The Gasoline Industry’s Golden Age?
Although the gasoline refining industry seems to have entered a golden age of higher margins, a recent Booz Allen Hamilton study suggests that optimism may be premature.
The gasoline refining industry seems to have entered a golden age. Gasoline demand has been rising steadily since the mid-1980s and shows no sign of flagging. Yet supplies are tight and getting tighter. The predictable result of rising demand and inflexible supply: higher margins for refiners. Indeed, industry sources predict that gasoline demand will continue to grow for the next quarter century, keeping prices and margins high. But a recent Booz Allen Hamilton study suggests that refiner optimism may be premature. The study considered three possible scenarios: 1) sustained high gas prices; 2) tighter fuel-efficiency standards; and 3) adoption of fuel-efficient hybrids. Each scenario resulted in demand falling substantially below current industry estimates. In the worst case, a gasoline surplus could occur as early as 2007.
If gas prices rise to $2.00 per gallon and stay at that level, demand would plummet below supply by 2007.
Consumers are already reacting to higher gas prices much as they did before. Carmakers now have to offer incentives to sell SUVs because buyers are looking for better fuel efficiency. In a recent poll by Kelly Blue Book and Harris Interactive, 40 percent of car shoppers said that they factored gas prices into their purchase decision, and 17 percent said that high gas prices had already changed their minds about which car to buy.
Booz Allen’s analysis found that if gasoline prices were to spike to a real inflation-adjusted average of $2.00 per gallon, close to today’s price, and stay at that level, demand would plummet below supply by 2007. In a more conservative scenario, if real prices were to increase only 2 percent per year faster than forecasted by the U.S. Department of Energy’s statistical agency, the Energy Information Administration (EIA), demand for gasoline would slip beneath supply by 2014.
Consumers weren’t alone in depressing gasoline demand during the last price shock. Regulators pitched in as well. In 1975, with oil prices high and the vulnerability of supply demonstrated by the Arab oil embargo, Congress introduced new Corporate Average Fuel Economy (CAFE) standards. The standards mandated that automakers produce more fuel-efficient fleets, with a target of 27.5 miles per gallon (mpg) for cars and 20.7 mpg for light trucks by 1985. What if regulators were to respond to current price and supply uncertainties by requiring light trucks to meet the same fuel-efficiency standards as cars? Diesel engines would likely be an attractive option for manufacturers, because they are much more efficient than gasoline engines.
Assuming regulators phased in new CAFE standards with a target of car and light truck parity by 2015, Booz Allen’s analysis shows that diesel vehicles could account for 43 percent of light truck production in 2012, and that gasoline supply would exceed demand in the same year.
Before long, though, there may be an even more desirable alternative to the traditional gasoline-powered car: the hybrid, which is a cross between an all-gas and an all-electric car. Already on the market, hybrids have proven as reliable as other cars, and their resale value is comparable. But they sell at a premium, battery replacement costs are high, and it’s not yet clear how long their batteries will last. That said, when the hybrid Lexus Rx400h is introduced in early 2005, it will cost only around $4,000 more than the gasoline version and its fuel savings will amount to about $2,500 per year over the first five years; what’s more, U.S. buyers receive tax incentives for buying so-called clean fuel vehicles. Thus, despite the premium purchase price, the Rx400h is already almost at breakeven with the gasoline model.
If gas prices continue to rise, hybrids could become economically superior choices. Their effect on gasoline demand would depend on how fast consumers buy them. Assuming hybrids achieved high levels of adoption — a 10 percent share of new vehicles by 2010 and 20 percent five years later — gasoline supply would top demand by 2015.
In the short run, refiners have reason to smile. Prices and margins are projected to stay high at least through 2006 because regulatory shifts and changes in consumer and automaker behavior will take a while to make a difference. So it is prudent for refiners to maintain and operate plants to take advantage of the good times. But longer term, caution is advisable. Refiners should prepare for possible tougher times by strengthening balance sheets, trimming expenses, and factoring lower future prices into any expansion plans. Given the current market, portfolio choices are paramount. And while a U.S. gas glut is not certain, it is certainly not out of the question. Refiners should start looking for export markets in places like China, Brazil, and Mexico, where demand will continue to exceed domestic supply.
The refining industry is traditionally cyclical. Long-term returns on capital averaged 9.5 percent between 1990 and 2002. But although the industry has experienced occasional periods of high returns, it has not been enough to compensate for the bad times. Refiners may hope that recent high returns signal better days as far as the eye can see. But the smartest of them won’t bet on it.
Harry Quarls (firstname.lastname@example.org) is a senior vice president with Booz Allen Hamilton in Dallas who specializes in the energy industry.
Robert Lukefahr (email@example.com) is a vice president with Booz Allen Hamilton in Houston. He has extensive experience in helping clients in energy and other industries with corporate growth strategies and long-term strategic plans.