A Price Volatility Episode with Implications for Forecasting

Larry Chorn, PhD, Chief Economist, Platts Analytics

The U.S. transportation fuel system is typically an effective carrier of natural gas and refined products, but it is codependent on other energy infrastructures. The 2005 hurricane season threw a wrench in the network, whose impact radiated through linkages into other infrastructure and illuminated the stresses besetting the U.S.'s aging systems.

THE U.S. CONSUMES AN AVERAGE OF 61.5 million gallons of gasoline per day. The unprecedented gasoline price spike in late summer of 2005 generated an inflationary spike in the U.S. economy and angered consumers but, more importantly, presented a clear picture of the vulnerabilities of the U.S. transportation fuel industry. Following the Gulf Coast landfalls of hurricanes Katrina and Rita, retail gasoline prices rose from an August 2005 national average of $2.49 per gallon of regular conventional blend to $2.77 per gallon average for the following two months, a 13% jump. The single week high price during this period was $3.04 per gallon, a 25% jump. Diesel fuel prices showed similar behavior. By the end of the year, three months after the hurricanes' landfalls, retail prices had fallen back to June 2005 levels (Figure 1). Crude oil prices, hurricanes, infrastructure limitations, corporate greed…everyone has an opinion of the cause of the price spike. Was there only one causative factor or was it a combination of events and circumstances?

1. Retail Gasoline Prices Post-Hurricanes Katrina and Rita. Source: Platts

The daily reports of destroyed damaged production platforms, damaged infrastructure, inoperable refineries and gasoline price volatility was a valuable (and sobering) look at the interconnectivity of the transportation fuel industry from production, transportation and refining through distribution. That interconnectivity was the source of the price spike and probably exacerbated its magnitude. No one factor caused the spike. It was a combination of the hurricanes' timing relative to refineries' production planning, the high density of refining capacity in the stricken area, an aging refining industry forced to operate at high utilizations for too long, failures in the power grid, and fear of supply shortfall that drove spot price speculation on the trading floors and regional price dislocations.

Refineries are built near crude oil supplies. As U.S. domestic production levels have fallen, refinery capacity has aggregated along the country's coastlines where Very Large Crude Carriers (VLCCs) can cost effectively deliver 60-plus percent of the U.S. demand from other countries. When harbors or tank farms are damaged, VLCCs cannot berth to offload oil. Refineries store millions of barrels of crude oil in tank farms. This storage capacity is intended to prevent shortfalls of raw material that would idle the refinery. Equipment malfunction and routine maintenance also shut down refining and distribution. As refineries age, maintenance must be conducted more frequently to avoid malfunctions. The most recent greenfield refinery construction in the U.S. was in 1973, so the U.S. refining infrastructure will become more and more susceptible to interruptions. As with anything mechanical, overuse tends to increase the potential for malfunction. The domestic refining industry has been operating at an average of 91% utilization of operable capacity since 1990, with periods of utilization as high as 99.4% and only 15% of the time at utilizations below 90%. Consequently, the recent spate of explosions associated with equipment failures and unplanned, maintenance-induced shutdowns are understandable given the aging and over-stretched facilities. All of these issues led to a domestic gasoline storage level shortfall of about 10% in mid-August 2005, relative to the five-year average. Immediately preceding the arrivals of Katrina and Rita, the country's storage levels were low by more than 20 million barrels of gasoline relative to recent historical levels. This is a small differential, so it was not the causative feature driving the price spike.

There is a high concentration of refining capacity along the U.S. Gulf Coast (Figure 2). From Pascagoula, Miss., to Corpus Christi, Texas, there are 6.655 million barrels per day of capacity with 3 million along the Houston Ship Channel alone. Hurricane Katrina forced the shutdown of 1.9 million barrels per day or 22% of the domestic capacity. Hurricane Rita forced the shutdown of an additional 0.66 million barrels per day refining capacity in the Port Arthur area. Within three months of Rita's landfall, all but Louisiana's Belle Chasse refinery (ConocoPhillips, 250,000 barrels/day) were fully operational. Refiners sustained a minimum of 82% of production overall through the fourth quarter of the year, indicating that refineries were back on-line sooner than expected, post-Katrina and Rita.

2. Refining Capacity Along the U.S. Gulf Coast. Source: Platts

On the product side of the refineries, several grades of gasoline, diesel fuel, heating oil, and jet fuels are stored in tank farms awaiting pipeline capacity to move to regional distribution terminals. Interruptions in crude oil deliveries, electric power, work force availability, and refined product pipeline capacity can result in inability to deliver gasoline to distribution terminals. Annually, during March and August, refiners move product emphasis from heating oil to gasoline in March and back again in August.

Refineries are not located near the regions of high population density, i.e. high demand. A handful of large pipelines transport gasoline and diesel fuel from refineries to local terminals where 6,000-gallon tanker trucks distribute supplies to individual service stations. The Colonial/Plantation is the major pipeline from the Gulf Coast refining region to the Atlantic Coast states and New England. It was shut down for several days when hurricanes Katrina and Rita damaged the electric transmission grid and left the pipelines without power. This outage led to local shortages, panic buying and a general price increase in areas served by the Colonial/Plantation pipeline backbone. Figure 3 provides a temporal illustration of the geographic distribution of inactive generation assets in the Gulf Coast, indicating when elements of the grid were returned to service after each hurricane.

During this period, gasoline demand dropped by about 4% from a combination of disruption and dislocation along the Gulf Coast and an increase in price. The price drop through November and December 2005 was a result of increased supply, coupled with seasonal reduced demand. Data now indicates this demand decrease was temporary. In fact, analysts are still studying the lack of demand elasticity shown by consumers during this past summer when prices exceeded $3.00 per gallon.

The hurricanes did major, albeit temporary, damage to the nation's ability to refine and distribute transportation fuels. To meet the shortfall, marketers imported an additional one million gallons of gasoline per day above the historical six million gallons imported per day on average between September 9 and December 1, 2005. Spare gasoline supplies in other parts of the world plus available tanker capacity allowed the U.S. to avoid significant shortfalls.

Based on these facts, viewed in hindsight, the abrupt rise in gasoline prices across the country was not caused by supply shortages except along the Mid-Atlantic and East Coast where distribution was interrupted. Consumer panic buying causing local stock drawdowns and the market's anxiety regarding the magnitude of damage to refining capacity appear to be the source of price volatility. Recently concluded investigations showed no evidence of price manipulation.

Where is the weak link in the transportation fuel infrastructure? Supply is not the weak link, even though high-quality, easily-refined crude oil has recently moved to a new price plateau with little sign of decline. Given 150± days of gasoline demand in storage, we cannot say that the refining industry is the weak link unless there is widespread capacity loss for an extended period. This leaves transportation between refining centers and local distribution terminals. The transportation system requires high reliability in the pipeline system as well as a reliable electric power grid to run the pumps. Failure in either component could result in a temporary shortfall. In fact, Hurricane Rita's damage to the interstate natural gas transmission system at Henry Hub in Louisiana illustrated this again within five weeks of Katrina's impact on the gasoline distribution system. The pipeline system appears to be the most susceptible link within our control in the country's transportation fuel system. The weakness could be mitigated with increased storage capacity in or near regions with high population density, but there is limited or no economic incentive for transportation companies to make the investments.

Will gasoline volatility return? Yes, given that the U.S. imports 60% of our crude oil requirements, localization of refining capacity in regions susceptible to hurricanes and the interrelated nature of the country's power and hydrocarbon (gasoline and natural gas) distribution systems, it is likely that we will again see price spikes caused by events outside our control.

What are leading indicators of renewed price volatility? There are probably several that in combination would cause price spikes. For example, crude oil import curtailments from the U.S.'s principal suppliers (Saudi Arabia, Venezuela or Nigeria) would reduce refinery operations within one to two months resulting in extended gasoline supply shortages. Hurricanes, particularly high-frequency, high-impact landfalls on the Gulf Coast, will generate price volatility periods much like those experienced in 2005. A serious generation or transmission problem in the Southeast power grids would cause temporary distribution disruptions to the upper Midwest, Mid-Atlantic and New England. Accidental or intentional damage to one or more of the major pipelines, like the Colonial/Plantation, would cause significant, but temporary, regional supply disruptions. For example, this past spring and summer prices rose in response to rapid demand growth around the world leading to a spare supply capacity of only 0.5 million b/d per day.

The bottom-line? When any system is run at or near its peak capacity with minimal redundancy there are opportunities for disruptions. The U.S. transportation fuel system is highly efficient and well run but it is also tightly interconnected to other energy infrastructures. Failure or damage to a link in the system will propagate broadly. Modeling a single link or even the entire supply/distribution chain for a single fuel ignores the critical infrastructure interconnections highlighted by the 2005 hurricane season. Future energy forecasting and planning models must address these linkages explicitly.

3a. Geographic Distribution of Inactive Generation Assets Post-Hurricane Katrina. Source: Platts

3b. Geographic Distribution of Inactive Generation Assets Post-Hurricane Rita. Source: Platts