Average U.S. gasoline prices have risen sharply during 2004, beginning the year at $1.50 pergallon and peaking at $2.06 in late May. They subsequently declined to $1.87 in August asinventories increased. Among the factors causing 2004's gasoline price volatility has been a shortage of domesticrefining capacity, which has affected gasoline supply availability, creating a need for substantialimports. U.S. gasoline imports -- in the form of conventional gasoline, reformulated gasoline, andgasoline components -- currently make up slightly more than 10% of the nation's supply. Potential policy concerns raised by growing reliance on gasoline imports include theavailability of foreign supplies that meet U.S. specifications, the speed at which incremental foreignsupplies can be provided to meet shifting domestic demand, and the delivered price of importedsupplies. The nation's stressed gasoline supply capacity has attracted recent legislative interest. In the House, the Gasoline Price Reduction Act ( H.R. 4545 ) was brought to thefloor under suspension of the rules (passage requires a two-thirds vote) on June 15, but failed by236-194. The bill was intended to increase gasoline availability by limiting the number of fuel blendsrequired to meet clean air standards and by allowing waivers of fuel blend requirements duringsupply disruptions. This would have made it easier to ship gasoline between markets when neededto balance supply. On June 16, the House passed the United States Refinery Revitalization Act( H.R. 4517 ) by a vote of 239-192. This bill would provide incentives to increaserefinery capacity, focusing on areas with closed refineries or those experiencing layoffs or highunemployment. It would also charge the Department of Energy (DOE) with centralizing the processof obtaining environmental permits for new refinery projects, including additions and upgrades. Gasoline demand in the United States continues to grow. Although gasoline comprises about45% of total U.S. petroleum consumption, its incremental growth during the recent past accountsfor virtually all of the increase in total oil demand. Figure 1 shows the trend in U.S. gasoline consumption during the past decade, during whichdemand rose 20%. Growth has persisted in more recent years, although 2004 may see some late-yearslowdown because of higher prices. Between 1999 and 2003, petroleum consumption increased byhalf a million barrels per day (mbd), rising from 19.5 mbd in 1999 to 20.0 mbd in 2003. During thesame time span, gasoline consumption rose by the same amount as demand grew from 8.4 mbd to8.9 mbd. Figure 1. U.S. Gasoline Demand: 1993 - 2003 Source: Energy Information Administration, Monthly Energy Review, June 2004, Table 3.4. Gasoline use has continued to grow during the first half of 2004, as almost 9.0 mbd ofgasoline was supplied to consumers, an increase of about 1.9% over the previous year's first half.While there is some preliminary evidence that high pump prices may have begun to retard growthin gasoline demand, it is still too soon to evaluate whether this trend has shifted, and how overallpetroleum demand might track for all of 2004. Gasoline is manufactured in U.S. refineries and imported from foreign refiners as well. Figure 2 shows data for total U.S. demand and domestic production. (1) The gap between the two setsof figures is filled by imported product made by foreign refiners. Imported supply consists offinished gasoline -- which meets U.S. specifications and is market-ready -- as well as blendingcomponents. The latter have become an increasingly important part of gasoline supply, since an increasingamount of ethanol-blended gasoline is being consumed in this country. The trend toward ethanolblends may continue because it is the oxygenate used to replace the additive methyl tertiary butylether (MTBE), which has been banned in New York, California, and Connecticut, and is beingphased out in other places. Figure 2. U.S. Gasoline Production & Demand: Jan. 2003 - July 2004 Source: EIA, Weekly Petroleum Status Report, June 30, 2004, Table 10. In one form or another, the nation imports slightly more than 10% of the gasoline itconsumes, the unavoidable outcome of growing motor fuel demand and refining capacity which hasnot kept pace. This supply is necessary to fill the gap between gasoline production and demandshown in Figure 2. Figure 3 shows the imports of gasoline in detail, the total of which is rising in the time-framein this figure. Total imports peaked this summer at about 1.1 mbd; for the first seven months of2004, they averaged 900,000 barrels per day. Imports fit into three general categories: Conventional gasoline, which comprises about half of the gasoline sold in thenation and conforms to the least stringent environmental standards currently in effect. The U.S.environmental standards for this fuel include a prohibition on the use of lead, limits on summertimevolatility, and limits on manganese and sulfur content. Reformulated Gasoline (RFG) is used in major metropolitan areas in 17 statesand the District of Columbia which have significant ozone problems. In April 2004, EPA designatedareas in a total of 32 states and the District as nonattainment areas for a new ozone standard to bephased-in between 2007 and 2021 (2) . RFG has several requirements, including the mandate that itcontain sufficient oxygenates to meet a minimum oxygen requirement of 2% by weight. Theoxygenate often added is either the chemical MTBE (now banned in several states) or ethanol. RFG's peak usage is during summer months, when it comprises about 29% of nationaldemand. Gasoline components are imported with increasing frequency, amounting to50% of imports during 2004. Gasoline is a "cocktail" of hydrocarbons blended at refineries and fuelterminals. Increasingly, cocktail ingredients are available from foreign refiners, and they are beingimported to expand U.S. refinery output. Since finished gasoline is a blended product, refiners cansupplement short capacity by buying foreign components and blending them here in such a way thatU.S. specifications are met. As a result of the Clean Air Act requirements and state mandates, many different types ofgasoline are sold in the United States. In addition to conventional and RFG, there is oxygenated fuel(higher oxygen content than RFG), low volatility conventional gasoline, and a variety of state andlocal blends. These "boutique fuels" include ethanol blends, California Cleaner-Burning Gasoline(also used in Nevada and Arizona) and a number of other local formulations. As noted above, the trend toward ethanol blends may continue because it is the oxygenateused to replace the additive MTBE. Ethanol blends cannot be stored or transported by pipeline,because ethanol and gasoline do not mix well and can separate. The blend must be mixed near thepoint of final consumption. Imported components of the gasoline "cocktail" fit into the increasingly common practiceof local blending for local markets, in that "cocktail" components often come from multiple sourcesand are assembled at terminals and other gasoline distribution points. For refiners, blending gasolinefrom component parts represents a small incremental supply bonus, since they can purchaseopportunistically those components that might be available on world markets, and manufacture theremainder in their own facilities. In total, U.S. refiners do not have the capacity to make all thegasoline sold in this country, but they often do have substantial flexibility -- within overall capacityconstraints -- to make hard-to-import components tailored to U.S. specifications which foreignrefiners cannot easily provide. The trend shown in Figure 2 suggests that U.S. refiners are able to produce during an averagemonth a bit more than 8.0 mbd, while demand is trending just under 9.0 mbd this year. The actualnumbers fluctuate from month to month. Figure 3 shows total gasoline imports averaging about900,000 barrels per day. (3) Imports of finished gasoline and components -- which have averaged, respectively, about 500,000barrels per day and 400,000 barrels per day during the past 12 months -- bridge the gap betweenU.S. refinery production and demand. Without this supplement, there would be a supply shortfall. Figure 3. Make-up of U.S. Gasoline Imports: Jan. 2002 - July 2004 Source: EIA, Weekly Petroleum Status Report, August 2, 2004, Table 9. The increasing use of blending components in building up the gasoline pool is seen in the riseof components as a proportion of nationwide gasoline inventories. Figure 4 shows that total gasolinestocks started 2003 at essentially the same level (212 million barrels) that they were at the end ofAugust 2004 (206 million barrels). But blending components held in inventory rose from 54 millionbarrels, or 26% of inventory, to 72 million barrels, or 35% of total inventory. This is a substantialincrease, and shows refiners' demand for stocks of components to meet the need for locally-mixedethanol blends as well as diverse boutique fuels. Fifteen states have chosen to address clean air issues by calling for localized gasolineformulations for all or part of their states (4) . Many of these requirements are in effect during summer monthswhen concerns about ozone are greatest. The diversity of fuel formulations has raised concerns among stakeholders regarding refiners'ability to provide the diversity of products required in sufficient quantities as well as the producttransport sector's ability to distribute the diverse product slate. In its Staff White Paper on BoutiqueFuels, (5) the EnvironmentalProtection Agency (EPA) contends that the refining and distribution system works well under normaloperating conditions. But the agency notes that when the entire fuel market is stressed, the placeswhere supply shortfalls and volatile prices tend to show up first and be most acute involvegeographically isolated fuel programs. Many state boutique programs are of this nature, and have fewer suppliers and fewertransport options. In situations where there is a transportation failure, a supply shortfall of gasolinecomponents, or some combination of these and possibly other factors, prices can become veryvolatile as small supply glitches impact an isolated local market disproportionately. There appear tohave been few such instances, but some have taken place. The experience in the Chicago metro area during the spring of 2000 is one example of howa confluence of circumstances can play out. As the Chicago metropolitan area transitioned toethanol-blended gasoline in the late spring of 2000, a key pipeline supplying gasoline from the GulfCoast refining area failed. The supply shortfall from traditional refiners -- coupled with the initialdifficulty in making reformulated gasoline blendstock for oxygenate blending in local refineries --combined to create a tight regional supply situation, which saw pump prices nearly double in Mayand June. (6) But by July,supply from other sources and restoration of pipeline flow began to return prices to accustomedlevels. The price spike, while only a few months in duration, was substantial, and is often pointedto as a "worst case" situation of how a convergence of mishaps can lead to a substantial disruptionin a market delineated by boutique fuel requirements. EPA notes that problems of this type to date have been limited in terms of geographical scopeand duration. It appears that the fuel supply system can support the current structure of fuelstandards, absent some set of untoward circumstances. Most stakeholders, EPA contends, (7) are instead concerned with theproliferation of boutique fuels into the future and would like to see limits on new boutique fuelrequirements. Figure 4. U.S. Gasoline Inventory: Jan. 2002 - Aug. 2004 Source: EIA, Weekly Petroleum Status Report, August 25, 2004, Table 3. Currently, one-third of gasoline imports comes from Canada and the U.S. Virgin Islands. Another third comes from Argentina, the Netherlands, Russia, the United Kingdom, and Venezuela;the remainder is imported in smaller quantities from a diversity of nations. Figure 5 illustrates trends in overall gasoline imports, as well as various suppliers' sharesof the imported gasoline market. It also shows how the amounts supplied by each important suppliercan vary from month to month, as well as changes in the overall supply of imports. Canada -- source of much of the nation's hydrocarbon imports -- is the single leading supplierof gasoline on a regular basis. Canada's exports have increased steadily during recent years. And theU.S. Virgin Islands -- location of the very large Hovenessa refinery, jointly owned by Amerada Hessand the Venezuelan national oil company Petroleos de Venezuela (PDVSA) -- is also a consistentsource of supply. But imports from the other major suppliers fluctuate monthly. Even Venezuela hasexperienced difficulties in meeting its historic refinery output levels since an oil workers strike inlate 2002. Venezuelan gasoline exports to the United States have dropped to about 40% of levelsseen prior to 2002's political disruption. Recent efforts to regain U.S. market position by PDVSA(discussed below) could produce a supply benefit, although refinery operations are still recoveringfrom the strike. Figure 5. Average Daily Gasoline Imports by Country of Origin Jan. 2000 - Apr. 2004 Source: EIA, June 2004. In addition to Canada and the Virgin Islands, increased gasoline imports now come from theUnited Kingdom and the Netherlands, where refinery utilization is much lower than in the UnitedStates; many other nations with spare refinery capacity are suppliers as well. A recent enhancement to the supply of imported gasoline has been made by PDVSA, whichhas started shipping the complete cocktail for ethanol blended gasoline (without the ethanol, whichis blended near the point of sale). PDVSA has planned to export 1 million barrels per month of thishigh-priced component, called RBOB, (8) starting with test cargoes in June. Platts Oilgram Price Report (9) noted that 720,000barrelswere exported in July, and the extra barrels in the U.S. market have provided extra competition forcomparable cargoes from Europe, where distances and shipping costs are greater. This illustrates thesignificance of the supply of foreign gasoline components, and how they can impact U.S. gasolineprices. It is likely that high U.S. prices for gasoline and its significant components will continue toattract foreign refiners' attention, perhaps leading them to seek permanent market share. PDVSA-- which also owns U.S. refiner CITGO, affording direct retail market access -- announced that forSeptember it planned to export 12 RBOB cargoes to the United States, including four or five for theNew York-Connecticut ethanol-only blended markets. (10) Another example of what may be taking place in off-shore refined product supply is therevitalization of a large refinery in Aruba that was recently acquired by Valero Energy, anindependent refining company with most of its facilities in the United States. While geographically well-positioned to serve U.S. markets, this facility had an unsuccessfuloperating history. Valero began improving operations quickly and is adding upgrading units so thatgasoline components can be made in increasing quantities from low-quality crudes. The capacity ofthis refinery is 275,000 barrels per day, a figure which suggests that it could -- when it reachescapacity -- contribute significantly to Gulf and East Coast gasoline supplies. Imports from Aruba areso recent that they are not reflected in DOE data (which lag by a few months) on product imports bycountry. Dependence on imports to meet over 10% of national gasoline needs has begun to causeconcern that these imports might contribute to 2004's high prices. While supplies from Canada mayhave similar physical characteristics and prices to the output from U.S. refiners -- and offer speedydelivery -- products from refineries farther afield may not. Factors such as the cost and timelinessof incremental supply, physical reliability, and meeting U.S. product specifications can affect priceand supply at the gas pump. Shipping cost may be an additional issue. Gasoline and many other refined products needto be protected from contamination from other oils. As a result, they must be shipped in cleanvessels. These product carriers are usually much smaller than crude carriers, and -- not benefittingfrom economies of large scale -- have higher unit costs. In addition, the clean tanker market isinfluenced by spot charter rates for vessels, making product shipping costs often higher and morevolatile than crude oil. It is cheaper to ship crude to a local refinery than to transport products anequivalent distance. (11) Imported products cost more than those refined domestically simply by virtue of transportcosts. The higher import costs impact the last units of gasoline supply, providing a price umbrellafor domestic refiners, whose pricing -- like all industrial pricing -- is linked to the cost of the lastincrements of the good involved. As long as gasoline is imported to meet a sizeable imbalancebetween domestic supply and demand, this situation offers a likelihood of prices which are abovethe cost of domestic manufacture. This assumes that new domestic refining capacity to replaceimports could produce U.S.-spec gasoline at costs below those of foreign refiners plus producttransport tariffs to the United States. In addition to price-related considerations, the speed of supply response to price signals fromU.S. gasoline markets seems less than it might be from a refiner located here. It may well be thatdistance mutes price signals related to an increase in demand, for example, and refiners abroad maybe slow to receive the message that U.S. consumers desire more gasoline and are currently payingprices which would justify a foreign refiner's manufacturing of U.S. specification fuel. Even if theforeign refiners' response to U.S. prices were instantaneous, it could take as long as a month -- insome cases more -- for the physical supply to arrive here. Manufacturing fuel for the U.S. market may be another source of delayed response to U.S.market signals. Some of the substances called for in satisfying U.S. fuel needs may not be producedin the ordinary course of refinery runs abroad. And some -- like RBOB -- are difficult for manyrefiners to make, calling for a longer set-up time. Lags in getting foreign supply may have contributed to 2004's price increases. Figure 3 shows low imports during late 2003 and early 2004, which corresponded to a decline in gasolineinventories and consistent price increases seen throughout the first half of 2004. Is dependence on gasoline imports for more than 10% of the nation's gasoline supplyundesirable? In theory, importing gasoline may have few drawbacks. It might make little differenceif this fuel were to be supplied from across the border in Canada. The products supplied might beU.S.-specification conventional gasoline or RFG. What about imports from a refinery operated bya major international oil company in Europe or nearby in the Caribbean? At what point does foreignrefined product dependence become a policy concern? There is no clear answer, but majorconsiderations in evaluating this question include: Availability of supplies meeting U.S. specifications, so that demand can be metwithout the need for waivers that could compromise environmentalprotections. The speed with which incremental supply might be available, givenjust-in-time gasoline inventories, in order to avoid excessive price volatility. The delivered price of foreign supplies, and whether they are above theincremental price of domestic output, such that they ultimately contribute to higherprices. The nation has no apparent defined policy on refined oil product imports, nor is there a policyregarding gasoline prices. There is a general perception among policymakers that price volatility isundesirable, but there is no consensus on what the price level ought to be. Nor is there consensusabout how the government might deal with market volatility. Similarly, there appears to be generalagreement that spot shortages -- run-outs and lines at gas stations -- are to be avoided. But there areno guides for policy actions to remedy such situations should they take place, and it could be thatletting market forces make corrections without government involvement would be the better courseof action. Some policy initiatives in the 108th Congress are embodied in two House bills focusing onthe proliferation of regional gasoline blends and expanding refinery capacity. H.R. 4545 , the Gasoline Price Reduction Act, centered on the proliferation of special, local boutiquegasoline blends. The bill failed to get the required two-thirds House vote for passage undersuspension of the rules. It would have authorized EPA during significant supply disruptions to issuewaivers of state provisions requiring boutique fuels. The boutique fuel requirement is seen aspotentially limiting supply by impeding the movement of fuel between areas; a shortage in one spotmight not be met with extra fuel from a nearby area because of differing requirements. The bill alsoproposed capping the number of boutique fuels at the current level. H.R. 4545 proposed dealing with supply fungibility; but it did not offer remediesthat could have increased the supply of domestically produced gasoline. H.R. 4517 , theRefinery Revitalization Act -- which passed the House, but has not seen Senate action -- is aimedat facilitating increases in capacity by fast-tracking the environmental review and permitting offacilities in a designated Refinery Revitalization Zone. The Secretary of Energy would designate thezones, coordinate environmental reviews, and make final decisions on federal authorizations for newrefineries within the zones. To the extent that those wishing to construct a new refinery -- or expandan existing facility -- have been hindered by environmental regulation, this measure is intended tooffer some assistance. These bills articulate at least some components of a gasoline supply policy, dealing withdomestic supply and indirectly with imports, and with fuel specifications that impact the distributionof supply. Both measures have drawn substantial criticism, however, particularly on environmentalgrounds. For example, with regard to the refining bill, opponents express concern that such ameasure would override state clean air programs. Among its cons, H.R. 4545 raisesconcerns about the overall cost of gasoline, given that many state programs which avoid full-fledgedRFG have been implemented to keep down gasoline costs. The refining proposals attempt to address the 1 mbd gasoline production shortfall, which ismade up by imports in one form or another. Encouraging growth in domestic refinery capacityimplies a judgment that it is advantageous to have that capacity in the United States, in contrast tooffshore, even if offshore is relatively nearby. As noted above, domestic production could reducetransportation costs and provide quicker supply response to unanticipated changes in demand. Thiscould shorten the duration of a potentially disruptive price spike resulting from a gasoline supplyshortfall. Refinery proposals under current debate do not address other issues impacting refineryprojects, such as an historic lack of profitability in this industry segment (12) . It may well be that thecurrent refining situation -- with imports holding a "price umbrella" over domestic gasolineproduction -- may be a profitable situation for many refiners, many of whom are realizing recordearnings in the first and second quarters of 2004. While this year's earnings may be high, one year'sexperience does not outweigh years of low profits. While a basic change in refiner profitability mightbe suggested, it is too soon for many firms to consider making significant investments in long-livedcapital equipment, whose cost is recouped over many years. Were the prospects for long-term profitability in the refining industry to improve by virtueof a sustainable recovery in refining margins, it is likely that additional investment in added capacitywould be seen. But it might take several years of high margins before firm managers and theirbankers would become confident enough to make substantial capital commitments.

Summary:
Gasoline demand in the United States has grown consistently during the past decade,increasing by a total of 20%. Between 1999 and 2003, gasoline consumption grew by 500,000barrels per day, accounting for all of the increase in petroleum consumption during that period. While 2004 may see growth slow down because of high prices, during the first seven months of theyear gasoline demand was up by another 1.9%. The fact that gasoline supply has not kept up with demand has been reflected in pump pricesthat have risen from $1.50 at the start of 2004 to as high as $2.06 per gallon in late May. Whensupply and demand become out of sync with their previous relationship, prices change to establisha new balance. The outcome has been a period of volatile gasoline prices, which have set recordhighs that have become a focal point for consumers and policy makers, and raised concerns abouttheir impact on the economy. Gasoline is supplied both by U.S. and foreign refiners. Domestic producers' capacity islimited. As a result, nearly 1 million barrels per day of gasoline and its components are imported.Imported blending components -- especially those used in ethanol-blended fuel -- are increasinglyimportant to total U.S. supply. Without this supplemental supply, gasoline would be less availableand prices likely higher. Imports most recently have come from Canada and the U.S. Virgin Islands, which supplyone-third of the off-shore supply. Argentina, the Netherlands, Russia, the United Kingdom, andVenezuela provide another third. Imports peaked in March 2004, took a dip, and reached new highsin July. Increased imports may have contributed to pump prices backing off their May highs in latesummer. New gasoline blending components from Venezuela and the rehabilitation of a refinery inAruba may also contribute to enhanced gasoline component supply later this year. Gasolinecomponent availability -- which has increased during 2004 -- gives domestic refiners an addedmeasure of flexibility in using their capacity, and contributes to enhanced supplies of fuels neededto meet demand for ethanol-based gasoline and other specialized regional blends. Potential policy concerns raised by growing reliance on gasoline imports include theavailability of foreign supplies that meet U.S. specifications, whether incremental foreign suppliescan be provided quickly enough to meet shifting demand, and the delivered price of importedgasoline. Two legislative efforts were debated in the House regarding gasoline supply issues during2004. One, H.R. 4517 , has passed the House but not been taken up in the Senate. Itwould provide for easier permitting for refinery capacity expansion. And H.R. 4545 ,which did not pass the House, would have limited the growth of special regional fuel blends, oftencalled "boutique fuels." This report will be updated as events warrant.