Released on January 5, 2006
(Next Release on January 11, 2006)

The Year of the Fuel Spec
A year from now, as we look back on 2006, oil market analysts may call it, “The Year of the Fuel Spec” (“spec” being short for specification). Regulatory and industry changes to the composition of both gasoline and diesel fuel will be key issues affecting these markets in 2006. How markets behave during the transition to these new transportation fuel specifications will go a long way in determining how high retail prices may reach for these two fuels.

Specifically, five fuel specification changes, some due to mandates for cleaner-burning fuels pursuant to the Clean Air Act Amendments of 1990, others resulting from the Energy Policy Act of 2005 (EPAct 2005) and industry responses to it, will stress the fuel supply system in 2006. Two of these changes, the ultra-low sulfur diesel (ULSD) program, and the removal of methyl tertiary butyl ether (MTBE) from reformulated gasoline by many suppliers, are likely to be the most challenging to the market. Three additional fuel specification changes in 2006 are expected, individually, to have only minor impacts on gasoline prices and price volatility, but in total, to exacerbate an already tight market. They are: (1) establishment of a renewable fuels standard in EPAct 2005 that requires an increasing volume of renewable transportation fuel to be used each year starting in 2006; (2) implementation of an EPAct 2005 requirement that reformulated gasoline meet the same volatile organic compound (VOCs) emission standard in northern and southern regions, in an attempt to begin consolidating fuel types to increase fuel fungibility; and (3) implementation of the full Tier 2 low-sulfur gasoline requirements, resulting in average gasoline sulfur content of 30 parts per million (ppm), one-tenth the average sulfur content only three years ago.

As the ULSD program and the removal of MTBE from reformulated gasoline (RFG) have the potential to cause the most volatility in prices during the transitions this year, it is worth focusing on these two changes a little more closely. In both cases, following the operational changes and new equipment installation required by refineries and distributors, supply problems may arise from:

The ULSD program begins in 2006 with the requirement that at least 80 percent of on-highway diesel fuel being supplied must have no more than 15 ppm sulfur content at retail. Refineries are scheduled to comply by June 1. (The sulfur content of non-road, locomotive, and marine diesel fuel will be ratcheted down in subsequent years.)

Notwithstanding the recent hurricanes, refinery modifications to allow production of ULSD are largely on track. The biggest challenge is expected to be delivery of the product from supply source to retail. ULSD will travel with other petroleum products through pipelines on the way to bulk terminals from which it will be shipped by tanker truck to truck stops and retail stations. However, other petroleum products traveling in the pipeline system with a much higher sulfur content could easily contaminate ULSD -- jet fuel, for example, can have 3000 ppm of sulfur. If ULSD is contaminated, it may not be possible to correct the batch by blending with additional low sulfur product. Contaminated ULSD may have to be returned to a refinery for reprocessing, which can be difficult because petroleum product transportation systems are not designed to return product to refineries.

While delivery of ULSD without contamination is being tested, successful delivery is still a question. In order to help with the transition to ULSD, EPA extended the time when terminals and retail must meet the requirements by 45 days to mid-October. During the 45-day period, 22-ppm diesel will be considered compliant fuel at retail. However, even without supply problems, the price of diesel should increase over what it would otherwise be due to the higher cost of producing ULSD.

The removal of MTBE from gasoline will increase the potential for higher gasoline prices and price volatility. Companies’ decisions to eliminate MTBE have been driven by State bans due to water contamination concerns and the potential for increased liability exposure due to the elimination of the oxygen content requirement for reformulated gasoline (RFG) included in the Energy Policy Act of 2005.

Currently, the largest use of MTBE is in RFG consumed on the East Coast and in Texas. Most companies eliminating MTBE in the short run will blend ethanol into the gasoline to help replace the octane and clean-burning properties of MTBE. As companies move to ethanol-blended RFG, they experience some loss in production capability in the summer months (about 5 to 6% outside of California), due to changes necessary to accommodate ethanol’s higher evaporative properties (RVP) and provide additional reduction in toxic components required for ethanol blendstocks. When New York and Connecticut moved away from MTBE last year, the affected volumes were small enough that refiners had some flexibility to keep from experiencing much volume loss. But when a refiner producing mainly RFG-type gasoline eliminates all MTBE-blended RFG, volume loss is unavoidable.

The distribution chain presents another challenge when moving to ethanol-blended gasoline. Ethanol-blended gasoline cannot be intermingled with other gasoline during the summer months, and ethanol must be transported and stored separately from the base gasoline mixture to which it is added until the last step in the distribution chain. Many areas of the distribution system cannot handle additional products. Some terminals and pipelines will choose to carry either MTBE-blended or ethanol-blended RFG, but not both.

Both capacity and transportation issues imply a very tight ethanol market for at least the first part of the year. While ethanol capacity is being rapidly expanded, sufficient capacity may not be ready if gasoline suppliers try to put their ethanol-blended product into place during the first and second quarters of 2006. The availability of storage and transportation infrastructure is perhaps an even greater challenge during the first half of 2006. For example, with a complete phase-out of MTBE, the East Coast would need to transport and handle as much as an additional 90 thousand barrels per day, or 2.5 times the quantity of ethanol being moved to the East Coast in 2005. Rail cars and barges may not be available. Moving ethanol from conventional gasoline in the Midwest may help to meet some of the demand, but logistics may not allow for easy movement from current uses in the Midwest to the East Coast. Ethanol imports from Brazil may be another solution.

Gasoline imports will also be affected by eliminating MTBE. Some foreign refiners are not now capable of providing MTBE-free finished gasoline to U.S. markets. While they might be able to provide some MTBE-free gasoline components, import facilities in the U.S. do not have the blending facilities to handle a large switch from finished gasoline to blending components. In addition, importers previously providing finished MTBE-blended RFG may not be able to provide as much volume of high quality, low-RVP blending components needed to produce the base RFG blendstock for ethanol blending.

Both the ULSD transition and the MTBE transition have the potential for regional supply disruptions with periods of increased volatility potential. The other three fuel specification changes are not likely to affect markets to nearly the same degree as the ULSD program and the removal of MTBE. How markets adjust to these fuel specification changes will be a major issue in 2006.

Residential Heating Oil Prices Decrease Slightly While Propane Prices Increase
Residential heating oil prices decreased for the period ending January 2, 2006. The average residential heating oil price fell by 0.1 cent last week to reach 243.2 cents per gallon, an increase of 48.1 cents from this time last year. Wholesale heating oil prices increased by 2.8 cents to reach 179.7 cents per gallon, an increase of 51.5 cents compared to the same period last year.

The average residential propane price gained 0.5 cent, to reach 201.1 cents per gallon. This established the price at 28.1 cents over the 173.0 cents per gallon average for this same time last year. Wholesale propane prices decreased 4.0 cents per gallon, from 117.9 cents to 113.9 cents per gallon. This was an increase of 29.0 cents from the January 3, 2005 price of 84.9 cents per gallon.

U.S. Average Retail Gasoline Prices Rise by 4 Cents
The U.S. average retail price for regular gasoline climbed 4.1 cents to 223.8 cents per gallon as of January 2, which is 46.0 cents higher than last year. Prices were up throughout most of the country, although West Coast prices fell by 1.1 cents to 220.5 cents per gallon. The Midwest region saw the largest average increase of 6.9 cents to 226.3 cents per gallon, closing in on the highest regional price, which was 226.4 cents per gallon on the East Coast.

Retail diesel fuel prices edged down 0.6 cent to reach 244.2 cents per gallon as of January 2, which is 48.5 cents higher than last year. Regional price changes were mostly down throughout the country, although price increases in New England and the Lower Atlantic left the overall East Coast price the same as last week at 248.1 cents per gallon. The highest regional price in the country was on the West Coast, where prices fell 0.4 cent to 251.9 cents per gallon. The Rocky Mountains saw the largest regional price decline of 1.8 cents and the lowest regional price of 239.2 cents per gallon.

December Propane Stockdraw Posts 5-Year High
The cumulative stockdraw during December, including last week’s 3.8-million-barrel draw, totaled nearly 14 million barrels, the highest for this month in five years and about 25 percent higher than the most recent 5-year average. Although several patches of cold weather swept through some of the major propane heating regions during the month, the overall weather for December was only slightly colder than normal in the East Coast and Midwest regions. In contrast, the overall stockdraw on propane inventories during the first half of the 2005-06 heating season (October through December) measured about 11 percent below the most recent 5-year average, the result of the relatively mild weather experienced during October and November. As of December 30, 2005, U.S. inventories stood at an estimated 57.6 million barrels, the highest level for this period since 2001.

The weekly stockdraw was mostly concentrated in the Gulf Coast region that reported inventories lower by 3.0 million barrels, followed by a modest 0.5-million-barrel draw in the Midwest. While the East Coast did not experience any stockdraw last week, the combined Rocky Mountain/West Coast regions showed inventories sharply lower by 0.4 million barrels during this same time. Propylene non-fuel use inventories posted a modest 0.1-million-barrel gain last week, pushing the share of this fuel up to 6.8 percent of total propane/propylene inventories from the prior week’s 6.2 percent share.

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