trying to encourage the agencies not to settle these cases.”
While various expansions and advances in technology at the remaining refineries have kept capacity up, dwindling physical plants mean that any shuttered facility, due to weather or routine maintenance or unanticipated accidents, has a much more pronounced impact. Between aging facilities and a rise in frequency of extreme weather events like hurricanes in the very Gulf Coast region where a lot of refineries are located, those shutdowns happen quite often.
A massive refinery in South Philadelphia exploded in 2019 and never came back online; it is now being redeveloped into housing. Refinery closures in 2020 shrank capacity in the U.S. to its lowest rate since 2015. Up to 1.69 million barrels of capacity is expected to go offline in the U.S. by 2023, according to a Bloomberg report. Globally, there were more refinery closures than new capacity built in 2021, and capacity fell for the first time in 30 years. As a result, we don’t have enough refining capacity to meet demand.
Moss sees some of these shutdowns as more than a coincidence. “The most direct and effective exercise of market power is to take a plant out of service,” she said. “And it’s not illegal under the antitrust laws to restrict output and jack up the price.” But it’s very difficult to distinguish between accidents and business decisions. “It’s easy for a company to say, ‘We’re not intentionally restricting output, we have this glitch,’” Borenstein said.
Borenstein added that refiners also followed market signals. When the COVID pandemic collapsed transportation use, companies expected lower oil demand in future years, because of the transition to electric vehicles, projected changes in commuting patterns, and the belief that the fiscal response to the crisis wouldn’t be particularly strong. Stories about peak demand proliferated.
Those expectations did not hold. Demand came roaring back, with people breaking free of pandemic lockdowns while remaining wary of public transit that puts them in close contact with others. And the imperative of a looming green transition made boosting refining capacity a tough economic play. “You can’t keep telling an industry that we will stop using your product and expect big investments,” Borenstein explained.
Chevron’s CEO, Mike Wirth, said earlier this month that no new refinery will ever be built in the U.S. again, because of the large capital investment necessary to build one, set against governmental desires and activist demands to wean the world off fossil fuels. There’s some truth to this; in reaction to Biden’s letter yesterday, the Climate Justice Alliance thundered, “We must keep fossil fuels in the ground” and not “sacrifice black and brown communities and all those living on the fence lines of refineries.”
But Wirth’s stance also happens to work out tremendously well for oil companies like Chevron, which gets to bottleneck supply at the refining stage.
Alas, there doesn’t seem to be a quick fix available. Some companies are in the process of converting refineries to biodiesel to keep them functioning over the long term. Biden has urged oil companies to shelve those decisions and bring idle capacity back online, but encouraging long-term fossil fuel infrastructure might be shortsighted, given climate goals.
Outside of jawboning, Biden’s tools are somewhat limited. One way to use a stick is to tax windfall profits, perhaps at the inframarginal level so it doesn’t strictly punish making more money in the future. But getting Congress to agree would be an extremely tall order.
“I think that this is one of the areas where the government really has very limited tools to cope with the problem,” Borenstein said, adding that it might be better to help people deal with high gas prices through rebates or inducements to more fuel-efficient modes of transportation, rather than trying to will $4-a-gallon gas back into being.
Right now, the main U.S. policy is to raise interest rates significantly, as the Federal Reserve did yesterday. But not only will this action not solve the shortfall in refining, it will actively worsen it, because higher interest rates will make investment less attractive and reduce the remote chance of increasing capacity. The Fed’s idea is to destroy demand and get it more in line with supply, by throwing people out of work and lowering wages. But some energy demand is inelastic; when it’s cold, you need heat, and if you have a job, you need to drive to it. Forcing recessionary conditions just makes it harder for lower-income people to afford this necessity, or pushes them into poverty.
But the situation does reveal a general inattention to the important role of middlemen in the economy. With gas prices, “everyone goes immediately to the top of the supply chain, at the crude oil level,” said Moss, “or they go to the pump. Nobody looks in the middle of the supply chain for mischief and bad conduct. It’s a problem in energy and health care and food and agriculture. The middle of the supply chain is strategically a place to exercise market power.”
