The Cost of Environmental Regulations

That title will immediately raise some eyebrows, but I am not suggesting that we don’t need the environmental regulations we have. Rather, I just want people to understand that this is part of the cost for gasoline. I want them to understand that they aren’t getting a free lunch here. But by no means do I condone the watering down of environmental regulations in order to make gasoline cheaper.

Rather, I want to reiterate something I wrote in a previous essay. When politicians enact new regulations, they need to have an understanding of what this means. First, this necessarily redirects capital that might have gone into expanding refining facilities. Second, it increases the costs of producing the fuel. Third, this additional level of processing reduces the overall product yield. Fourth, and perhaps of greatest importance, it increases the complexity of the refinery.

Those are the consequences. The more complex the refineries are, the more unreliable they are going to be. There are more ways for it to now break down. There is more danger as the inventory of hazardous materials is increased. So, politicians who are passing these laws shouldn’t sit around and ask “Gosh, I wonder why gasoline prices are going up?” Stricter environmental regulations – which I agree with – are one more piece of the puzzle. They have helped crimp supplies and add to costs.

Along those same lines, I received a comment following a previous essay that should be its own essay. He addresses some of these issues in a good bit of detail. While I don’t agree with everything he says, there is a lot of very good information in his comments. Here they are:

26 year old refinery guy said…

More than half of the 300+ US refineries that were in operation in the early 1980’s have closed their doors…”. The thing that Congress and the news media isn’t talking about is why all those refineries closed permanently.

Although there are probably several different reasons, I believe the main reason is from the Tier II Regulations that were passed by the EPA. Most people (including those in Congress) don’t realize the cost that each refinery had to invest to meet the Tier II Regulations. In general terms, these regulations state that gasoline must have less than 30 parts per million of sulphur and diesel fuel must have less than 15 parts per million of sulphur. Previous requirements were 300 ppm for gas and 500 ppm for diesel.

To meet the new regulations, each refinery was required to spend huge amounts of money, from tens of millions for smaller refineries to hundreds of millions for larger refineries. Refineries had to make a choice, spend the huge amounts of money to upgrade and stay in business or not spend the money and shutdown.

For smaller refineries, the profits at the time didn’t justify the huge investment to upgrade so they stopped producing gas and diesel fuel. Most of these refineries became storage terminals because, without the upgrades, they could no longer sell their products and the cost of closure, which includes demolition and clean-up, prohibited them from actually closing. In other words, the EPA sees them as an operating facility but they no longer produce gasoline and diesel fuel. In the early years of some of the refinery closures, other larger refineries de-bottlenecked (increased capacity) which offset the loss of capacity from the closed refineries. Once these large refineries increased capacity as much as practical, other smaller refineries were still continuing to close.

Eventually, we end up where we are today, total refinery capacity in the USA is less than current demand. I can remember in the early 1990’s when gas was cheap and refineries were losing money during certain times of the year because there was an oversupply of product. Where were the Congressmen and news media back then. I never heard one Congressional request for an investigation back then into why gas prices were so low. Another thing about the Tier II issue is that the cost to meet the regulations was so huge, the refineries that did make the investment were limited on the money they could spend on other capital improvements. These are the improvements to become more efficient and more reliable.

Most refineries took about 3 to 4 years from start to finish to meet the Tier II Requirements. During this time, the refineries continued to operate but were not making the normal improvements that they would have without the Tier II cost. Most people don’t realize that process units in refineries must take turnarounds every 4 to 5 years. This must be done to operate safely and maintain equipment properly. Depending on the refinery, some schudule turnarounds for different process units during different years to minimize production downtime and limit their exposure to market conditions. Most refineries try to schedule turnarounds during the time of year when they believe demand and margins will be at their lowest. This is usually during the spring and fall. However, during the last few years, demand has been continually increasing even during the spring and fall. Imports is another issue. I believe that the imports from Europe still have a 50 part per million sulphur specification.

This means that every gallon of imported gasoline must be blended with gasoline that is less than 30 ppm so the level at the gas pump meets the EPA required 30 ppm. Because most refineries don’t make a gasoline blend that is significantly lower than 30 ppm to blend with the 50 ppm imported gasoline, imports will continue to be limited until Europe requires the same 30 ppm specification. Regarding ethanol, must people don’t understand that it takes more energy to make a gallon of ethanol than it does to make a gallon of gasoline and ethanol doesn’t have the BTU value of gasoline.

In other words, you would have to use approximately 20% to 30% more E85 gasoline to go the same distance you would with 100% gasoline. E85 gas is a mixture of 85% ethanol and 15% gasoline. Another thing most people don’t realize is that the gasoline blend that is used to make the E85 gas and the 10% ethanol blended gasoline must start out at a higher octane rating than the 87 octane that you buy at the pump. When MTBE was used, it had an octane rating around 100. MTBE could be blended with a low 80 octane blend and the final product still ends up with the 87 octane. The higher the octane blend stock the more expensive it is to make. That’s why 93 octane premium grade is higher than 87 octane regular gas.

Back to the EPA, I believe there is talk that they want to reduce the sulphur requirement to below 10 ppm in the future. In this regulation gets passed, the remaining operating refineries will have another huge investment and the cycle will start all over again. By the way, lowering the sulphur in gas and diesel doesn’t make your vehicle go any farther on a gallon. Eventually, you get to a point of diminishing returns. In other words, the huge investments required to meet the regulations never justify the end results. I believe that the Supreme Court has ruled that the EPA does not have to consider cost in its decisions when passing regulations. Maybe I don’t understand how the EPA works but it seems that they actually violate the Constitution of the United States since they make their own laws, they pass their own laws, and they enforce their own laws. I thought this country was set up with three branches of Government so one body wouldn’t be able to have all of the power.

Regarding one of Gas Guys comments about the cost of building a new refinery, he was a little low. The cost in today’s dollars to build a 200,000 barrel per day refinery would be about $5 billion to $7 billion and it would take about 5 to 7 years assuming you could get the necessary EPA permits in a timely manner. With Congress talking about passing Windfall Profits Taxes and President Bush talking about reducing demand by 20% in the foreseeable future, I don’t know of any company that would be considering building a new refinery. If you were a “widget” manufacturer and there was a widget shortage, you would want to make as many widgets as you could if they were selling as fast as you made them at a price that was higher than the previous 5 year period. However, if there was talk of a “Widget Tax” for future profits and the government was going to take action to reduce the demand for widgets, would you as a widget manufacturer be willing to spend billions of dollars without knowing if you will ever get a return on your investment?

By the way, I saw an article the other day that talked about the Kuwati Government cancelling their plans to build a 600,000 barrel per day refinery. The article stated that the estimated cost went from an earlier estimated $6 billion to the latest revised cost of $15 billion and that was without the US EPA being involved.

The costs with the EPA are estimated at 50 cents per gallon by

19 thoughts on “The Cost of Environmental Regulations”

  1. I’m under the impression that may of the smaller refineries had problems securing crude at a reasonable price after the industry was deregulated in the early ’80’s. The Majors no longer had to supply them crude at below market prices.

  2. anon – yes many of the closed refineries were inland facilities built near large crude sources. When the crude dried up, so did their competitive source of supply.

    26-year-old refinery guy – you asked about EPA and making laws. Yes, they do make law with congressional oversight. They do it through something called the “rulemaking process”. This a very rough explanation of a complicated government process.

    Using a football analogy, imagine congress sets up the basic rules of football. Congress determines the number of players on each team, basic dimensions of the field, outlines how to score and how to determine the winner of the game. Then EPA has to figure out the hundreds of rules required to actually play the game. Like what constitutes holding or pass interference, who is eligible to receive a forward pass.

    There are 14 major pieces of federal regulation that EPA administers. The biggies are: The Clean Air Act (CAA); The Clean Water Act (CWA); The Resource Conservation & Recovery Act(RCRA), and The Comprehensive Environmental Response, Compensation, and Liability Act Superfund (CERCLA).

    EPA follows a process where they propose a rule, then hold public comment and hearings on the rule. They then determine the Final Rule, publish it in the Federal Register and it becomes law within a year. All concerned parties lobby very hard during rulemaking. This is where you make your case as to the benefits and costs of any particular rule. Once a rule becomes final, someone affected by it could sue arguing the rule did not follow the law or was not what congress intended. Courts generally give deferrence to the administrative agency, so it is usually more difficult to turn over a rule unless there was an error. But it happens.

    You can also petition congress to change the law. The 14 major laws come up for periodic reauthorization. But it is very difficult to make changes to the law. Sometimes congress makes minor changes to the 14 major laws through amendments to other laws.

    You are right in that the Supreme Court said that EPA did not HAVE to consider costs. But I believe that congress made that a requirement.

  3. To illustrate how EPA can get things get screwed up, lets look at the Safe Drinking Water Act. In the final days of the Clinton administration, the EPA changed the limits on arsenic in drinking water from 50 parts per billion to 10 ppb. (That Mr. Clinton changed it as he was leaving should tell you something.) Christine Todd Whitman, Mr. Bush’s first EPA administrator changed it back to 50 ppb. If you do a google search on “Bush arsenic water” you will get all kinds of articles that might lead you to believe that the President is breaking into homes at night and slipping arsenic and lead into baby bottles.

    The reality is that meeting the new standard costs some municipal water systems nothing, while placing great burdens on others cities. Arsenic occurs both naturally in aquafiers, but is also found in groundwater runoff from mining operations. Arsenic in drinking water may cause bladder cancer. Reducing the level of arsenic would reduce the number of bladder cancers. Environmentalists will say the average costs per person are small, true when averaged over the whole US, but the regulation most impacts well water systems, the source usually for smaller midwestern towns and cities. Making cities comply with 10 ppb could divert funds from other critical services like police or fire. Costs for water could rise to the point that some people chose to drill their own water wells, which often have water quality worse than town water. It is a difficult public health situation. Nobody (not even President Bush) wants people to get cancer or other diseases, but there are always cost-benefit tradeoffs with any regulation.

    I read about a small town of 300 in Kansas that was having trouble complying with a rule on nitrates in drinking water. Nitrates can cause birth defects in pregnant women and can impact infants. At the time the rule was to go into effect, there was only 1 pregnant woman in town. The town offered to purchase bottled water for her and any pregnant women in the future. That didn’t satisfy the EPA. I don’t recall what happened.

    Perhaps President Bush should impose a national speed limit of 5 mph on his last day in office. That would certainly save tens of thousands of lives every year and reduce our demand for fossil fuels and greenhouse gas emissions. Then when the next president changes it back we can complain about how insensitive and anti-environmental they are.

  4. Have you noticed the stock move since the Today Show appearance? I think that profit graph – while misleading – caught the eyes of some investors. We have been off to the races for that past couple of days.

  5. Yes, I’ve noticed. Don’t necessarily think the Today show appearance is related, but it didn’t hurt.

    Price is moving to bring it more in line with our peers. XOM and BP plc trade at 10 times forward earnings, Chevron at 9 times. We were around 8. At 9 times share price should be $85.

    Our friends at FTCR had links to the following chart:

    href=”” > Oil Company Mergers

    To FTCR and John Edwards this is the smoking gun that shows why gasoline prices are so high. I don’t agree, but I liked the chart anyway.

  6. Don’t necessarily think the Today show appearance is related, but it didn’t hurt.

    I think it’s related. First, while I have been telling everyone who would listen that we have been undervalued since the merger, we still haven’t caught up to where we should be. But when that profit graph was put up there, you got the impression of a company strongly and consistently growing profits. That day, we closed up, ahead of all of our peers. In fact, I think some of the others were down. And we have closed up strongly since then. The sector as a whole is going up, but we have been going gangbusters.

    To FTCR and John Edwards this is the smoking gun that shows why gasoline prices are so high. I don’t agree, but I liked the chart anyway.

    The FTC testified on that before the Senate a couple of weeks ago. They concluded that the mergers had in fact added to the cost of gas – by 1 cent per gallon.

    Cheers, Robert

  7. Kingfly, your assessment about how the EPA “rule making process” works does not apply in this case. Please reference the following article on how the EPA used fradulant data to justify this dasterous regulation (after it was too late for public comment or congressional oversight)not to mention how the court swept this matter under the rug:

    EPA Makes Public Pay for More Smog
    Tuesday , February 08, 2005
    By Steven Milloy

    After more than four years of stalling tactics by the Environmental Protection Agency, a federal appellate court just might finally consider the matter of whether the agency used junk science to force both gas prices and smog levels higher.

    I say “just might” because it looks like the court is about to sweep the matter under the rug in favor of the EPA.

    On Feb. 14, the U.S. Court of Appeals for the District of Columbia is scheduled to hear arguments in National Alternative Fuels Association (NAFA) vs. EPA (search). The lawsuit centers around EPA regulations issued in 2000 mandating lower levels of ground-level ozone (search) in urban areas by reducing the amount of sulfur in gasoline, called the “Tier 2 standards.” (search)
    By way of background, the Clean Air Act Amendments of 1990 (search) directed the EPA to issue regulations reducing emissions from motor vehicles, including those contributing to ozone such as volatile organic hydrocarbons (search) (VOCs) and nitrogen oxide (search) (NOx). These standards resulted in reformulated gasoline, which has been in the market place for some time.

    The law also directed the EPA to study whether further emission reductions would be required following implementation of the reformulated gasoline (search) rules. This study was then used by the EPA to justify issuing the “Tier 2” standards — here’s where the controversy begins. The EPA claimed that, unless low-sulfur gasoline (search) was mandated nationwide, the emissions reduction accomplished under the Tier 2 rules might be nullified — citing auto makers’ dubious concerns that conventional gasoline might harm the new emissions control equipment required by the rules.

    This claim was tested and validated in its study, according to the EPA. According to NAFA’s lawsuit, however, a report prepared for NAFA by an independent emissions testing laboratory indicates the EPA rigged the test to achieve a pre-ordained result.

    “It was concluded that [the] methodology used by EPA was faulty and that the data used did not support the conclusion that emissions from Tier 2 vehicles [caused harm to emissions equipment]… Emissions data from only four vehicles were used… an SUV, a pickup and two minivans…. The SUV [vehicle] emissions were weighted to represent 2/3 of the final estimate…,” concluded the laboratory.

    Adding insult to injury, the EPA’s tests were then introduced into the public rulemaking record after it was too late for the public to comment on them, according to the NAFA lawsuit.

    Four years later, the public may now be paying a real price both in terms of higher gas costs and increased pollution as a result of the EPA’s actions. When asked about rising gas prices in an August 2004 interview on National Public Radio, economist Philip Verleger of the Institute for International Economics attributed the $0.50 increase occurring between March-July on the EPA’s low sulfur regulations and limitations on gasoline refinery capacity.

    NAFA estimates the costs of the low sulfur rules are in the $0.20-0.25 range. (closer to $.60-$.90 as of june 1, 2007) But the ultimate irony — as pointed out by the Competitive Enterprise Institute’s Dr. Kay Jones in 1999 using the EPA’s own data — is that the agency’s Tier 2 rules may actually worsen air pollution.

    Although the EPA characterizes NOx as a precursor to ozone, NOx reductions can actually increase or decrease ozone concentrations depending on the locations and emission rates of NOx and other air pollutants, says Dr. Jones, citing work done by the National Academy of Sciences.

    “Smog in many urban areas increases when NOx concentrations are further reduced, while declines generally occur in less heavily populated downwind areas,” says Dr. Jones. His prediction has come true according to some leading atmospheric scientists — NOx reductions may, in fact, be increasing urban ozone levels around the country.

    You would think that a federal court would be eager to get involved where a federal agency may have engaged in faulty scientific testing resulting in higher costs to consumers and more pollution. Yet, the D.C. Court of Appeals seems on the verge of letting the EPA get away with it.
    After allowing the EPA to stall the case for four years, the Court granted the EPA’s objection to a request by NAFA to extend by 30 days the filing of its opening brief. Such extensions are routine and are almost always granted.

    NAFA filed a hastily prepared opening brief on time, followed by a more completed amended opening brief 30 days later. Without a showing of any harm done, the EPA objected to NAFA’s amended brief and the Court granted EPA’s request summarily — that is, without explanation.

    The EPA answered NAFA’s opening brief and, although NAFA replied, the EPA subsequently filed a motion to reject NAFA’s reply based on legal technicalities. The Court granted the EPA’s motion, denying NAFA an opportunity to address the technicalities as would almost any court. The Court provided no explanation or reasoning for this unusual move.

    This week, NAFA filed with the Court an emergency request for reconsideration and a reply brief curing all the technical matters that EPA objected to.
    If not granted, the Feb. 14 hearing is likely to be short and sweet — in favor of the EPA, but against all the rest of us.

  8. Price is moving to bring it more in line with our peers. XOM and BP plc trade at 10 times forward earnings, Chevron at 9 times. We were around 8. At 9 times share price should be $85.

    I was just doing a little research, which I have done frequently over the past 5 years. You are right; we are at 8.2. The industry average, according to CNN, is 12.6. The sector average is 11.9. Amazing.

    Cheers, Robert

  9. Four years later, the public may now be paying a real price both in terms of higher gas costs and increased pollution as a result of the EPA’s actions.

    This is a problem that I see a lot. I will give you an example. I have seen a case in which a point source emission of CO2 was achieved – at a cost of an enormous increase in electricity usage. That electricity is produced by coal-fired power plants. So, was the overall CO2 actually reduced? Probably not. But, to an untrained eye that certainly appears to be the case.

  10. anon – excrement happens. I was answering a question about how EPA gets to make law. I am familiar with the Tier 2 case. I agree that EPA’s methodology was flawed.

    I do projects in both the US and Europe. One would think that in the pro-business US, permitting is easier. I disagree. European regulations are much more straightforward and less political.

    As for silly EPA things, One of my projects put a wastewater cooler because the average temperature increase of our discharge was 2 F higher than allowed. The discharge was into the Caribbean Sea, where it immediately warmed back up by 2 F or more. Go figure.

  11. Robert – We’ve had to live with a low P/E for a long time. Prior to the merger the reason analysts gave is that we were’nt big enough. After the merger the excuse was that mergers seldom delivered the expected results. Once earnings started shooting up the reason was not enough history. Now after 5 years of earnings growth maybe they have run out of excuses.

    At the Senate Paul Sankey tried to make the same point about other stocks. The equity markets have decided that energy companies aren’t a good long term bet. Most stocks trade at higher P/E multiples. Capital should be flowing out of overpriced tech and into US oil and gas companies, but it isn’t. If John Edwards and FTCR are right about anti-trust and price gouging, then who wouldn’t want to invest in an energy company? They can just set prices and earnings as high as the CEO wants. No sweating quarterly earnings, no need for cost cutting, just call down to the service station and tell them to set the price at whatever we want. It would be riskless investment.

  12. The sector as a whole is going up, but we have been going gangbusters.

    A couple of weeks ago, we were 6th among our peers. Today, we are 2nd. Looking back, I do notice a couple of things I had missed. There was an upgrade by Bernstein on May 23rd to “outperform.” Earnings estimates have also been moving steadily up over the past 30 days.

    I have told many people that there was a reason I came to work for an oil company. It looked to me like energy was about to become expensive, and stay expensive, and an energy company seemed like a safe place to be.

    Cheers, Robert

  13. I have seen a case in which a point source emission of CO2 was achieved

    That should read “point source emission reduction was achieved.”

  14. Don’t forget the company announced it would be buying back more of its stock. It makes you wonder if one or more energy companies might consider going private. With bond rates pretty cheap and earnings high, it could happen.

    The other thing hanging out there is Venezuela. I can’t imagine sinking any more money into investments there. If there is positive cash flow without investment it might be better to stay.

  15. Heh. Interesting that you mention that. Someone wrote to me yesterday, asking about investments. Part of what I wrote back:

    Our stock has outperformed all of the other majors over the past 3 and 5 year period, and yet we still trade at a discount to them. One reason is our exposure in Venezuela, and the potential loss of billions in assets.

  16. I was just doing a little research, which I have done frequently over the past 5 years. You are right; we are at 8.2. The industry average, according to CNN, is 12.6. The sector average is 11.9. Amazing.
    So, what? Are you coming out of the closet (so to speak) and officially telling us who you are working for? Somehow the Scotland thing had me believing it was BP. Should have known, I guess.

  17. Are you coming out of the closet (so to speak) and officially telling us who you are working for?

    No. And this is as close as I will ever get. But there is an official government document floating out there that identifies my employer. A lot of people are aware, so it is a poorly kept secret who I work for. But, I don’t mention them, because I don’t want their to be any implied endorsement of my positions. I also take some positions that are contrary to official company policy.

    Cheers, Robert

  18. No. And this is as close as I will ever get.
    Crud. That was not very subtle, IMHO. But then OK, I’ll play along…

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