SEven before the hurricanes hit this fall, we were seeing some very unusual distillate prices, which raises the question of what was happening to distillate markets that was different this year.  Then the hurricanes hit, affecting supply severely in the short term. SThis presentation will provide background on distillate supply and demand, and then will focus on what has happened since Katrina and Rita and how the loss of U.S. refining production capability may impact the winter fuels situation.

SThe presentation will begin with a brief overview of the unusual distillate and gasoline prices seen in 2005 before the effects of the hurricanes.  The unusual prices consumers experienced were not limited to the United States. SEurope is a key player in Atlantic Basin petroleum markets, and in order to understand what is happening to U.S. gasoline and distillate prices, we need to look at how these two regions interact.  SThe last portion of the presentation will focus on the near term affects of Katrina and Rita and discuss some major uncertainties that have arisen for the upcoming winter heating oil season as a result.

SThe unusual distillate price strength this past year was not limited to the U.S.  Heating oil prices on both sides of the Atlantic and in Asia (not shown) exceeded gasoline prices through late summer. SThe provocative question is whether this highly unusual gasoline/distillate price situation in summer 2005 stems from a temporary situation or is the beginning of a more fundamental shift in the relative pricing of these primary light refined products.  SWe have all been watching the growth in diesel demand, and at some point, price for diesel will have to rise relative to gasoline to produce the incentives needed to shift refinery investment towards more distillate production.  Is this the beginning of that situation? SEurope is highlighted on this chart because it plays an important role in world and in particular Atlantic Basin markets. 

SEurope and the U.S. represent the major refining centers of the Atlantic Basin.  They both run at fairly high utilization, but this is not unusual.  While both regions have increased utilizations over the drop seen in 2002, in 2004 Europe and the U.S. utilizations were not as high as seen in 1998. SWhile this graphic shows that refinery capacity has not “maxed out” in the U.S. under normal conditions -- dealing with unusual hurricane damage that resulted in an average loss of 12-13% of U.S. crude input capacity for two months is a major problem! SStepping back from  the hurricanes, we need to look at the underlying changes taking place in the Atlantic Basin.  The relationship between EU-15 oil product demand and refining capacity has shown little change since 1998, and European concerns about global warming have created efforts directed at demand declines in the future. But beneath the picture of total utilization, there are stresses in meeting the demand for a changing mix of transportation and fuel products. SFor many years, both the U.S. and Europe have relied on imports as well as local refinery production for supply of certain products.  Those product imports are an increasingly important component of refined product supply for Europe and the U.S. and will be covered in detail in this presentation.

SThis chart illustrates the dramatic product mix change that has taken place in Europe relative to the rest of the world by graphing distillate demand’s share of total demand for gasoline and distillate.  SDistillate in this graph includes diesel, heating oil and jet fuel, but the change in distillate demand share captured in the chart is driven mainly by changes in diesel fuel demand. SWhile not shown on the chart, the U.S. share of distillate has shifted slightly higher and the rest of the world has actually shifted a bit towards more gasoline.  SEurope’s strong shift away from gasoline to distillate has created some supply challenges that affect the U.S. gasoline and distillate markets.

SIn addition to changes in demand mix, changes in diesel quality affect price.  As expected, European ultra-low sulfur diesel (ULSD) has been commanding a premium over heating oil.  That differential has averaged about 13 cents per gallon over the past year. SIn the U.S., New York Harbor diesel spot values have averaged about 4 cents per gallon over heating oil.  SThe high European prices for ULSD likely helped to pull other distillate fuel prices up as well.  SThe question is whether the European differential is being driven more  by transition issues than by longer term factors.  Will the U.S. see these kinds of price differences?  Or will the U.S. ability to supply ULSD help to ease the price difference and result in lower differentials between heating oil and diesel  fuel?  SBecause  we are seeing and will see transition issues associated with ULSD this year and next, it is hard to determine how these factors will play out in the long term. 

SThe changes in European demand for gasoline and diesel have created a growing imbalance between refinery production and product demand. Import and exports have been one of the primary means of resolving the imbalance. SThe U.S. product markets have been important in balancing European refinery production and European product demands. It’s important to understand the fit between these regions as we look to the future.

SEurope and the U.S. provide an interesting example of how international product trade can benefit consumers. SThe U.S. depends on product imports – particularly gasoline.  But this is not simply because it is difficult to expand refining capacity in the U.S.  There are some very economic sources of product available as imports – particularly from Europe. SIn the following slides, the presentation will illustrate how these two regions work together to balance supply and demand. SThe presentation will highlight why distillate is probably more of a concern for Europe than for the U.S., but how Europe resolves its issues will affect the U.S. SProduct quality changes are also important.  Both Europe and the U.S. are moving to low sulfur products.  These changes will likely play an important role over the next few years, but how that will evolve is highly uncertain.  As a result, we will not address that topic further in this presentation.

SWhile a previous slide showed the ratio of distillate and gasoline demand in Europe, this slide shows the volumes.  Diesel-fuel demand has been growing in both the United States and Europe.  But in Europe, diesel-fuel demand is growing rapidly while gasoline demand is declining.  In fact, diesel-fuel demand today exceeds gasoline demand. SLooking ahead, European diesel-fuel demand is expected by many forecasters to continue to grow, while gasoline demand will continue to decline. SGenerally, total demand for distillates and gasoline in Europe is growing very little, which has been part of an ongoing effort to stem transportation demand in order to reduce CO2 emissions in response to greenhouse gas concerns. 

SEurope’s refiners have responded to the change in demand by increasing their distillate yield – both by operating changes and with some process investments.  SHowever, this shift has not been sufficient to match the demand shift from gasoline to diesel. SEuropean refiners are at the point where additional process facility changes are needed to further increase distillate yields and reduce gasoline production.

SThe major process in which European refiners are investing to significantly increase distillate yields is hydrocracking.  Fluid catalytic cracking units (FCC), which many refiners in both Europe and the U.S. have, take heavier materials from distillation units and produce mostly gasoline.  The hydrocracking units use heavy feedstocks, and can generate more distillate.  SAs this slide shows, European refiners have been increasing hydrocracking capacity to increase production of diesel compared to gasoline.  Since 1990, hydrocracking as a percent of distillation capacity has increased from 2% to almost 7%, while FCC capacity as a percent of distillation has leveled at about 16%. SDespite the growth in hydrodcracking capacity, the deficit in diesel production and the excess in gasoline production compared to demand have continued to grow.  Additional planned hydrocracking investments would increase average European refinery distillate yields by perhaps 2 percent.  However, even this increase in distillate yield likely will be insufficient to keep up with the gasoline-to-diesel demand shift.  SThis implies that Western Europe may be able to provide the United States with higher gasoline imports in the next few years. 

SThis chart combines the gasoline and distillate imbalances in Europe.  Distillate products (diesel, heating oil, and jet fuel) are imported in increasing quantities, and excess gasoline is exported in increasing quantities S Note that in 2004, distillate imports grew less than gasoline exports. Is that a situation that is likely to continue? Does it reflect growing difficulty in finding economic distillate imports? Perhaps.  SLooking to the future, imports are likely to be more difficult to locate as European sulfur specifications are lowered.  This could mean a larger price incentive for diesel supply, and a resulting push to produce more distillate at the expense of gasoline production.  Still, this may not happen quickly. 

SThis slide summarizes some of the key sources for European imports and exports.  Several regions dominate these flows. SThe countries of the former Soviet Union are the source of 3/4 of the additional 400 thousand barrels per day of diesel and gas oil imports in 2004 compared to 1995. SThe U.S. East Coast provides a market for 3/4 of Europe’s excess gasoline production. SIn place of investments in refinery process changes to produce more distillate and less gasoline, Europe has found a combination of economic distillate import locations and economic markets to send excess gasoline.  But that could change in the future. 

S This slide summarizes what we have seen in looking at the European side of the Atlantic before turning to the U.S. and the connections between these two regions. SAs we look to the future, Europe’s challenge will  be how best to continue meeting its distillate demand growth.  Its traditional  sources of imports (Former Soviet Union and Middle East)  may be limited in their ability to increase supply, particularly now that Europe has moved to low sulfur diesel.  Europe is a major market force in the Atlantic Basin, and as its need for distillate increases, the relative price of diesel and gasoline may change, and any price pressure will be felt in the United States. 

SBoth increased production and increased imports can contribute to meeting demand growth.  First we focus on refinery production.  Increases in refinery production comes from 2 sources – an increase in crude runs and an increase in the yield of gasoline or distillate.  SThis graph shows that refinery throughput, or gross inputs, has increased – both due to refinery capacity running at increased utilizations and increases in that capacity.

SU.S. refinery light product yields have increased since 1990, even as the quality of crude oils being run in refineries has been declining. SBut yields for gasoline and distillate have changed differently.  Distillate yields increased more than gasoline, rising about 3.5% since 1990.  SGasoline yield from crude oil input has changed very little, but it is up about 2% due to the addition of oxygenates from outside the refinery. 

SNow we turn to gasoline, where imports are critical to meeting demand. This chart focuses on the increases in supply from domestic refineries and from imports.  From 1998 to 2004, the increases in domestic production and imports have been similar, each meeting about half of the growth in demand.  As this chart shows, each source of supply increased about 400 thousand barrels per day. SIncreases in imports are not necessarily bad for consumers.  In the last decade gasoline imports have been very competitive in the U.S. gasoline market, as demonstrated by the growth in gasoline imports compared to the increase in supply from domestic refineries.  Suppliers have purchased imports even when U.S. refiners could have increased production, because the price of those imports was more economic than increased domestic production. 

SThe next few slides are going to explore gasoline imports further to build the groundwork for helping to understand international product market dynamics. SThe US is a major market for the refineries in Eastern Canada, the Hovensa refinery in the Virgin Islands, and, to a lesser extent, the Venezuelan export refineries. SWestern Europe has become a growing source of US gasoline as the US has been the market to absorb their excess gasoline production resulting from the growth of diesel demand in Europe. SFor the “other” sources, the economic relationship weakens as the distances between these sources and the U.S. market increase.  Also, alternative markets are available to compete with the U.S. for these other available gasoline exports.

SNot surprisingly, as Europe’s excess gasoline supply has grown, much of the growth in gasoline imports to the U.S. during the past few years has come from European sources. SFuel quality may also have been a factor influencing growth in volumes from Europe.  Europe’s low-sulfur gasoline program is similar to the U.S. program.  Note that when we began the Tier 2 program in 2004, European gasoline import volumes (January through July) increased by 128 thousand barrels per day (46%) from the same period 2003. SAt the same time, we saw a drop in volumes of 39 thousand barrels per day from Brazil and Other Latin America. 

SDistillate imports play a different supply role than gasoline imports.  Generally Eastern Canadian refineries, Hovensa in the Virgin Islands and Venezuela provide a rather steady inflow of product.  In some years, these sources represent most of the imports, but when we get a cold winter, the picture changes dramatically. SThis slide compares two winters where we have had cold weather surges: the winter of 1999/2000, when we had a brief cold spell and supply pinch, and the winter of 2000/2001, which was a more protracted, tight supply/demand balance.  These two examples illustrate that, with sudden demand surges brought on by cold weather, distillate imports begin to flow from Eastern Europe, Latin America, Asia, and Western Europe.  Monthly imports levels can double in these cold winter situations. SMany of these regions do not have low sulfur fuel specifications yet, so much of the product that arrives during these cold snaps can be high sulfur. 

SBefore moving to the summary of how the U.S. and Europe fit together, this slide summarizes the U.S. situation.

SThis chart summarizes the supply changes that occurred since 1995 to meet changing demand for both gasoline and distillate in the U.S. and Europe.  SDemand changes are met by changes in net imports and changes in refinery production. Refinery production changes are broken down into the volumes affected by changes in yield, and those resulting from changes in crude runs.  The yield changes stem from combinations of changing refinery unit operations, changing types of crude oils, and installation of new processing units.  SOn the left, the chart shows that the U.S increased gasoline demand has been met by increasing refinery input and imports, with yield changes making a very small contribution. By comparison, increased refinery production from yield improvements played a large role in helping to meet distillate demand.  U.S. refinery distillate yield improvement ranked a little below increased refinery inputs and well above imports as a supply contributor. SIn EU-15 countries, refinery production’s contribution to European gasoline demand remained almost unchanged, as production from increased refinery inputs were counter balanced by declines in production from declines in yield.  Excess product was exported.  For distillate, increased refinery production from both increased throughputs and yields provided about half the added product need, and the other half came from imports. 

SWe will now look at U.S. distillate supply for last fall through this fall and the prospects for the next few months and how that will leave us prepared (or possibly somewhat unprepared) for the coming winter. SOf course, a key aspect of this discussion will be the impacts of hurricanes Katrina and Rita on U.S. distillate supply and what distillate supply may be as we move into the winter fuels season.

SWith distillate prices remaining higher than usual as we moved from winter into the summer driving season in 2005, U.S. refineries responded.  U.S. refineries have been running with unseasonably high distillate yields – more like winter yields.  SAs the chart shows, refinery, distillate yields this summer were about 2% above normal, which translates to about 300 thousand barrels per day more distillate production. SThese high distillate yields allowed distillate inventories to recover from the winter.  And strong gasoline imports supported gasoline supply. SHigh summer gasoline demand caused gasoline inventories to draw down in July and August, and during August, refiners began shifting distillate yields down and gasoline yields up.  Then Katrina and Rita severely reduced refinery production, and refiners increased gasoline yield to maximum levels by further reducing jet and distillate yields.

SThis plot shows our latest estimates of the loss of crude input to the Gulf Coast refineries that were shutdown because of hurricanes Rita and Katrina. The refinery crude input levels were based on historic fall levels for each refinery when its operations were not affected by maintenance activity. SThe peak week is the week ending September 30th, with over 4 million barrels per day of crude input lost.  Actual crude input was 11.7 million barrels per day compared to a level that would have been about 15.8 million barrels per day. SThe result of the low crude input was a drop in gasoline stocks of 4.4 million barrels and in distillate stocks of 5.6 million barrels for the week ending September 30.. SDespite the fact that gasoline production is normally twice that of distillate, the stock drop was greater for distillate than gasoline. This was because gasoline supply was increased to a much greater extent by increased imports, the beneficial impacts of waivers, and the yield shifts from distillate and jet to gasoline. SFor the months of September and October, the average estimated lost crude input is 2 million barrels per day. The associated lost product production will have to be made up from increased imports, reduced demand, increased yields (helped by waivers), deferred refinery maintenance, and a draw down of inventories.

SThis graph shows the dramatic decline in U.S. refinery distillate production in the final week in September when the refinery outages had reduced crude input by over 4 million barrels per day. That’s a reduction of about 25% of crude input, and distillate production fell a similar 25% from a normal level of over 4 million barrels per day to 3 million barrels  per day -- a drop of over 1 million barrels per day. SThe plot also shows the impact of Ivan in 2004. But the hurricane decline was greater this year from Katrina and Rita, and the production volume will only again reach 4 million barrels per day at the end of October or early November. For the month of October, distillate production is estimated to be about 400 thousand barrels per day below what it would have been if the hurricanes had not damaged the Gulf Coast refineries. SWhile we lump heating oil and diesel together when we talk about distillate, the products are not interchangeable. The Gulf Coast refineries produce high fractions of diesel fuels and provide almost all the diesel needs of the markets in Southeastern U.S., which may mean that the lost diesel production impacts are disproportionately reflected in the Southeast.

SThe last slide’s estimates of distillate inventories include estimates for imports and demand. We have yet to see much increase in distillate imports in EIA’s weekly data, and very few refiners have indicated to us that they planned for increased distillate imports.  This is partially because the shortfall so far is in low sulfur diesel rather than heating oil.  However, we are still early into the hurricane recovery period, and changes could occur. But  at this point our estimates for supply include only small increases in net distillate imports. SLooking back before  the hurricanes when distillate prices were hovering well above gasoline prices in Europe and elsewhere during 2005, speculations arose whether those prices might draw distillate away from the U.S. While that didn’t happen, the U.S did see relatively greater price strength for distillate products versus gasoline. SExports, while larger than last year over this time period, have not been unusually large, and Latin America remains the primary export destination. 

SThe demand estimates behind the prior distillate inventory picture also did not  include any unusual fuel switching, which may occur. SThe loss of natural gas production on the Gulf Coast is affecting prices relative to petroleum products.  With both the need for portable generators running off of diesel in the areas affected by power outages and the reduced natural gas volumes and price differential encouraging early fuel switching in the Northeast, we could see higher distillate demand than assumed. SThus, we still are in a precarious position for winter heating oil.  Even though refineries are recovering even as we speak, the story is far from over for heating oil supplies.

SIn 2004, we saw the gasoline and distillate market balances diverge, with distillate tightening while gasoline inventories moved from low to high levels.  SGasoline imports remained strong in 2005.  On the other hand, the distillate price premium over gasoline caused refiners to increase distillate yield and move toward a better product balance.  Distillate stocks were at a comfortable level at the end of August, looking like we were on the way to being well set for the winter fuel season. SThen hurricanes Katrina and Rita have caused an unprecented level of refinery outages. We are now seeing distillate stock fall as we speak  -- 5millon barrel decline in distillate stocks last week, possibly another 4 million this week, another 3 million barrels next week and the situation is transformed from a comfortable to an uncomfortable situation.

SNow as we look ahead to this winter, we are faced with even more uncertainty than usual for this time of year.  Not only did we have an unusual underlying distillate market leading up to this fall, the hurricanes wreaked havoc with supply in general. SThis time of year we normally are seeing the last builds in distillate inventories in October and November before the winter heating fuel season hits its peak in December through February.  Instead, because of the low refinery production resulting from the hurricanes, distillate4 inventories are being drawn down.  SThe main distillate supply affected by the hurricanes was low sulfur diesel and jet fuel, which is not easy to replace with imports.  Although heating oil inventories in the  Northeast did not drop like diesel fuel inventories, they will be affected by the general loss of distillate product none the less. SU.S. refinery production is still damaged and struggling to come back; import availability of low sulfur diesel and jet is uncertain; and there are signs that demand for distillate may increase more than usual from fuel switching due to the loss of natural gas supply on the Gulf Coast. SUnfortunately, most of the uncertainty points towards tighter supply this winter rather than looser supply, which translates to high prices.  Even warmer weather may not ease prices much under these circumstances.