Energy prices have been on the rise since the second quarter of 2020 after taking a brief but severe tumble in the early months of the pandemic. As the economy attempted to stabilize and recover, oil rallied to trade over $125 per barrel at one point in March of this year. More recently, the national average price for a gallon of gasoline rose to just over $5, an all-time high, before backing off over the last month or so.
While energy prices were on the rise well before the Russian invasion of Ukraine last February, geopolitical tensions have helped to further push energy prices higher as supplies relative to demand have tightened. Sanctions aimed at limiting Russia’s ability to sell oil and crude distillates further disrupted the supply/demand imbalance just as gasoline, diesel fuel, and jet fuel saw increased demand as U.S. and global economies began to recover.
Consumers in the U.S. have seen more of their incomes go toward filling up their vehicle’s fuel tank every week. Travelers have taken notice of meaningfully higher airfares and crowded planes as people go on more business trips and vacations. Higher prices have started to cool demand for products and services tied to the price of energy.
The Biden administration is asking oil companies to produce more oil and refiners to distill more end-user product in an effort to knock down energy prices. The concept seems simple: produce more supply relative to demand and prices are likely to fall. But the reality is more complicated. Let’s look at this issue from the refiner’s point of view.
Chart 2. U.S. operable crude-oil distillation capacity
Sources: U.S. Energy Information Administration, Wells Fargo Investment Institute, as of August 11, 2022.
As the U.S. Energy Information Administration (EIA) points out, U.S. refinery capacity decreased during 2021 for the second consecutive year (Chart 2). Operable crude oil distillation capacity totaled 17.9 million barrels per calendar day (BPD) as of January 1, 2022, down from a distillation capacity of 18.1 million BPD on January 1, 2021, and 19 million BPD at the beginning of 2020. This has occurred while the demand for gasoline, diesel, and jet fuel has increased and U.S. exports of distillate products to Europe have jumped higher as prices “across the pond” rose relative to the U.S. as less Russian product reached the Continent.
Ideally, as with most other products, producers look for ways to increase capacity and therefore boost profits as demand increases. But there is the refining rub. According to EIA data, U.S. refiners are operating at approximately 94% of total capacity. Given that refineries are frequently shut down for short periods of time for regular maintenance and occasional unscheduled repairs, there is not much unused capacity to boost production by any noticeable amount.
That begs the question, “Why don’t we just build more refineries?” Once again, let’s rely on EIA data for perspective. The EIA tells us that as of the start of 2022 there were 130 operable petroleum refineries in the United States. The newest refinery, located in Texas, came online at the beginning of the year and produces just 45,000 BPD. But the last refinery built with what the EIA considers “significant downstream unit capacity” came online in 1977 with 585,000 BPD. That is not a misprint, the last major refinery in the U.S. was built 45 years ago. There has, however, been some incremental additional capacity added at a couple of other refineries over the last 10 years. But still, given the growth of the domestic economy in recent decades and the growth in demand for distillates over the same time frame, one can argue refining capacity is well below what many would consider adequate levels.
Government permitting processes for refining expansion or the building of new facilities are stringent and can take many years. Of course, the building of new facilities also suffers from the “not in my backyard” mentality as communities would prefer that new refineries be built in other locations. The push for energy sources that are not fossil fuels also creates headwinds as proponents of greener alternatives fight to prevent additional refining capacity from being built. And finally, refining companies are looking at the cost of building new production facilities and the decades it can take to generate an acceptable return on their investment and trying to determine, quite literally, how long their industry may exist.
From a portfolio standpoint, we currently carry a favorable tactical rating on the Energy sector over the coming 6-18 months. The shortage of refinery capacity contributes to our tactical favorable rating by limiting the supply of distillates. When summer driving or business and vacation travel demand increase, prices are likely to increase without drawing out any new supply from producers. From a longer-term perspective, Energy will continue to play a large role in powering the growth of the economy looking ahead. The fact is, renewables are unable to replace fossil fuels any time soon, meaning that limited supplies over a multi-year horizon are likely to create favorable conditions if demand continues to increase as we expect. Investment in both traditional energy and alternative-energy companies will be necessary as the transition to a carbon-free or near carbon-free economy will likely take decades.