Bryan Caplan  

Are Refineries Really a Bottleneck?

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The Macro Tangle... Arnold Kling and Russ Roberts...

When I was writing my New York Times column on the gas tax, my editor pushed me to argue that other economists were underestimating the price-sensitivity of the supply of gasoline. I resisted. A wide range of economists seemed to agree that refineries were running at capacity. On the left, Krugman argued:

Is the supply of gasoline really fixed? For this coming summer, it is. Refineries normally run flat out in the summer, the season of peak driving. Any elasticity in the supply comes earlier in the year, when refiners decide how much to put in inventories.
On the right, similarly, I'd often heard free-market economists blame our energy troubles on regulators' decades-long refusal to site any new refineries.

When economists reach this broad of a consensus, I normally defer to it. But after writing my op-ed, I started paying more attention to the interaction between oil and gas prices. And frankly, I'm finding it pretty hard to buy the refinery bottleneck story. Did you notice how quickly the price of gas seemed to respond to the recent fall in oil prices? If the bottleneck story were true, the price of gas would have stayed at $4.00 to ration a fixed supply - not dipped to $3.60 in a matter of weeks.

The lesson, I suspect, is that outside observers - economists included - tend to underestimate elasticities. It's tempting to slide from, "I can't think of any way to expand gasoline production under existing conditions," to "No one knows how to expand gasoline production under existing conditions." But it's a temptation we've got to resist, because industry insiders see margins of flexibility that outsiders can barely imagine.


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COMMENTS (18 to date)
Ryan writes:

Well put. This is a lesson I think we all need to absorb. Our economy is much more flexible than we tend to realize, which makes it all the more unfortunate when regulators seek to apply stifling restrictions to micromanage its function.

Bob Knaus writes:

?????

As a retailer, I price my product based on replacement cost, not actual cost. If I don't know why I do this, it does not matter... because my competitors will force me to do it.

I'm all in favor of economists' confessions of ignorance... but there is a simpler explanation!

Matt writes:

Spot on, Brian. We are much more elastic than normally assumed.

There is another effect that causes us to delay our elastic decisions.

Unit writes:

The unelastic bias?

DTT writes:

Refiners are running at around 80% capacity. This is a published number by the DOE every month.

Or you can just check the stock price of VLO. Down over 50% from its high earlier in the year.

Turns out the higer prices have led to consumers using less fuel. Bad for refiners...even Exxon that lost several hundred million in its downstream (refining) operations last year.

Gasoline is just like every other commodity and is not immune to the law of supply and demand.

Greg writes:

The US does import refined gasoline. Even if refineries are "at capcity" there is still some suppply elasticity. Also, "at capacity" refineries have some supply elasticity by, for instnace, deferring maintenence.

spencer writes:

Oil refining is one of the least profitable businesses in the US.

That is the markets way of telling us we do not need more refineries.

B.H. writes:

I checked the data.

For the 7 months available for 2008, the capacity utilization rate for oil refining is 91%. That is close to the highest since 1974. It is especially remarkable in that the periods of low utilization are, unsurprisingly, during recessions. For the USA to be in a borderline recession condition with such a high utilization rate suggests to me that refinery capacity is limited. A revival of fuel demand from an economic recovery could push gasoline prices up a lot. Or push gasoline imports up a lot.

spencer writes:

Tell me, who is the regulator that refuses to site new refineries?

I bet you can not.

eric writes:

Silly Bryan: all demand curves and supply curves are inelastic! See Stigler's Law of Elasticities.

Brian writes:

B.H., I don't know where you found your data, but if you look at the EIA's weekly refinery utilization rates it has only been above 90 percent in one week this whole year. Actually, it was the first week in January. The average weekly rate for 2008 to date is a measly 86 percent. When you consider this includes the period of highest operating rates (to produce gas for summer driving), it is a really lousy time to be a refiner.

Jeremy writes:

I work in Alaska, and the price of gas up here has not fallen all that much from its peak, despite the 20%(?) drop in oil prices. What is it that makes the market up here unique? Is it isolation? Supposedly we're at the wellhead.

John writes:

Refineries are not described by Leontief technology. They have smooth isoquants. They can shift the ratios of products produced as the prices change for specific products such as gasoline, kerosene, jet fuel, naptha, and other petroleum products. Hence, as the prices of gasoline and jet fuel increase, refineries can increase these outputs even if they are running at capacity in some total sense. Supplies of individual products are elastic

David Friedman writes:

I was puzzled a while back about why everyone was claiming that all economists agreed that cutting the gas tax would have no effect on the price, merely give money to the oil companies. Even if world supply were inelastic, U.S. supply wouldn't be, because the U.S. can bid gasoline away from other markets. So we would expect cutting gas taxes to lower prices at the pump (ceteris paribus), although not by the full cut, while raising world pre-tax prices.

Dr. T writes:

Spencer writes:

Oil refining is one of the least profitable businesses in the US.
That is the markets way of telling us we do not need more refineries.

That would be true if markets were the only factor determining refinery profitability. Unfortunately, we have these entities known as governments, regulations, and environmental groups. They have huge negative impacts on the profitability of refineries or other chemical processing facilities.

diz writes:

The truth is mildly complicated: Sometimes the US refining system is at or close to capacity, sometimes it isn't.

Demand is seasonal, there are unplanned and planned maintenance/turnarounds, weather disruptions, pipeline outages, etc. There are also markets for co-products that affect things as well. Right now, refineries are likely maximizing their diesel cut because it is a more valable product - though the ability to do this is obviously limited or gas and diesel prices would have converged already.

EIA capacity numbers can be a bit misleading. They typically refer to just the use of the crude tower. Most refineries have a series of more complex units that take intermediate products from the crude tower and futher process them into gasoline and other high value products. The last barrel of crude into a nearly full refinery may produce relatively small fractions of finished products if the refinery does not have sufficent upgrading capacity downstream of the crude unit.

As has already been mentioned, you can usually look at refining margins and get a feel for how close to capacity the industry is. Margins were very high back in 2007, but have gotten thin as of now. Obviously, with demand declining utilization has fallen.

MSK writes:

Is there any realistic ink between supply and demand of oil products and the price we see at the pump - at least in the short term? On today's WaishingtonPost.com site the following national average gas price information was posted: 1 year ago $2.75, 1 month ago $3.97, today $3.67. Has there been a 10% drop in demand since last month? Really? Has there been a 30% drop in supply since last year? Not that I can find evidence of - I have seen a shift in institutional investments from mortgage based securities into the oil futures markets. I think a much stronger case can be made for the law of unintended consequences that for the law of supply and demand. Can't a much stronger case to be made for the effects of investments in the futures market directly effecting prices at the pump than there is for any supply side metrics? The same unfounded enthusiasm that fueled the dot com boom and the housing bubble appears (to me) to be at work in the oil futures markets. Let's watch the price per barrel as Hurricane Gustav nears the gulf, how much of an effect will that have on prices at the pump? And how quickly? http://www.washingtonpost.com/wp-dyn/content/business/special/3/

dtt writes:

The thing to remember about capacity is that there are only about 150 refineries processing crude in the US day. 25 years ago, that number was nearly twice that. Capacity creep and more efficient produces drove others out of business that could not compete. Until three years ago, it was very hard to earn a return in refining that exceeded cost of capital. The low utilization will certainly drive the marginal producers out of business and we will move toward 100% capacity until several of the announced expansions get built.

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