    [House Hearing, 108 Congress]
    [From the U.S. Government Publishing Office]

                    THE STATUS OF THE U.S. REFINING INDUSTRY

    =======================================================================

                                    HEARING

                                   before the

                     SUBCOMMITTEE ON ENERGY AND AIR QUALITY

                                     of the

                        COMMITTEE ON ENERGY AND COMMERCE
                            HOUSE OF REPRESENTATIVES

                          ONE HUNDRED EIGHTH CONGRESS

                                 SECOND SESSION

                                   __________

                                 JULY 15, 2004

                                   __________

                               Serial No. 108-113

                                   __________

           Printed for the use of the Committee on Energy and Commerce

     Available via the World Wide Web: http://www.access.gpo.gov/congress/
                                     house

                                   __________

                        U.S. GOVERNMENT PRINTING OFFICE
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                        ------------------------------

                        COMMITTEE ON ENERGY AND COMMERCE

                          JOE BARTON, Texas, Chairman

    W.J. ``BILLY'' TAUZIN, Louisiana     JOHN D. DINGELL, Michigan
    RALPH M. HALL, Texas                   Ranking Member
    MICHAEL BILIRAKIS, Florida           HENRY A. WAXMAN, California
    FRED UPTON, Michigan                 EDWARD J. MARKEY, Massachusetts
    CLIFF STEARNS, Florida               RICK BOUCHER, Virginia
    PAUL E. GILLMOR, Ohio                EDOLPHUS TOWNS, New York
    JAMES C. GREENWOOD, Pennsylvania     FRANK PALLONE, Jr., New Jersey
    CHRISTOPHER COX, California          SHERROD BROWN, Ohio
    NATHAN DEAL, Georgia                 BART GORDON, Tennessee
    RICHARD BURR, North Carolina         PETER DEUTSCH, Florida
    ED WHITFIELD, Kentucky               BOBBY L. RUSH, Illinois
    CHARLIE NORWOOD, Georgia             ANNA G. ESHOO, California
    BARBARA CUBIN, Wyoming               BART STUPAK, Michigan
    JOHN SHIMKUS, Illinois               ELIOT L. ENGEL, New York
    HEATHER WILSON, New Mexico           ALBERT R. WYNN, Maryland
    JOHN B. SHADEGG, Arizona             GENE GREEN, Texas
    CHARLES W. ``CHIP'' PICKERING,       KAREN McCARTHY, Missouri
    Mississippi, Vice Chairman           TED STRICKLAND, Ohio
    VITO FOSSELLA, New York              DIANA DeGETTE, Colorado
    STEVE BUYER, Indiana                 LOIS CAPPS, California
    GEORGE RADANOVICH, California        MICHAEL F. DOYLE, Pennsylvania
    CHARLES F. BASS, New Hampshire       CHRISTOPHER JOHN, Louisiana
    JOSEPH R. PITTS, Pennsylvania        TOM ALLEN, Maine
    MARY BONO, California                JIM DAVIS, Florida
    GREG WALDEN, Oregon                  JANICE D. SCHAKOWSKY, Illinois
    LEE TERRY, Nebraska                  HILDA L. SOLIS, California
    MIKE FERGUSON, New Jersey            CHARLES A. GONZALEZ, Texas
    MIKE ROGERS, Michigan
    DARRELL E. ISSA, California
    C.L. ``BUTCH'' OTTER, Idaho
    JOHN SULLIVAN, Oklahoma

                          Bud Albright, Staff Director

                       James D. Barnette, General Counsel

          Reid P.F. Stuntz, Minority Staff Director and Chief Counsel

                                     ______

                     Subcommittee on Energy and Air Quality

                         RALPH M. HALL, Texas, Chairman

    CHRISTOPHER COX, California          RICK BOUCHER, Virginia
    RICHARD BURR, North Carolina           (Ranking Member)
    ED WHITFIELD, Kentucky               TOM ALLEN, Maine
    CHARLIE NORWOOD, Georgia             HENRY A. WAXMAN, California
    JOHN SHIMKUS, Illinois               EDWARD J. MARKEY, Massachusetts
      Vice Chairman                      FRANK PALLONE, Jr., New Jersey
    HEATHER WILSON, New Mexico           SHERROD BROWN, Ohio
    JOHN B. SHADEGG, Arizona             ALBERT R. WYNN, Maryland
    CHARLES W. ``CHIP'' PICKERING,       GENE GREEN, Texas
    Mississippi                          KAREN McCARTHY, Missouri
    VITO FOSSELLA, New York              TED STRICKLAND, Ohio
    GEORGE RADANOVICH, California        LOIS CAPPS, California
    MARY BONO, California                MIKE DOYLE, Pennsylvania
    GREG WALDEN, Oregon                  CHRIS JOHN, Louisiana
    MIKE ROGERS, Michigan                JIM DAVIS, Florida
    DARRELL E. ISSA, California          JOHN D. DINGELL, Michigan,
    C.L. ``BUTCH'' OTTER, Idaho            (Ex Officio)
    JOHN SULLIVAN, Oklahoma
    JOE BARTON, Texas,
      (Ex Officio)

                                      (ii)

                                C O N T E N T S

                                   __________
                                                                       Page

    Testimony of:
        Caruso, Guy F., Administrator, Energy Information
          Administration, Department of Energy.......................    24
        Cavaney, Red, President, American Petroleum Institute........   121
        Cooper, Mark, Director of Research, Consumer Federation of
          America....................................................    85
        Douglass, Bill, CEO, Douglass Distributing...................   132
        Early, A. Blakeman, Environmental Consultant, American Lung
          Association................................................   114
        Edwards, Gene, Senior Vice President, Supply, Trading and
          Wholesale Marketing, Valero Energy Corporation.............    67
        Holmstead, Hon. Jeffrey R., Assistant Administrator for Air
          and Radiation, Environmental Protection Agency.............    33
        Kovacic, William E., General Counsel, Federal Trade
          Commission.................................................    42
        Murti, Arjun Narayama, Managing Director, Goldman, Sachs &
          Company....................................................    72
        Schaeffer, Eric, Director, Environmental Integrity Project...   127
        Slaughter, Bob, President, National Petrochemical and
          Refiners Association.......................................    91
        Wells, Jim, Director, National Resources and Environment,
          Government Accountability Office...........................    41
    Additional material submitted for the record:
        Douglass, Bill, CEO, Douglass Distributing, response for the
          record.....................................................   144
        Wrona, Nancy C., Director, Air Quality Division, Arizona
          Department of Environmental Quality, letter dated July 29,
          2004, enclosing material for the record....................   169

                                     (iii)

                    THE STATUS OF THE U.S. REFINING INDUSTRY

                                  ----------

                            THURSDAY, JULY 15, 2004

                      House of Representatives,
                      Committee on Energy and Commerce,
                        Subcommittee on Energy and Air Quality,
                                                        Washington, DC.
        The subcommittee met, pursuant to notice, at 10 a.m., in
    room 2123, Rayburn House Office Building, Hon. Ralph M. Hall
    (chairman) presiding.
        Members present: Representatives Hall, Whitfield, Shimkus,
    Fossella, Bono, Rogers, Issa, Otter, Sullivan, Barton (ex
    officio), Allen, Waxman, Wynn, Capps, Doyle, and Dingell (ex
    officio).
        Also present: Representative Tauzin.
        Staff present: Bill Cooper, majority counsel; Mark Menezes,
    majority counsel; Sue Sheridan, minority counsel; Bruce Harris,
    minority counsel; Michael Goo, minority counsel; and Dick
    Frandsen, minority counsel.
        Mr. Hall. The subcommittee will come to order. Without
    objection, the subcommittee will proceed pursuant to Committee
    Rule 4(e). So ordered. The Chair recognizes himself for an
    opening statement.
        Oil prices on the futures market closed yesterday at 41
    bucks a barrel. The headlines in many of the media outlets say
    that the reason is based on concerns about crude oil and fuel
    supplies. U.S. refiners pulled some 200,000 barrels of gasoline
    from storage last week, due to higher outputs, raising
    performance to 95.2 percent of capacity. Bloomberg reports,
    ``Last week's 2.1 million barrel draw on U.S. commercial oil
    stockpiles was quadrupled to 500,000 barrels median estimate of
    ten analysts surveyed by Bloomberg.'' In other words, demand is
    so strong that even the professionals were fooled.
        The Energy Information Administration, in its weekly
    petroleum reports, says that it expects demand to grow 1.5 to 2
    percent per year, on average, and whether existing domestic
    refinery expansions keep pace with demand, we just don't know.
    Most analysts say that they will not.
        Today's edition of Oil Daily reports that the past 3 years
    have used an additional 180,000 barrels per day of gasoline
    output, ``well below the increase in gasoline demand.'' How do
    we make up the difference if we don't expand capacity
    domestically? We increase imports. Again, Oil Daily reports
    ``to satisfy demand, imports of finished motor gasoline have
    increased by nearly 100,000 barrels per day to 555,000 barrels
    per day in May.'' Now, these are staggering numbers and this is
    sobering news.
        Every week, the trade magazines and newspapers report the
    number of refineries closed for maintenance, unanticipated
    breakdowns, or other problems. It reads like a rural newspaper
    reporting on the weekly gossip in the community, but the news
    is far more serious. Why? Because refineries are stretched to
    the limit, and any shutdown, no matter how minor, has a major
    impact on the market. Any shutdown is big news.
        So, today we will hear from just about every stakeholder in
    the refining world the main focus on refining capacity, and all
    that subject might encompass. Hopefully, based upon the
    testimony presented, Congress can decide its rightful role in
    assuring an affordable adequate supply of gasoline for the
    consuming public for years to come.
        I can't envision a more important hearing than this hearing
    today, and I am very grateful, on behalf of the subcommittee,
    to you men and women who have given your time and are giving
    your knowledge. You will help us write the legislation, and we
    know it took you time to get here, time to prepare to come
    here, time to give your testimony, and we are very grateful to
    you.
        So, I again thank all the witnesses for your testimony and
    your willingness to take time out of your schedules to be here,
    and I now recognize Mr. Gene Green for an opening statement.
        Mr. Green. Thank you, Mr. Chairman. And like you, I am glad
    this hearing has been called today because it is important. Gas
    price fluctuation has hit all American consumers hard,
    especially those on tight family budgets. But most folks don't
    have a clear picture of all the steps that it takes to get
    gasoline into the family car at a given price.
        High prices at the pump are basically due to the high price
    of the crude oil and refining capacity shortages. The high
    price of crude is a result of instability in the Middle East,
    which does not appear to be improving, and Congress' inability
    to allow reasonable environmentally responsible oil and gas
    production in the U.S. either in Alaska or off-shore. For one,
    I believe that producing oil and gas safely in Alaska and off-
    shore is much easier and less costly than attempting to bring
    democracy to the Middle East. Refining capacity is short
    because of the investment climate that limits investments and
    capacity expansion. That is the proper focus of today's
    hearing.
        I am in a unique position where blue collar workers at the
    refineries in my district provide a tremendous amount of
    gasoline for the nation. The Houston area is by far the largest
    concentration of refining capacity, with the Gulf Coast
    accounting for approximately 40 percent of our Nation's
    gasoline supply. The number of refineries in the United States
    has fallen dramatically from over 200 in 1990, down to less
    than 150 today, and the capacity of these fewer refineries,
    though, has increased slightly, by about 7 percent, so we are
    producing a little more from fewer refineries.
        Congress needs to provide a certain and fair investment
    climate for the refining industry. Otherwise, they would not be
    able to expand capacity to meet our gasoline demand. Already,
    10 percent of our refined product is produced overseas and
    imported. These imports are part of a disturbing trend. First,
    we became dependent on overseas suppliers. Now, our gasoline
    supplies may soon be in the power of a foreign government as
    well, not to mention the loss of high-paying U.S. jobs.
        So, we need to create an investment climate in the U.S.
    that will ensure adequate refining capacity that is best for
    the consumers and energy security, and we still can improve air
    quality. Reformulated gasoline and other blends are important
    for public health, saving billions in health care costs, but we
    cannot keep changing the rules of the game on gasoline
    formulations. We need a more orderly process.
        My position on MTBE has been clear many times in this
    committee, and I don't want to repeat it--the Federal
    Government de facto requirement of MTBE with the oxygenate
    requirement. MTBE has improved public health, but if we slam
    refiners with defective product lawsuits for a product that was
    required and clean the air as expected, we send a terrible
    message to the industry and its investors.
        When you discourage investment like that, capacity
    shortages are likely and consumers feel the hit in their family
    budgets. Congress should refrain from further tinkering with
    the number and type of gasoline blends that are now required.
    Instead, we should repeal the oxygenate requirement and conduct
    a detailed study on the issue of other different required blend
    fuels.
        In emergencies, RFG and other blends can pose supply
    issues, but these blends are necessary to improve the air
    quality in most American cities. If our cars do not do their
    part to reduce emissions, then larger and heavier emission
    reduction burdens fall on the manufacturers.
        In my home town, industry is struggling with the mandated
    85 percent emissions cut as part of a State implementation
    plan. Without improved blends of gasoline, it would be
    impossible in Houston to meet the Clean Air Standards. In fact,
    the Houston area refineries themselves could find it hard to
    expand without these reductions from car emissions.
        Also contributing to lower investment in refining capacity
    is the uncertain requirements of the New Source Review. The
    worthy goal of resource review is to achieve continuing
    pollution control improvements over time, but the changing and
    competing interpretations of the regulations hurts the goal of
    pollution control and capacity investment. And I am glad to
    hear from the EPA today on what they are doing to control
    emissions in an orderly way, so that the communities, refinery
    managers, investors know what to expect.
        My constituents often live and work in those refineries,
    and we need to provide clean air and achievable environmental
    standards for the refineries to maintain U.S. manufacturing
    jobs while improving our public health and the environment.
        Again, thank you, Mr. Chairman.
        Mr. Hall. Thank you, Mr. Green. The Chair now is pleased to
    recognize the chairman of the full committee, the Honorable Joe
    Barton, for as much time as he needs.
        Chairman Barton. Thank you, Mr. Chairman. And we all want
    to welcome our former chairman, Mr. Tauzin, back. He's been
    working hard this week--even though his choice of ties isn't
    what it used to be.
        Mr. Tauzin. My wife bought me this tie.
        Chairman Barton. He has lost so much weight, he is pulling
    out these suits from when he was 30 pounds lighter and 10 years
    younger.
        Mr. Hall. I understand all these committee chairmen get fat
    and heavy.
        Chairman Barton. I have gained 5 pounds in the last 2
    months, there may be something to that. Anyway, thank you, Mr.
    Chairman, for holding this hearing.
        Last month, the House voted on a bill that I had sponsored,
    H.R. 4517, The United States Refinery Revitalization Act of
    2004. That bill passed by a vote of 239 to 192, but it had not
    been the subject of any hearings, had not gone through regular
    order, and in the floor debate a number of members of this
    committee and the general House opposed it on the principle
    that we had not followed regular order, and I had to agree that
    was the case.
        But after the vote, several members who had voted against
    the bill because of the procedure, came to me and said that
    they were interested in working on a bipartisan basis to see if
    we could craft a bill that would increase refinery capacity,
    and that they would be willing to help on crafting that bill if
    we would go through regular order. This hearing is the start of
    that process, and I want to thank you, Mr. Chairman, for
    beginning that process.
        The lack of refinery capacity needs to be addressed. Demand
    for refined product outpaces supply by over 10 percent, the
    differences coming from foreign imports. Domestic refiners are
    producing flat-out, operating at over 95 percent of capacity.
    Forecasts show no appreciable increase in refining capacity,
    all the while the demand is ever increasing.
        So, we are starting a process with this hearing today not
    to have a legislative hearing on a particular bill, but to
    gather the facts and build a record so that we can craft, as I
    said earlier, a bipartisan bill.
        The panels that are going to appear before us are balanced,
    and we are going to hear from all sides on this subject. We
    will hear testimony from the Energy Information Administration,
    the Environmental Protection Agency, the Federal Trade
    Commission, the Government Accounting Office, from refiners,
    consumer groups, distributors, and the private sector in terms
    of the investment analysts that follow the refinery industry in
    this country. The information that we gather today hopefully
    will serve as the basis for future decisions concerning the
    role that Congress can play legislatively in helping to resolve
    the refinery capacity problem here in the United States.
        I look forward to hearing from the witnesses, and I
    appreciate their appearance. I look forward to a very positive
    hearing and, with that, Mr. Chairman, thank you again for
    putting this hearing together, and I yield back the balance of
    my time.
        Mr. Hall. Thank you, Chairman Barton. The Chair recognizes
    the gentleman from California, Mr. Waxman.
        Mr. Waxman. Thank you very much, Mr. Chairman. Today's
    hearing focuses on refinery capacity issues and State clean
    fuels requirements. This is ironic because the House has
    already debated legislation on both these issues. In fact,
    without ever holding a hearing or a Commerce Committee markup,
    the House passed a bill that trumped the States' regulation of
    refinery pollution and weakened the Clean Air Act and the Clean
    Water Act. This committee process is completely backwards, but
    I believe it is representative of how the Republican leadership
    has approached the Nation's energy policy.
        I will be blunt. A terrible fraud is being perpetrated upon
    the American people. The American people are being told that
    the President's Energy Bill will relieve the Nation's
    dependence on foreign oil, and it will reduce consumers' energy
    costs, but the Administration's own analysis shows these
    assertions are simply not true. President Bush, Majority Leader
    Tom DeLay, former Chairman Billy Tauzin, Republican members of
    this committee, have repeatedly stated that the President's
    Energy Bill will ease our dependence on foreign oil, but the
    charts that I want to show today from the Energy Information
    Administration found facts that I want to bring to the
    attention of the members.
        In the first chart, we see that the need for imported crude
    oil increases by more than 70 percent. Even if the President's
    plan is enacted, this would result in a record high need for
    imported oil.
        The second chart shows an EIA projection of domestic oil
    production under the President's Energy Bill. As you can see,
    the domestic crude oil production will decline by almost 20
    percent from 2002 levels even if the Energy Bill is enacted.
        This information has been publicly available and unrefuted
    since February, yet, despite these facts, Republican leaders
    continue to say that the Energy Bill will significantly reduce
    dependence on foreign oil, but the statements don't end there.
    Both the White House and Republican leaders in Congress have
    resolutely worked to convince the public the Energy Bill will
    reduce gasoline prices, yet EIA directly refutes these
    statements, too, projecting that the Energy Bill will actually
    increase gasoline prices 3 to 8 cents per gallon.
        What we need to do instead is to work together to confront
    the real energy problems we face--the Nation's dependence on
    oil, global warming, air pollution, and energy security.
    Powerful industries like the coal industry, the electric
    utility industry, and the oil and gas companies want to
    preserve the status quo, or even to roll back important
    environmental protections, but that takes us in the wrong
    direction.
        We have to look to the future, and our goal has to be to
    provide our children with a more secure energy future that is
    based on innovation, efficiency, conservation, and clean
    energy. Thank you, Mr. Chairman.
        Mr. Hall. The Chair recognizes Mr. Shimkus, the gentleman
    from Illinois.
        Mr. Shimkus. Thank you, Mr. Chairman. I would love to
    continue this debate on the National Energy Plan with my friend
    from California. We worked on the bill. It has a major hydrogen
    initiative. It brings wind power, clean coal technology--there
    are so many good things in this Energy Bill that to not move it
    as is the case, I think, is the real fraud being perpetrated on
    our country and our citizens. There is no reason.
        But we are here to talk about refineries. You know what? We
    haven't built a new one in 28 years. People can't believe that.
    We have not built a new refinery. Now, thank heaven that the
    industry has been able to ramp up to 98 percent capacity. That
    is amazing. That is laudable. That should be congratulated. But
    it also is the fear of huge spikes in gasoline prices with the
    bulkinization of fuels that we have out there. One refinery
    goes down, one pipeline gets disrupted, holy heck breaks lose.
    And we have seen that.
        Wisconsin has seen that. Illinois has seen that. So we have
    to have--we really have to address this issue. I applaud the
    chairman for bringing the bill to the floor on the refinery
    bill. It shows you the strength of the argument when you don't
    go through the process and you still get a bipartisan majority
    to pass the bill on the floor. It shows that there is a need to
    address this.
        Now, I had some industry folks visit me. They want to pipe
    heavy Canadian crude oil from western Canada to the Gulf Coast,
    to get to a refinery that will refine the fuel. I mean, does
    that make sense? I had another group say they wanted to build
    an L&G facility in the Bahamas and then pipe the liquefied
    natural gas into Florida. Now, does that make sense? We lose
    the jobs. We lose the tech base. We lose the value-added. This
    is crazy.
        So, I hope we have a good hearing on the need to develop
    and expand the refineries. The only refineries that are going
    to be expanded, thankfully, are the ethanol refineries, which I
    applaud. A lot of new ethanol refineries out there, we want to
    encourage that, but I do think that we ought to have some
    petroleum-based refineries built in this country. I think that
    the supply and demand equation works. You limit the supply and
    you keep the same demand, you have higher prices. We need to
    increase the supply both of the crude oil and we need to
    increase the supply of refined products and put competitive
    market forces on this. We need new refineries. With that, Mr.
    Chairman, thank you. I yield back my time.
        Mr. Hall. Thank you. The Chair recognizes Mr. Doyle, the
    gentleman from Pennsylvania.
        Mr. Doyle. Thank you, Mr. Chairman. I am going to waive my
    opening statement and save time for questions.
        Mr. Hall. Thank you. The Chair recognizes Ms. Capps.
        Ms. Capps. I thank the chairman. I guess I am glad that we
    are holding this hearing on U.S. refineries. I only wish that
    we were holding it 1 month before instead of 1 month after the
    House considered H.R. 4517, the Refinery Revitalization Act,
    but perhaps that would have interfered with one of the theme
    weeks Republican leadership has lined up. And since the theme
    weeks are more about showmanship actually than passing good
    laws, I guess it is understandable that the hearing on this
    issue comes after we have passed the bill.
        If we had held this hearing before we considered H.R. 4517,
    this committee would have been able to learn about the numerous
    flaws in the bill. For example, the bill would give the
    Department of Energy unprecedented authority over all
    environmental permitting of refineries, creating serious
    conflicts between the Department of Energy and State, and the
    Federal agencies charged with protecting our environment.
        The premise of the bill is that environmental regulation is
    limiting refinery expansion, but refining capacity has
    increased in recent years. Environmental requirements have not
    prevented that increase. While there has been a decrease in the
    number of refineries, this seems to be due to increasing market
    concentration resulting from refinery mergers. Thus, big oil
    and not environmental laws are to blame for fewer, but bigger,
    refineries.
        But even if environmental permitting requirements were the
    problem, H.R. 4517 would make the situation worse by wrecking
    havoc with the well-established partnership in place today.
    Under this bill, Department of Energy would be given lead
    authority over environmental permits, and would be able to
    overrule permit denials by other State and Federal agencies.
    The Department of Energy, I submit, lacks the expertise in
    interpreting or implementing environmental laws because its
    mission is not focused on environmental protection. That is why
    we have checks and balances. While this bill is no doubt
    supported by the refineries, it is not supported by anyone with
    a stake in environmental protection. All the major
    environmental organizations oppose this bill.
        This bill also creates a special consultation process for
    industry. Before any other parties would even know a permit is
    being planned, H.R. 4517 would require that DOE provide any
    permit applicant with a chance to meet with the permitting
    agencies and obtain an informal reading regarding the agency's
    plan for granting the permit. This would give the inside track
    to the applicant over groups with public health and
    environmental concerns.
        Finally, DOE would be able to shape the record and the
    timing and the procedure for granting permits. That power, in
    itself, is highly significant, since the major part of permit
    evaluation is whether the permittee has supplied sufficient
    information and, in many cases, the environmental statutes and
    regulations specify precise permit content. Under the bill, DOE
    would be allowed to determine that ``such data as the Secretary
    considers necessary had been submitted,'' and move to permit
    issuance in 6 months or less. That would allow DOE to move a
    permit forward, even where a permit applicant has clearly
    failed to meet fundamental requirements for basic information.
    Simply put, H.R. 4517 is a bad bill that should never have
    passed the House. With any luck, that is the last we will see
    of it.
        Mr. Chairman, high gas prices are a serious problem in this
    country, and they have gone up again. I should know because gas
    prices in my district are perhaps the highest in the Nation.
    Congress should be passing legislation to help bring down
    prices by reducing our energy use, promoting alternative and
    renewable energy sources. H.R. 4517, like H.R. 6, was just
    another bad bill that wouldn't help make America any more
    energy independent. I yield back my time.
        Mr. Hall. Thank you, Ms. Capps.
        Ms. Capps. Thank you for letting me go over.
        Mr. Hall. You men and women heard the same buzzer and bells
    that we heard. There is a vote on. There will be a couple of
    votes after that time. But we have one of the most outstanding
    chairmen in the history of the Energy and Commerce Committee in
    our presence. We are going to recognize Billy Tauzin. He is
    Chairman Emeritus or Chairman-in-Exile, or something--I don't
    know what he is--but whatever he wants to be, we recognize him,
    and then we will recess for 30 minutes.
        Mr. Tauzin. Thank you, Mr. Chairman. I will be very brief.
    First, I want to give you good news. As you know, even though
    the Energy Bill is stalled on the other side, one of the key
    provisions that we inserted into it with the help of the
    Resource Committee was a provision to increase incentives for
    deep drilling in the shallow Gulf of Mexico, off the coast of
    Louisiana and Texas, in particular. As you know, the bill
    hasn't moved out of the Senate, but the Administration moved
    forward with an Executive Order on that very same principle,
    and in March of this year we held a lease sale in the Gulf of
    Mexico. The United States got $364 million for over 542
    tracts--61 percent of those tracts were in the shallow, 200
    meter or less, areas, and they are going after the deep gas
    that the provisions of the bill predicted they would go after.
    We simply encouraged it with the same royalty relief program we
    extended to deep drilling, in the deeper Gulf. So, it is
    already working, Mr. Waxman. At least one provision that we
    anticipated would develop new resources of natural gas for
    America is already underway, and that is good news.
        I just want to leave you with one thought. I am going to
    end my service here in a few months, after 25 years in
    Congress. Before I started my service in Congress, the last
    refinery was built in my district in Garyville--28 years ago.
    We haven't built one since. And for those of you who think that
    we have simply expanded enough capacity in existing refineries
    to make up the difference--the facts are pretty stubborn
    things--these are the facts. Refinery capacity peaked in 1981,
    a year after I got here. That was the peak. And we had surplus
    capacity that year of over 5.5 million barrels per day. We have
    got almost no surplus capacity today, and demand continues to
    rise.
        So, whether or not we import more oil, or we don't import
    more oil, or we produce more oil in this country, or we use a
    strategic petroleum reserve for purposes or not for purposes
    that you support, the fact of the matter is that our refinery
    capacity peaked in 1981 and demand is still growing. We built
    750 million new vehicles in the last 25 years, and we haven't
    expanded our refining capacity.
        Now, however you feel about energy in America, whether you
    think we ought to produce more or depend more on foreign
    sources, it doesn't make a whole lot of sense not to process it
    here. Instead, we are beginning to build a foreign dependence
    on processing our fuel, and that probably is the most dangerous
    dependency we could ever build for our country.
        So, as I leave you in the next few months, I would just
    urge you to work together in a bipartisan fashion and find an
    answer, whatever that answer may be, to make sure our refining
    capacity is increased in this country, regardless of what else
    you do in energy, to make sure we have some surplus capacity
    so, as Mr. Shimkus pointed out, when one refinery goes down,
    one pipeline goes down, we don't have a shock effect on
    consumers, as we saw in the Midwest, in Milwaukee and Chicago,
    where prices spiked so dramatically because one refinery went
    down, one pipeline went down, one ship blocked the harbor in
    Lake Charles, Louisiana. That ought to not happen in this
    country. Whatever you feel about energy, we at least ought to
    process more here in this country as we need it, and I would
    urge you to look at those facts. They are stubborn. How we fix
    it is debatable, but the facts won't go away. Our refining
    capacity is flat, our demand is rising, that is dangerous. And
    this country faces enough danger that we don't need to create
    new ones for us.
        Thank you very much, Mr. Chairman. And I will have a chance
    before I leave officially, but I didn't have a chance yet in a
    committee hearing to say how much, Ralph, we welcome your
    service on this committee as chairman of this Energy
    Subcommittee, and I wanted to extend my congratulations to your
    ranking member. You have got a great team here working on
    Energy together.
        Mr. Green, we have been together for a long time. Somehow,
    some way, we have got to get past some of these awful divides
    that separate us from finding some answers. We have got to find
    some answers for this country. I would ask you, please, to
    think as Americans rather than Democrats and Republicans, when
    it comes to this one, and find some answers before it is too
    late. We shouldn't have commissions 1 day red-faced, looking
    back, like a 9/11 Commission, wondering what we could have done
    before it was too late. We ought to do it now before it is too
    late. God bless you on your service to the country, Ralph.
        And to the new chairman, Mr. Barton, I extend my greatest
    commendations. You are doing a great job, and I wish you well,
    sir. I love this committee more than you know, and I wish you
    the best of luck as we move forward in the future. Keep it
    bipartisan, keep it American. That is how I tried to help build
    it when I took over. Keep it that way. Find some answers. I
    have watched you on C-SPAN from the hospital over the last 6
    months. It is not pretty. It is too partisan. Americans are
    watching you. Try to think as Americans for a while, even
    through this election cycle, I think that is the best
    recommendation I can leave you with, particularly when it comes
    to energy security because everything else in our economy
    depends upon that. Thank you, Mr. Chairman.
        Mr. Hall. Thank you very much. You and I remember, and
    maybe some others here, when we asked Mr. Waxman and Mr.
    Dingell, who were at loggerheads over the Clean Air Act, to go
    into a room one morning at 9 o'clock, and they came out late
    that night with an answer. Mr. Waxman is capable of working
    with you, and we have got to work together to find this. It is
    not a Republican or Democratic matter, it is an American
    matter. It might keep our youngsters off of a troop ship. That
    is what we have to do.
        Mr. Green. Mr. Chairman, I want to briefly thank Chairman
    Tauzin for many years of friendship, and hopefully we can make
    it bipartisan.
        Mr. Hall. The subcommittee will recess for 30 minutes.
        [Brief recess]
        Mr. Hall. We have our witnesses back in place, and the
    Chair notes the presence of the former chairman of the Energy
    and Commerce Committee, long-time chairman, the venerable John
    Dingell. I am glad to recognize you, Mr. Dingell.
        Mr. Dingell. Mr. Chairman, I thank you, you are very
    gracious. Mr. Chairman, I think this is a useful hearing, and I
    am pleased that it is being done. I want to express to you the
    appreciation of this side for the cooperation you have shown
    with respect to witnesses.
        The subject matter of our discussion today is an important
    one. It is also a very complex topic that deserves the
    committee's attention. Because of its complexity, it us a topic
    that demands a thorough understanding and a full record before
    any attempt is made to legislate. On that note, I would observe
    with some sadness that it is regrettable that we find ourselves
    holding a hearing some 2 weeks after the leadership took two
    bills to the House floor, one on refineries and the other on
    boutique fuels without ever having a single hearing or markup.
        This is backwards. The cart is in front of the horse. It is
    a style of legislating that reflects poorly on this committee,
    and one which is inconsistent with the practices of this
    committee over the years. I hope we will not repeat that
    unfortunate event again.
        Gas prices have been at record highs for several months
    now, and while the Energy Information Agency reports increases
    have abated somewhat to a national average of $1.89 per gallon,
    statistical drops in the price of gasoline are of little
    comfort to the consumers in my State who continue to pay more
    than $2 per gallon. I know other States have similar
    situations.
        While crude prices have dipped from their June high of $42
    a barrel to down to $35 per barrel, EIA states they are on the
    rise again and, as of yesterday, were hovering at around $40. I
    asked the Bush Administration some months ago to aggressively
    jawbone OPEC to open the spigots, but it seems the
    Administration has chosen to ignore that advice. Of course,
    refinery capacity does have an effect on the ultimate price to
    consumers. It is a well known fact that the number of U.S.
    refineries has declined steadily from the early 1980's through
    the 1990's. We should indeed examine this development, as well
    as the reasons why it has occurred, as well as the fact that
    despite the decline in the number of refineries, the refinery
    capacity in this country has, in fact, increased, and is
    projected to continue doing so, as well as having noted that
    refinery utilization has increased as well.
        The fact remains that the refining industry operates in a
    tight market of its own making. Some of this is said by
    consumers and consumer advocates to be done in order to
    maximize profits and minimize underused capacity. From the
    industry's perspective, this is simply good business. Whether
    it is good for consumers I leave to them to judge, but I don't
    think you'll find much agreement that it helps them.
        I note that the GAO will be testifying today concerning its
    findings on mergers and acquisitions in the refining industry.
    This is an important question. And the GAO will be talking
    about how these matters have led to increased market
    concentration and higher prices. The decline in the number of
    refineries is the principal reason cited for bringing H.R. 4517
    to the floor outside of the regular order. That bill would have
    nullified three decades of expertise that EPA has acquired
    regarding environmental permitting, and transferred that
    function to the Secretary of Energy, under the theory that we
    would see an increase in refinery reopenings.
        On June 22, I wrote to EPA Administrator Leavitt, to
    determine the number of permits that were being delayed and
    would reopen closed refineries, but I have yet to receive a
    response. Perhaps the committee could assist me in procuring
    that response. We have a witness from EPA here today, and
    perhaps he will provide one for us. Certainly, I will ask him
    for the answer to those questions and for a response to this
    letter.
        At this point, Mr. Chairman, I ask unanimous consent that
    my letter be inserted in the record, along with EPA's response
    when, and if, received.
        Mr. Hall. The letter and the response will be entered,
    without objection.
        [The information referred to follows:]

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        Mr. Dingell. I have also been long concerned about the
    balkinized fuel supply and the effect that it has on the
    fungibility of gasoline and the prices consumers pay at the
    pump. This is a serious issue. While the issue of boutique fuel
    does need examination, we must remind ourselves that we again
    confront a question of balancing important environmental
    benefits that can be achieved and that none of us want to see
    eliminated versus cost, convenience, and perhaps a better way
    of distributing our fuels to our country.
        I look forward to a complete hearing today and, again, Mr.
    Chairman, I express my thanks to you for your courtesy to me. I
    yield back the balance of my time.
        Mr. Hall. Thank you, Mr. Dingell. The Chair recognizes Mr.
    Whitfield of Kentucky, if he would like to make an opening
    statement.
        Mr. Whitfield. Mr. Chairman, I am going to waive my opening
    statement.
        Mr. Hall. I know you were the earliest here because you and
    I thought this started at 10 o'clock and we were both here.
        The Chair recognizes Mr. Issa of California.
        Mr. Issa. I waive my opening statement, Mr. Chairman.
        Mr. Hall. The Chair recognizes Mr. Allen of Maine.
        Mr. Allen. Thank you, Mr. Chairman, for holding this
    hearing on the status of the U.S. refining industry. I am
    reminded of the old adage, ``Shoot first and ask questions
    later.'' Exactly 1 month ago, the House passed H.R. 4517, the
    U.S. Refinery Revitalization Act. Now we will ask some
    questions.
        Mr. Chairman, I speak today with concern about the
    direction of the Energy and Commerce Committee. We have taken
    legislation to the House floor without a committee markup. We
    pushed partisan legislation that abandons $15 billion in the
    Nuclear Waste Fund and fails to address the funding crisis that
    Yucca Mountain faces at the hands of appropriators. Last week,
    we had a hearing on the U.N. Oil for Food Program, at which the
    State Department failed to show up. Just Tuesday, the State
    Department witness left a hearing of the Environment and
    Hazardous Materials Subcommittee without permission, before she
    had responded to questions.
        We face real challenges in this country, and I believe this
    committee needs to lead the Congress in addressing them.
    Refineries are significant emitters of volatile organic
    compounds, a precursor pollutant to ground-level ozone. The
    facilities pose a threat to human health and are regulated
    under the Clean Air Act. As I read it, H.R. 4517 undermines
    Clean Air Standards at refining facilities. The bill lowers the
    standard at some facilities, makes enforcement of the Clean Air
    Act optional, and hands over the task of environmental
    protection from the Environmental Protection Agency to the
    Department of Energy.
        The bill states, ``The best available control technology,
    as appropriate, shall be employed on all refineries located
    within a refinery revitalization zone.''
        In places where the air already contains unhealthy levels
    of pollution, the Clean Air Act holds new and modified
    refineries to an even higher standard described as the ``lowest
    achievable emissions rate,'' and also requires offsetting
    emissions reductions for new sources of pollution. The weaker
    standard and no pollution offsets would lead to more pollution
    than current health-based standards permit.
        Furthermore, H.R. 4517 requires refineries to use best
    available control technology only as appropriate. Does this
    legislation authorize the Secretary of Energy to label best
    available control technology inappropriate in certain
    circumstances? If so, does the legislation permit the Secretary
    to selectively enforce the Act?
        Finally, H.R. 4517 would place the Secretary of Energy in
    charge of the permitting process, the official record, and the
    only environmental review document. Even if EPA's experts
    conclude that a proposed refinery project fails to comply with
    the substantive safeguards set forth in the Clean Air Act, the
    Secretary of Energy may issue the necessary authorization
    anyway. Under the law, EPA's three decades of expertise would
    be supplanted by an agency with no experience enforcing the
    Clean Air Act.
        Mr. Chairman, our former chair, Mr. Tauzin, a few moments
    ago before the break, urged us to think as Americans and not as
    Republicans and Democrats. I believe we will get there when we
    have legislation in front of us that deals not only with
    supply, but that significantly reduces demand. The evidence
    simply does not support the Clean Air Act as at fault for
    rising gas prices.
        Neither H.R. 4517 nor the so-called Gas Price Reduction Act
    address the real causes of increased oil price. They do not,
    for example, address market concentration, create stability in
    the Middle East and other oil producing regions, help families
    increase the efficiency of their home thereby reducing oil use,
    require or create incentives to increase fuel efficiency in our
    vehicle fleet which is at its lowest level since 1980, invest
    in hybrid or hydrogen technology, extend the tax breaks for the
    purchase of high efficiency vehicles, end the tax break for
    Hummers and other large SUVs, reduce heavy truck idling, or
    improve air traffic management.
        I hope that this hearing allows us to go back to the
    drawing board. Supply strain and exploding demand are both
    driving prices. To address price issues, we need to stabilize
    supply and reduce demand, and when we do both with equal
    measure, then I think we will be thinking as Mr. Tauzin urged
    us, to think as Americans and not as Republicans and Democrats.
    Mr. Chairman, I thank you and yield back.
        [Additional statement submitted for the record follows:]

        Prepared Statement of Hon. Charlie Norwood, a Representative in
                       Congress from the State of Georgia

        Thank you, Mr. Chairman.
        I take great interest in today's hearing and would like to commend
    you, Mr. Chairman, for allowing the Subcommittee to investigate the
    status of our country's refining industry.
        The citizens of the Ninth District of Georgia, along with others
    across the country, want to know what we in Congress are doing to help
    lower their gas prices. I wish there was a quick fix, but the facts are
    clear that there is no such thing.
        Tapping into our national oil resources, such as the one in the
    Arctic National Wildlife Refuge, will not guarantee lower gas prices
    unless we improve our refinery capabilities as well.
        There are currently 149 refineries in the U.S., operating in 33
    states. Total refining capacity is approximately 17 million barrels per
    day. Total domestic demand for crude oil stands at 20 million per day.
        While we do our best to combat high gas prices in the present we
    must also prepare for demand in the future. U.S. gasoline consumption
    is projected to rise to 13.3 million barrels per day by 2025, up from
    8.9 million barrels per day currently.
        The refining industry is operating at around 95 percent capacity,
    compared with an average of 82 percent operating capacity for other
    industries.
        I was pleased to support Chairman Barton's legislation, H.R. 4517,
    the Refinery Revitalization Act, on the House floor in mid-June. This
    well crafted legislation includes our continued dedication to ensuring
    that the environment is protected. This bill will require an
    accelerated review and approval of all regulatory approvals and will
    not waive or diminish any existing environmental, siting or other
    regulations.
        Also, it goes without saying I am a big supporter of the Energy
    Bill, which continues to linger over in the other body.
        Mr. Chairman, I am greatly looking forward to the testimony of our
    witnesses today as they lend us their expertise on the state of the
    refining industry. With that, I thank you for this time and I yield
    back.

        Mr. Hall. All right. Time has expired, and we now go to the
    panel. We hope you are educated on what we think, and can now
    give us the facts of life. Mr. Caruso, Administrator of Energy
    Information Administration, Department of Energy, always
    helpful, and thank the Department for always showing up when we
    ask you for help over here.
        I think Chairman Barton went through all you before, but
    Jeffrey Holmstead, Assistant Administrator for Air and
    Radiation, Environmental Protection Agency; Jim Wells,
    Director, Natural Resources and Environment, Government
    Accountability Office, and General Counsel for the Federal
    Trade Commission, Bill Kovacic. It is a great panel, and at
    this time we would hope you would generalize on your testimony
    and stay as close to 5 minutes--but not hold you to that--as
    you can to where we can get this hearing over with maybe before
    milking time tonight.

    STATEMENTS OF GUY F. CARUSO, ADMINISTRATOR, ENERGY INFORMATION
         ADMINISTRATION, DEPARTMENT OF ENERGY; HON. JEFFREY R.
       HOLMSTEAD, ASSISTANT ADMINISTRATOR FOR AIR AND RADIATION,
    ENVIRONMENTAL PROTECTION AGENCY; JIM WELLS, DIRECTOR, NATIONAL
     RESOURCES AND ENVIRONMENT, GOVERNMENT ACCOUNTABILITY OFFICE;
        AND WILLIAM E. KOVACIC, GENERAL COUNSEL, FEDERAL TRADE
                               COMMISSION

        Mr. Caruso. Thank you, Mr. Chairman, and thank you, members
    of the committee, for asking the Energy Information
    Administration to present its outlook for the refinery
    situation in the U.S. Certainly, as we have heard repeatedly,
    it is appropriate at this time, with high prices and tight
    capacity, to discuss this issue.
        Just this morning, WTI, West Texas Intermediate crude,
    opened up at $41 per barrel. On Monday, the retail gasoline
    price average was released at $1.92. And the reasons why prices
    are high, of course, are multifold.
        While refining capacity is an exacerbating factor in this
    outlook, it is not the primary cause of the current high
    gasoline prices. Robust economic growth has led to strong
    global energy demand, particularly oil, demand. Crude oil
    capacity around the world is operating close to 99 percent, and
    inventories are low. But the lack of extra refining capacity
    will certainly make it more difficult to rebalance this market,
    once the additional crude is made available. And, clearly, the
    volatility in this market--the low refinery capacity and tight
    operating conditions are certainly adding to volatility, and
    they are reducing the cushion that we would have to respond to
    any changes in supply or demand.
        There are charts available to the committee, and the first
    one shows that we are consuming about 20 million barrels a day
    of oil in the United States, about 84 percent of that is from
    our domestic refineries. Another 9 percent or so is from
    natural gas source products, and then ethanol and other
    oxygenates 2 percent, and net product imports about 5 percent.
        The fact that we are now experiencing tightness in refinery
    capacity is a relatively new phenomenon. During the mid 1970's
    to mid 1990's, we actually had surplus capacity, but since that
    time, many small, less-efficient, refineries have shut down,
    and, as has been mentioned, the last grassroots refinery was
    built in 1976.
        Even with these shutdowns and no new refineries, total
    capacity has increased and trended upward as operating capacity
    has expanded at existing facilities, and has helped meet
    increasing demand. From 1997 to 2003, demand increased in this
    country by 1.4 million barrels a day and refinery capacity at
    existing facilities had a net increase of 1.2 million barrels a
    day, which is the equivalent of adding one medium-sized
    refinery per year. However, it wasn't enough, and net product
    imports have increased by about 500,000 barrels a day since
    that time.
        As we look ahead to the next 10 and 20 years, we are
    projecting that increase in demand in products in this country
    will be about 4 million barrels a day in a 10-year period up to
    2013, and that we are going to need an additional 20 percent
    capacity or product imports to fill that need.
        EIA projects that the United States will see both increases
    in refinery capacity and product imports, perhaps as much as 3
    to 4 million barrels a day of refinery capacity, and this of
    course remains uncertain, as we have heard from some of the
    statements, as to whether some of these investments will
    actually be made in a timely fashion. There is a great deal of
    uncertainty with respect to the return-on-investment in this
    sector of the economy and the requirements that will be imposed
    for environmental and other reasons, as well as siting issues.
        So, we will need substantial increased refinery capacity to
    meet this kind of outlook, and whether it will be domestic
    refining or more imports depends on a number of the factors
    that we will be talking about in this hearing.
        On the import side, clearly there is uncertainty because of
    tightness on a global basis in refining capacity. The
    increasing requirements that more stringent specifications be
    met by foreign refiners, and we have seen some evidence that
    the current tightness has limited, to a small extent, imports
    this year, and of course that would mean that we would have
    fewer options if this continues.
        As we look ahead, both U.S. refining capacity and product
    imports will play very important roles in meeting our needs,
    and clearly the work of this committee and the Congress will
    play an important role in meeting those objectives.
        Thank you, Mr. Chairman. I would be pleased to answer
    questions at the appropriate time.
        [The prepared statement of Guy F. Caruso follows:]

    Prepared Statement of Guy F. Caruso, Administrator, Energy Information
                      Administration, Department of Energy

        Mr. Chairman and Members of the Committee: I appreciate the
    opportunity to appear before you today to discuss the history and
    status of U.S. refining capacity. The Energy Information Administration
    (EIA) is the independent statistical and analytical agency within the
    Department of Energy. We are charged with providing objective, timely,
    and relevant data, analysis, and projections for the Department of
    Energy, other government agencies, the U.S. Congress, and the public.
    We do not take positions on policy issues, but we do produce data and
    analysis reports that are meant to help policymakers determine energy
    policy. Because the Department of Energy Organization Act gives EIA an
    element of independence with respect to the analyses that we publish,
    our views are strictly those of EIA. They should not be construed as
    representing those of the Department of Energy or the Administration.
        Recent high prices for crude oil and petroleum products, including
    gasoline, have raised increased attention to domestic refining
    capacity. Refining capacity utilization has risen to typical high
    summer levels, averaging about 96 percent for the past 4 weeks as
    gasoline demand has been increasing seasonally. West Texas Intermediate
    crude oil prices have fluctuated mainly between $36 and $42 per barrel
    since early March, and the national average retail price of regular
    gasoline prices reached $2.06 per gallon in late May before declining
    to $1.92 on July 12. Our current Short Term Energy Outlook (STEO)
    projects crude oil and product prices to remain high relative to recent
    years over the remainder of the summer. Crude prices are expected to
    average about $37 per barrel and gasoline prices may average about
    $1.83 per gallon over the second half of the year. Looking ahead to
    2005, both international and domestic petroleum markets are projected
    to remain relatively tight, with low inventories and relatively high
    prices.
        While refining capacity is an exacerbating factor in this Outlook,
    it is not the primary cause of these high prices. A combination of
    rising world oil demand growth and oil supply restraint by the
    Organization of Petroleum Exporting Countries (OPEC) has kept oil
    supplies tight, as reflected in low petroleum inventories worldwide
    since early last year. Even if more refining capacity were available,
    petroleum product prices would be high. But this lack of extra refining
    capacity means it will take longer for the market to ultimately
    rebalance when more crude oil supply arrives, and the potential for
    price volatility increases with little extra product inventory or
    refinery capacity that can act as a cushion in response to unexpected
    supply problems.
        Today we consume about 20 million barrels per day of petroleum, of
    which about 84 percent comes from 149 domestic refineries, 9 percent
    comes from natural gas (e.g., propane and butane), 2 percent from
    ethanol and other oxygenates, and 5 percent from imports (Figure 1).
    About 70 percent of the net product imports are finished gasoline or
    gasoline blending components, of which almost two thirds came from
    Western Europe (29 percent), Canada (21 percent), and Virgin Islands
    (14 percent).
        Concern regarding the adequacy of refining capacity is relatively
    recent. There was significant surplus capacity from the 1970's until
    the mid 1990s. Since the mid-1990s, both U.S. capacity and product
    imports have increased to keep up with growing demand for petroleum
    products. From 1997 through 2003, demand grew by 1.4 million barrels
    per day. During this same period, refiners expanded capacity at
    existing facilities by 1.2 million barrels per day,\1\ which is
    equivalent to adding one medium-sized refinery per year, and net
    product imports grew by 0.5 million barrels per day, with total
    gasoline imports accounting for more than two-thirds of that product
    import growth.
    ---------------------------------------------------------------------------
        \1\ Capacity represents the change in average capacity available in
    1997 compared to the average available in 2003. It does not include the
    moist recent additions to capacity.
    ---------------------------------------------------------------------------
        As we look ahead over the next 10 to 20 years, total petroleum
    product demand is expected to increase about 1.6 percent per year,
    assuming current policies, with transportation fuels accounting for
    most of that growth, as projected in EIA's Annual Energy Outlook. EIA
    is projecting increases in refinery capacity and product imports will
    be needed to meet the continuing demand increases. Refinery capacity
    growth for the next 10 years will likely be the result of expansions at
    existing refineries, which have been more economical than building new
    refineries.
        The breakdown between additional domestic refining capacity and
    increased product imports to meet projected demand growth in our
    forecast is highly uncertain. Our country's concerns over environmental
    quality can be expected to increase the cost, complexity, and time
    required for any expansion. In some cases, hurdles such as land
    constraints or public concerns may prevent expansions. At the same
    time, growing world demand is expected to continue to increase
    competition for product imports, and U.S. product specifications may
    result in a reduction in available suppliers to the United States. U.S.
    gasoline and diesel specifications are currently more stringent than
    those in most other countries, which are moving towards cleaner fuels
    more slowly. As a result, some foreign refiners that previously
    supplied the United States may not be able to produce U.S.-quality
    gasoline until their own countries' specifications shift.
        Absent policy changes (or other factors such as a sudden change in
    economic growth or weather) that unexpectedly reduce demand, EIA
    expects refineries will continue to run at relatively high utilizations
    during peak demand times, with little production cushion to respond to
    unexpected supply/demand imbalances. Under these circumstances, when
    markets are tight, as is the case this year, refinery outages can
    create temporary regional shortfalls that result in price spikes.

                                   BACKGROUND

        Refineries take crude oil and process it into many different
    petroleum products, from gasoline and diesel fuel to petrochemical
    feedstocks that are used to produce plastics and many other products.
    Crude oil is first separated into different components by heating the
    oil in the refinery primary distillation unit and collecting materials
    or fractions that evaporate within different boiling point ranges
    (Figure 2). For example, at this stage, some material in the gasoline
    boiling range is produced, but the yield of this gasoline volume may be
    small, representing only a fraction of the final gasoline produced.
        Refiners then take the various streams from the distillation tower
    and process them further to make more gasoline, diesel, and other
    higher-value products. Different types and sizes of process units are
    needed for different crude oils. In general, more investment is needed
    to be able to process heavy, high-sulfur crude oils than light, low-
    sulfur crude oils. The processing downstream from the distillation
    tower involves splitting molecules (cracking processes) and re-
    combining or restructuring molecules (e.g., alkylation, reforming), as
    well as treating processes to remove sulfur and other materials that
    would add to air pollution when burned.
        Finally various streams from these downstream units and some
    material from outside the refinery are combined or blended to produce
    the final products. For example, gasoline includes the gasoline stream
    that came directly from the distillation tower, alkylate from the
    alkylation unit, reformate from the reformer, and a gasoline stream
    from the fluid catalytic cracking unit. Each of these components has
    different properties (e.g., octane), so blending involves different
    ``recipes'' for different kinds of gasoline. The U.S. refinery system
    today can produce about 50 percent gasoline from a barrel of crude oil.
    This is called the gasoline yield.
        The United States has 149 refineries totaling 16.9 million barrels
    of refinery distillation capacity, 72 percent of which is located in
    several major refining centers: The Gulf Coast (40 percent);
    Philadelphia and New Jersey (9 percent), Chicago and lower Illinois (8
    percent), Los Angeles, San Francisco and Western Washington (15
    percent). The remaining 28 percent of capacity is spread throughout the
    country, including Hawaii and Alaska.
        The petroleum transportation system evolved to move product from
    major refinery centers to the rest of the country. The Gulf Coast,
    which is the largest refinery center in the world, moves product both
    into the Midwest and to the East Coast, mainly by pipeline. The
    Midwest, for example, receives about 27 percent of its gasoline from
    the Gulf Coast, and the East Coast receives about 50 percent. It takes
    about 20 days to move product from the Gulf Coast to the upper Midwest
    or Northeast. The East Coast also is highly dependent on gasoline
    imports. It receives most of the nation's gasoline imports, which serve
    about 25 percent of that region's demand. The West Coast is largely
    self-sufficient.
        The pipeline and storage systems were originally designed to
    distribute a much smaller number of products than the number being
    handled today. The Clean Air Act Amendments of 1990 resulted in changes
    in product specifications requiring cleaner-burning fuels and also
    increased the number of fuel types being used in different parts of the
    country. Different types of gasoline evolved to meet both Federal and
    State clean air requirements. Areas with the worst smog problems were
    required to use the very clean Federal reformulated gasoline. In other
    areas, States could require cleaner fuels as part of their
    implementation plans to meet national air quality standards. Often,
    such requirements were tailored to meet local needs, resulting in a
    fuel that was cleaner and more expensive than conventional gasoline,
    but cheaper than Federal reformulated gasoline. But these different
    fuels had the effect of balkanizing the gasoline market, creating
    islands of different gasoline fuel types. As more distinct fuels were
    developed, the existing delivery and storage system became more
    strained.
        This balkanization has affected the petroleum system's ability to
    respond quickly to unexpected problems. An area using a distinct fuel
    cannot turn to nearby surrounding areas for supply if an unexpected
    problem develops. If a specialized type of gasoline, such as that
    required in the Chicago-Milwaukee region, runs short because an area
    refinery has an unplanned outage, extra product may not be stored
    nearby, and other area refineries may not be able to boost production
    to help re-supply the market quickly. The region may have to wait until
    new supply arrives from a great distance, thus, contributing to the
    potential for price spikes when unexpected supply/demand imbalances
    occur.
        The major price impacts associated with these distinct fuels have
    been in California and the Chicago-Milwaukee region, whose specialized
    fuels are harder to produce than other gasoline types. This results in
    fewer alternative suppliers to help meet any unexpected needs in these
    areas. In most other areas, price problems stemming from fuel
    distinctions have been relatively minor to date, but that could change
    if the market becomes further fragmented in the future.
        There is no easy supply solution. Reducing the number of fuels from
    our current slate may ease the distribution and storage strain on the
    system, but such changes may shift the problem back to production.
    Reducing the number of fuels generally means producing more clean
    fuels, which are harder and more expensive to produce. This could
    create supply problems at refineries (e.g., lower gasoline yields, more
    closures, more investment), while easing problems in distribution. It
    is possible that expanding pipeline and storage infrastructure to
    better handle the increased fuel types might ease the problem more
    effectively than reducing the number of fuels.

                       HISTORICAL PERSPECTIVE ON CAPACITY

        Concern regarding the adequacy of refining capacity is relatively
    recent (Figure 3). There was significant surplus capacity from the mid-
    1970's until the mid-1990s. The U.S. refining industry reached its peak
    in 1981 with 324 operating refineries with a total distillation
    capacity of 18.6 million barrels per calendar day. That same year,
    excess or surplus refining capacity, measured as operable capacity
    minus gross inputs, totaled about 5.9 million barrels per day,
    resulting in an average utilization rate of 69 percent. The excess had
    occurred as demand fell (particularly for residual fuel oil) following
    the large crude oil price increases in 1979-80.
        Many small, inefficient refineries shut down in the early 1980s
    when the Domestic Crude Oil Allocation Program was removed and their
    subsidies ended, but capacity was still in excess relative to demand.
    Many small refineries have continued to close, albeit at a slower rate
    than in the early 1980s, to reach 149 refineries today. The last new
    grassroots refinery was completed in 1976. Even with the shutdowns,
    however, total capacity remained relatively flat since the mid-1980s as
    operating refineries expanded at exiting facilities.
        Meanwhile, demand grew, filling the excess capacity that remained.
    In 1994, U.S. refinery capacity was 15.0 million barrels per day, its
    lowest point since the peak in 1981, and utilization had risen to 92.6
    percent. Since the mid-1990s, both U.S. refining capacity and product
    imports have increased to keep up with growing demand. Utilization
    reached a peak in 1997 and 1998 during the summer months (May-August),
    averaging 98 and 99 percent, respectively, driven by gasoline demand.
    Increases in supply relaxed that very tight situation somewhat in the
    intervening years, with summer utilization varying between 93 and 96
    percent. The added supply from 1997 through 2003 came from refiners
    expanding capacity at existing refineries by 1.2 million barrels per
    day and from net product imports by growing 0.5 million barrels per
    day, with total gasoline net imports accounting for more than two
    thirds of that product import growth (Figure 4). During this same time
    period, product demand grew by 1.4 million barrels per day--slightly
    less than supply.
        This year may see U.S. refiners pushing towards those 1997-98 high
    utilization levels again. Gasoline demand growth has averaged 2.2
    percent in the first half of the year compared to first half of 2003,
    while imports have been slightly lower than last year. Imports have
    been more difficult to attract due both to increasing international
    competition for volumes and fewer sources of gasoline supply able to
    produce U.S.-quality gasoline as a result of changing U.S. product
    specifications.

                             FUTURE CAPACITY NEEDS

        As we look ahead, EIA projects total petroleum demand to grow on
    average 1.6 percent per year, assuming no changes in current policies.
    This means that over the next 10 years (through 2013), the United
    States will need an additional 20 percent or 4 million barrels per day
    of total petroleum product supply. The largest part of this growth is
    in the transportation sector, which will require an additional 3.5
    million barrels per day of product, mainly gasoline and diesel fuel.
    EIA projects that the United States will see both increases in refinery
    capacity and product imports to meet that continuing demand growth over
    this period. Net product imports are projected to continue to supply
    about 5 percent of demand,\2\ resulting in an increase of about 0.5
    million barrels per day over the next 10 years. This implies that some
    foreign refiners may be able to meet U.S. specifications more cheaply
    than U.S. refiners in the future. U.S. refining capacity would have to
    increase between 3 and 4 million barrels per day to serve the remaining
    demand growth.
    ---------------------------------------------------------------------------
        \2\ Excludes unfinished oil imports, which are further processed in
    refinery units, and thus are not considered ``product'' imports for
    this paper.
    ---------------------------------------------------------------------------
        While our forecast presents one scenario, the future availability
    of increased product imports to meet our growing demand is highly
    uncertain. For example, gasoline imports have been a very competitive
    supply source historically. A major source of these imports is Europe,
    which has been increasing use of diesel fuel in its light-duty
    vehicles, resulting in its refinery system producing more gasoline than
    European consumers require. The United States has been able to buy
    European gasoline more economically than expanding domestic refineries,
    so the relationship has benefited both regions. As we look to the
    future, some shifts in world markets are occurring.
        First, world demand is growing and there is more competition for
    petroleum products available for sale internationally. The increasing
    competition for these products tends to increase their price, making
    them less attractive.
        Second, the United States has stricter environmental gasoline
    specifications today than in many parts of the world. Although the rest
    of the world is also moving towards cleaner fuels, the number of
    suppliers that can produce U.S.-quality gasoline today has diminished.
    Our need for higher-valued gasoline and the reduced number of suppliers
    tends to increase the price we pay for imported gasoline. Both
    increased demand and change in product specifications have resulted in
    lower gasoline imports so far this year than last year. But how long
    will this imbalance last? Higher-priced alternative import supplies
    will tend to make domestic refinery expansion look more attractive than
    if imports were available at a lower price. But as other countries move
    to stricter product specifications and their refineries adjust, we
    could see a larger share of U.S. future demand being met by imports.
        Additional domestic refinery capacity is needed not only to meet
    growing demand but also to counter some reduction in ability of
    refiners to produce gasoline from a barrel of crude oil as a result of
    changing product specifications. For example, the ban on MTBE seems to
    have reduced California refiners' ability to produce reformulated
    gasoline for that State during the summer months by about 10 percent.
    These refiners may be able to partially compensate with other process
    improvements, but that seems to be occurring slowly. Since refineries
    in that part of the country run near full capacity, more products must
    be shipped into the State to meet demand. In general, the move towards
    cleaner-burning fuels also results in some loss of yield.
        While supply will evolve to meet demand, what cannot be predicted
    well is how much will come from U.S. capacity versus imports.

               FACTORS AFFECTING DECISIONS TO SHUT DOWN OR EXPAND

        The following discussion highlights some of the factors that
    influence individual company's decisions to shut down facilities or
    expand. This discussion is illustrative rather than comprehensive in
    order to highlight the many different factors that affect capacity
    decision making.
        Even though demand has caught up with capacity, we continue to see
    refineries close, and we expect closures to continue. Most refineries
    that have closed are small, having capacities of less than 70 thousand
    barrels per day. Smaller refineries are less efficient than larger
    refineries, and many factors enter into their decision to close rather
    than expand. In some cases, environmental requirements play an
    important role. All refiners today must make environmental investments
    to stay in business. These investments are large, and generally
    economies of scale mean higher costs per barrel for smaller refineries.
    Small, less-efficient refiners facing these investments must consider
    if they can compete and earn an adequate return on that investment. In
    many cases, the answer has been no.
        On net, refinery expansions have exceeded loss of capacity from
    shutdowns in the last 10 years. These expansions occurred at existing
    facilities and, on average, represented the equivalent of adding one
    medium-sized refinery per year. EIA's most recent capacity data for
    January 2004 indicate capacity increased over 2003 by 137,000 barrels
    per day, the equivalent of yet one more medium sized refinery. Yet
    demand growth has required even more product imports.
        Each company must consider whether or not a capacity investment
    will realize a reasonable return in the future. For much of the 1990s,
    returns on refining investments were small. Those returns have improved
    since 2000, but not smoothly or predictably. Price spikes during the
    spring and late summer for gasoline, and winter distillate price spikes
    in the past several years, contributed to improved returns, but in
    2002, when international markets loosened, U.S. refining margins were
    low in spite of U.S. refineries running at high utilization rates. Yet,
    during tight markets, high utilization can exacerbate price volatility
    since refiners have little or no extra production capacity to respond
    to unexpected needs. Will margin increases seen since 2000 continue in
    the future long enough to merit increased capacity investments? Each
    company must weigh its decision based on market fundamentals and its
    own unique situation.
        The way in which companies have expanded capacity over the last 20
    years indicates it has been more economical on a dollar-per-barrel
    basis to expand at an existing facility than to build a grassroots
    refinery. Siting approvals are also generally easier at an existing
    location. Between 1990 and 2003, 14 medium and large refineries
    increased capacity by more than 50 percent. Those refineries alone
    added more than 1million barrels per day of capacity during that time.
    The economics of expansion in either case are affected by varying
    regulatory hurdles and public acceptance. The higher these hurdles are,
    the higher the margins required to justify expansion.
        Dollars available for expansion may also influence decisions. Right
    now, the industry is investing billions of dollars to remove sulfur
    from both gasoline and diesel fuel. While these investments will create
    much cleaner-burning fuels, they also may detract from expansion for a
    short time.
        Companies will view the factors affecting future expansion
    differently. Their differing views on future margins, on their ability
    to compete with other domestic refiners or importers, on market growth
    and so forth will lead one company to expand and another to shut down a
    facility. But ultimately, we expect to see some refinery expansion
    continue in the future.
        Thank you for the opportunity to testify before the committee
    today.
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    [GRAPHIC] [TIFF OMITTED] T5456.012

        Mr. Hall. Thank you, and we will have questions.
        Mr. Holmstead.

                 STATEMENT OF HON. JEFFREY R. HOLMSTEAD

        Mr. Holmstead. Thank you, Mr. Chairman and members of your
    subcommittee, for the invitation to appear here today.
        EPA began to regulate motor fuel back in the 1970's, when
    the Agency first required that lead be phased out of gasoline,
    but the focus of attention in recent years has been on two
    clean fuel programs that came directly from the 1990 Amendments
    to the Clean Air Act. One is known as the Reformulated Gasoline
    program, or RFG. The other one is the Tier 2 low sulfur
    gasoline program, and let me just briefly mention each of
    those.
        By statute, every gallon of RFG, of reformulated gasoline,
    is required to contain a minimum amount of oxygenates, such as
    ethanol or MTBE. EPA and the Department of Energy have
    estimated that the cost of producing RFG is about 4 to 8 cents
    per gallon greater than the cost of producing conventional
    gasoline, and about half of this cost increment is due to the
    cost of the oxygen requirement itself. Now, I should note that
    the average retail price, the price that we actually pay at the
    pump, the price of RFG today is, on average, about 4 cents per
    gallon greater than the cost of conventional gasoline.
        The second clean fuel program I mentioned, the Tier 2
    program, began on January 1 of this year. By 2006, this program
    will reduce the sulfur content of most gasoline sold in the
    U.S. by about 90 percent. This reduction in the sulfur content
    immediately reduces emissions from all gasoline-powered
    vehicles, but it also enables the use of advanced technologies
    to control pollution. So, the Tier 2 program also includes a
    phase-in that begins this year of much more stringent tailpipe
    standards, so we are regulating both the fuel and the vehicles.
    We estimate that the Tier 2 will cost about a penny a gallon
    today, and when it is fully phased in in 2006, that cost will
    be about 2 cents a gallon, two pennies.
        The important thing, the way we look at these programs, is
    to compare the cost of the program with its benefits. On the
    benefit side, we estimate that the Tier 2 program including
    both the fuel and engine standards will prevent every year
    approximately 4,000 premature deaths, approximately 10,000
    cases of chronic and acute bronchitis, and tens of thousands of
    respiratory problems a year. And on this program, as far as I
    know, everyone agrees that the public health benefits of the
    program far exceed its cost.
        As you have heard this afternoon already, this morning and
    this afternoon, the retail price of gasoline is affected by
    many factors. We believe that the run-up in gasoline prices
    earlier this year was primarily the result of a steep increase
    in crude oil prices, and we can say with great confidence that
    the clean fuel regulations have had only a minimal impact on
    gasoline prices.
        Let me turn now very quickly to the issue of so-called
    ``boutique fuels.'' The Clean Air Act specifically authorizes
    States to regulate fuel as part of their State air quality
    plans if they need this type of regulation to achieve a
    national air quality standard. This has resulted in a number of
    different fuel formulations being required by different States.
    These formulations are often referred to as ``boutique fuels,''
    and 15 States have adopted their own clean fuel programs for
    part or all of the State.
        In October 2001, EPA released a comprehensive White Paper
    discussing the range of issues associated with the boutique
    fuel programs, and the three basic conclusions of this paper
    were: (1) that the current gasoline refining and distribution
    system works quite well except during times of unexpected
    disruption, which you have alluded; (2) that fewer fuel types
    would improve the fungibility of the gasoline pool; and (3)
    options exist to reduce the number of fuel types and to improve
    fungibility while maintaining or improving air quality, but the
    fungibility benefits from taking these actions are likely to be
    modest, and there may be a significant cost or supply
    implications associated with these options.
        Now, we are committed to working with Congress to explore
    ways to maintain or enhance the environmental benefits of clean
    fuel programs while exploring ways to increase the flexibility
    of the fuel distribution infrastructure and provide added
    gasoline markup liquidity. And I will say that the best way
    that we have identified to accomplish these goals is to replace
    the current oxygen requirement for RFG with a renewable fuel
    standard that includes a flexible nationwide credit trading
    system, but this can only be done through legislation such as
    the renewable fuels provisions in the Energy Bill which the
    Administration strongly supports.
        Mr. Chairman, members of the subcommittee, we at EPA have
    learned a great deal about cleaner burning fuels and boutique
    fuels programs since 1990, and we would be pleased to work with
    Congress and with this subcommittee to look for ways to make
    improvements.
        This concludes my prepared statement and, again, at the
    appropriate time, I would be happy to answer questions.
        [The prepared statement of Hon. Jeffrey R. Holmstead
    follows:]

     Prepared Statement of Jeffrey Holmstead, Office of Air and Radiation,
                      U.S. Environmental Protection Agency

        Thank you, Mr. Chairman and Members of the Subcommittee, for the
    invitation to appear here today. I appreciate the opportunity to
    discuss the vital role cleaner burning gasoline plays in improving
    America's air quality and to comment on the subject of gasoline prices
    and ``boutique fuels.'' I also will explain the status of the
    Environmental Protection Agency's review of California's and New York's
    requests for a waiver of the oxygen content requirement in reformulated
    gasoline used in those States.

                     BACKGROUND OF CLEANER BURNING GASOLINE

        Mr. Chairman, as you know, EPA began to improve the quality of
    motor vehicle fuel in the 1970's when unleaded gas was first
    introduced. Today, I would like to focus my comments on two clean fuel
    programs that are a direct result of the Clean Air Act Amendments of
    1990: reformulated gasoline (RFG) and Tier 2 low sulfur gasoline. The
    purpose of both programs is to improve public health by reducing
    harmful exhaust from the tailpipes of motor vehicles. The RFG program
    began in 1995 and was designed to serve several goals. These include:
    (1) improving air quality by reducing ozone precursor pollutants; (2)
    reducing emissions of specific toxic pollutants such as benzene; and
    (3) extending the gasoline supply through the use of oxygenates. Every
    gallon of RFG is required to contain a minimum amount of an oxygenate,
    such as ethanol or MTBE. EPA and the Department of Energy have
    estimated the cost of producing RFG to be approximately 4 to 8 cents
    per gallon greater than conventional gasoline. Of this amount,
    approximately half of this cost increment is due to the cost of the
    oxygen requirement itself. I should note that the average retail price
    of RFG today is only about 4 cents per gallon greater than conventional
    gasoline.
        New regulations to control pollution under the Tier 2 Vehicle and
    Gasoline Sulfur Program began this year. This program, established in
    1999, is the result of a collaborative effort involving a wide range of
    stakeholders. EPA worked closely with auto companies, oil companies,
    states, public health and environmental organizations, and others to
    design a stringent, but balanced program that all key stakeholders
    could support. The sulfur content of gasoline is being phased down
    nationwide over several years with a 120 parts per million (ppm) limit
    this year, a 90 ppm limit in 2005, and a final 30 ppm average limit set
    to take effect in 2006. Ultimately, these new standards will reduce the
    sulfur content of gasoline by up to 90 percent. As sulfur is being
    reduced from gasoline, tight tailpipe emissions standards are also
    being phased in for new passenger vehicles.
        EPA estimates this Tier 2 program will prevent as many as 4,300
    deaths, more than 10,000 cases of chronic and acute bronchitis, and
    tens of thousands of respiratory problems a year. The public health and
    environmental benefits of this program (more than $25 billion) far
    exceed the costs to consumers. EPA estimates that the Tier 2 program
    only increases costs to consumers by about 1 cent per gallon today, and
    will still cost less than 2 cents per gallon when the program is fully
    phased in, in 2006.
        We have been monitoring very closely the transition to the low
    sulfur gasoline program, and believe that it has been--and will
    continue to be--a smooth one. This success is largely attributed to the
    fact that the Tier 2 program incorporates a number of flexibilities to
    ease the economic burden on the oil industry. These include:

     A market-based trading system, which allows companies to reduce costs
            by averaging, banking and trading sulfur levels among different
            refineries, between companies, and across time.
     A geographic phase-in program, which provides a slightly higher
            interim sulfur standard for gasoline sold in parts of the
            Western U.S. This program recognizes that this area is
            dominated by small capacity, geographically-isolated refineries
            that would have a more difficult time competing for engineering
            and construction resources to modify their refineries to meet
            the standards.
     A small refiner program, which gives small refiners more time to meet
            the standards, recognizing their financial challenges in
            raising capital for the de-sulfurization investments; and
     A hardship provision, which allows refineries to apply on a case-by-
            case basis for additional time and flexibility to meet the low
            sulfur standards, based on a showing of unique circumstances.
            Under this program, thus far EPA has granted hardship waivers
            to six refineries.

                                COST OF GASOLINE

        The retail price of gasoline is affected by many factors, and my
    colleague from EIA will provide further information on this subject.
    However, I would like to mention several key points:

     Worldwide crude oil prices are at their highest level since 1990 with
            West Texas Intermediate (WTI) oil prices reaching a 13-year
            peak of $42.33 per barrel on June 1, 2004.
     Fuel demand continues to increase as Americans travel more. Over the
            past twenty years vehicle miles traveled (VMT) has increased
            five times faster than U.S. population.
     Since 1997, fleet-wide fuel economy has been relatively constant,
            ranging from 20.6 to 20.9 miles per gallon (mpg). Fleet-average
            fuel economy peaked in 1987 at 22.1 mpg, but has declined since
            then due to the increasing popularity of less fuel-efficient
            light trucks, particularly SUVs.
     The number of refineries in the U.S. has been declining steadily,
            while the capacity of the remaining refineries has been
            increasing. In 1990, the number of refineries in the U.S. was
            205 with a capacity of 15.5 million barrels per day. In 2002,
            the number of refineries decreased to 153; with a capacity of
            16.8 million barrels per day. As a result, the share of
            imported gasoline has nearly tripled over the last two decades.
        Crude oil costs are the single largest component of gasoline
    prices, and account for nearly half of the cost of gasoline. Exhibit 1
    shows that gasoline price fluctuations track very closely with crude
    oil prices. The chart shows the price of RFG since 2000 to the present,
    as well as the price of crude oil in that same time period. The price
    increase was essentially the same for both RFG and conventional
    gasoline.
        With the exception of several instances of serious disruptions in
    the production and distribution system, such as pipeline breaks and
    refinery fires, fuel suppliers have provided a sufficient supply of
    gasoline to motorists. The run-up in gasoline prices earlier this year
    was primarily the result of a steep increase in crude oil prices. We
    believe that environmental regulations have had a minimal effect on
    gasoline prices. As I discuss below, additional state and local clean
    fuel requirements may pose challenges to fuel suppliers during times of
    market disruption.
        Exhibit 2 tracks gasoline prices and crude oil prices from October
    2003 to the present. Like the long term trend shown in Exhibit 1, this
    chart also indicates that the price of RFG tracks closely with the
    price of crude oil. The chart indicates the percentage of the cost of
    crude oil to the price of RFG at the pump for the time period of
    October 2003 to the present. The percentage is relatively constant,
    even during the period during which the Tier 2 low sulfur gasoline was
    being phased in, and during the transition from winter to summertime
    RFG. Thus, it is apparent that crude oil prices play a large role in
    the price at the pump.

                              REFINERY PERMITTING

        Recently, some representatives of the refining industry have stated
    that the permitting process in the U.S. is a major barrier and source
    of uncertainty to both building new refineries and expanding the
    capacity of existing ones. I would like to address this very important
    issue.
        The term ``permitting'' encompasses many different regulations,
    activities, and governmental agencies. One of the programs that affect
    permitting decisions is the New Source Review or NSR regulations.
    Congress established this program with the goal of ensuring that new
    sources (and existing sources that make major modifications that
    increase emissions) install good air pollution controls. Pursuant to
    the Clean Air Act, EPA has set minimum requirements for NSR programs.
    States then have the option of implementing EPA's program or running
    their own programs, which can be more stringent than the federal
    program. There are also state and local requirements, such as
    conditional use permits, that involve land use and other issues. For
    these state and local permits, over which EPA has no control,
    stakeholders such as local citizen groups may get involved and
    challenge the refiner's proposed action.
        In response to the President's National Energy Policy (May 2001),
    EPA conducted a review of the NSR process and its effect on potential
    new refineries and on expansion of capacity at existing refineries. In
    a Report to the President (June 2001), we concluded that NSR had not
    significantly impeded investment in new refineries. We did find,
    however, that NSR discouraged projects for the refining and other
    industries that would have provided additional capacity or efficiency
    improvements and would not have increased air pollution. In response to
    these findings, EPA recently revised its NSR regulations to remove
    barriers to beneficial projects that would provide the additional
    capacity or achieve efficiency improvements with no increased air
    pollution, and to provide greater regulatory certainty for industry. We
    expect these reforms to streamline the NSR process for refineries and
    provide flexibility for sources to continue to meet our energy needs in
    an environmentally protective fashion for years to come. We are working
    with States to get these reforms approved and implemented as
    expeditiously as possible.
        There are circumstances that may require special attention to the
    permit process so that critical facilities can be built or expanded,
    while still meeting environmental regulations. When presented with
    these circumstances, EPA and the states have demonstrated a willingness
    to ensure that appropriate permits move expeditiously. For example,
    although the refining industry was very concerned during the
    development of the Tier 2 low-sulfur gasoline rules that NSR permitting
    would make it difficult to make the facility changes necessary to meet
    the new rules, we have not found that to be the case. In response to
    the industry's concerns, EPA committed to work closely with the state
    and regional organizations responsible for processing permit
    applications to help expedite the process to the extent possible. As
    part of this effort, we prepared guidance for conducting Best Available
    Control Technology (BACT) analyses, as required under the Prevention of
    Significant Deterioration permit program, and provided resources to
    expedite the processing of permit applications. We offer the same
    degree of cooperation with agencies and refiners in helping to
    streamline the permitting process to the greatest extent possible under
    the existing regulatory structure.

                      STATE AND LOCAL CLEAN FUEL PROGRAMS

        Let me turn now to the issue of the so-called ``boutique fuels.''
    The variation in fuels due to state and local fuel requirements is
    occasionally pointed to as contributing to higher gasoline prices, and
    some have inquired why EPA has approved the use of such fuels. The
    Clean Air Act authorizes states to regulate fuels as part of their
    state implementation plans--or SIPs--if EPA finds such regulations
    necessary to achieve a national air quality standard. This has resulted
    in a number of different formulations being required by states, which
    are often referred to as boutique fuels. Fifteen states have adopted
    their own clean fuel programs for part or all of the state. In those
    states that require gasoline that differs from federal standards, such
    gasoline generally has lower volatility than gasoline under the federal
    standards. In some cases, a state has adopted such a fuel program
    because it wanted the benefits of cleaner burning gasoline, but without
    the requirement that it contain an oxygenate.
        Before adopting these boutique fuel controls, states often engage
    in a public advisory process to consult with stakeholders, including
    refiners and fuel suppliers that serve the affected region, and other
    members of the public. Refiners typically have worked with states to
    design fuel controls that meet the region's air quality needs at the
    lowest possible cost. Therefore, the process of adopting fuel programs
    that contain different requirements than federal regulations is
    typically a joint effort between the refiners and suppliers, the
    public, and the state environmental agencies. Fuel supply and cost are
    important considerations when designing the program. Therefore, we
    advise states that are considering adopting their own clean fuel
    program to initiate this collaborative process.
        The President's National Energy Policy issued in May, 2001 directed
    EPA to study opportunities, in consultation with DOE, USDA and other
    agencies, to maintain or improve the environmental benefits of state
    and local boutique fuel programs, while exploring ways to increase the
    flexibility of the fuels distribution system.
        In October, 2001 EPA released an extensive EPA Staff White Paper on
    boutique fuels. The broad conclusions from this White Paper still hold
    up today: (1) the current gasoline refining and distribution system
    works well, except during times of disruption, (2) fewer fuel types are
    likely to improve fungibility, and (3) options exist to reduce the
    number of fuel types and improve fungibility while maintaining or
    improving air quality, although the fungibility benefits from taking
    these actions are likely to be modest and there may be significant cost
    or supply implications associated with these options.
        EPA's authority to address many of these issues is limited. We are
    committed to working with Congress to explore ways to maintain or
    enhance the environmental benefits of clean fuel programs, while
    exploring ways to increase the flexibility of the fuels distribution
    infrastructure, improve fungibility, and provide added gasoline market
    liquidity. The Administration supported energy bill provisions that
    would replace the statutory oxygen content requirement for RFG with a
    renewable fuel standard that includes a flexible, national credit-
    trading system.

            REQUESTS FOR WAIVERS FROM THE OXYGEN REQUIREMENT IN RFG

        I would now like to talk about the status of California's and New
    York's requests for a waiver of the oxygen requirement in RFG. The
    Clean Air Act requires that RFG be used in the highly polluted areas of
    the U.S. and that RFG contain a minimum of 2.0 percent by weight
    oxygen. In order to receive a waiver from the federal RFG oxygen
    requirement, a state must show that the requirement will interfere with
    the state's ability to attain a NAAQS.
        Congress set a high hurdle for granting such waivers, and severely
    limits EPA's discretion. For example, the Clean Air Act does not allow
    the Agency to consider the risks of MTBE contamination of drinking
    water in California and New York. It also does not allow the Agency to
    consider the effect on gasoline prices or energy supplies that the
    oxygenate requirement and state bans on MTBE might have.
        As was apparent in our denial of California's request in June of
    2001, analyzing the emissions effects of granting a waiver is a very
    complicated endeavor. For example, the granting of a waiver would not
    result in the use of a uniform market of non-oxygenated RFG in the
    California RFG areas but, rather, some amount of oxygenated RFG would
    be used. Because California enacted a ban on the use of MTBE in
    gasoline, the oxygenate in California RFG is ethanol. A market which
    includes both non-oxygenated and ethanol oxygenated RFG creates the
    potential for mixing, called commingling, of the two types of fuel in
    the gas tanks of automobiles, which in turn results in increased
    emissions of volatile organic compounds. Other complicated issues arise
    such as how refiners would reformulate their gasoline without an oxygen
    requirement and still meet the emissions performance requirements of
    RFG. In combination, these issues and others determine whether the
    granting of a waiver would, in fact, help or hinder the air quality
    situation in the state. We continue to sort out these complex issues as
    we review the data and analyses submitted by the State in support of
    its waiver request. Our actions with respect to the waiver requests
    from California and New York are no different in this regard.
        In short, the Clean Air Act provides significant constraints for
    granting waivers of the oxygen requirement in RFG. We believe that the
    difficulties that the oxygen requirement poses for certain states can
    best be remedied by passage of comprehensive energy legislation that
    will simplify federal gasoline requirements by replacing the RFG
    oxygenate requirement with a national renewable fuels standard that
    includes a flexible credit trading system.
        Mr. Chairman and members of the Subcommittee, the clean fuel
    programs I have talked about today are critical to our nation's efforts
    to reduce the harmful effects of air pollution from motor vehicles.
    They are also important to the production and distribution of gasoline
    at a fair price to consumers. We have learned a great deal about
    cleaner burning fuels since 1990 and the Agency will continue to look
    for ways to make improvements.
        This concludes my prepared statement. I would be pleased to answer
    any questions that you may have.

    [GRAPHIC] [TIFF OMITTED] T5456.013

    [GRAPHIC] [TIFF OMITTED] T5456.014

        Mr. Hall. Thank you very much.
        Director Wells.

                         STATEMENT OF JIM WELLS

        Mr. Wells. Thank you, Mr. Chairman. We welcome the
    opportunity to contribute to your hearing today on issues
    relating to the U.S. refining industry. We all know that world
    crude oil prices and its availability are the principal price
    drivers. However, even if you have all the crude oil you need,
    our refining capacity can be a choke point.
        Today, we have 149 refineries. Twenty-three years ago, we
    had 325. I might add that not all of today's refineries are
    actually producing gasoline. Statistics say that they are
    running at about 96 percent capacity in utilization. The
    challenges will clearly be to meet the growing demand, pick
    your number--10 million, 15 million, 20 million barrels a day--
    if something breaks or supply is disrupted, one of the first
    things that happens is price volatility.
        In 2002, we agreed to do a study to look at a study of the
    effect of the wave of mergers that occurred in the mid to late
    1990's. Twenty-six hundred mergers changed the landscape of how
    the sale of petroleum products occurred. Large oil companies
    combined with other large oil companies who previously competed
    with each other. For example, in 1998, BP and Amoco merged, and
    later acquired ARCO, while Exxon acquired Mobile. Since the mid
    1990's, approximately 40 refiners have been involved in
    mergers. Did this wave of mergers reduce competition and
    generally lead to higher gasoline prices? Our study came to a
    conclusion that said ``yes.''
        To our knowledge, we have produced the only study of this
    magnitude and scope to date. What analysis was in the
    literature and academia publications was on a smaller scale,
    and clearly not nationwide or dealing with the multitude and
    multiple factors involving multiple mergers.
        We constructed econometric models to estimate the effects
    of these mergers on market concentration on prices at the
    wholesale because we believed that the bottlenecks in the
    gasoline markets are most commonly detected at the refining and
    distribution levels. Also, price changes at the wholesale
    levels generally get passed through at the pump in terms of
    prices.
        What we did find and document was that the marketplace
    clearly had changed. There are fewer oil companies and
    refiners. There is less non-branded gasoline that was
    traditionally offered to the marketplace at lower prices.
    Distribution and availability of gasoline to the smaller
    dealers, the mom and pops, if you will, is on the decrease.
    Market concentration which relates to market shares and market
    activity increased at the refining levels across the board. On
    the one hand, it is clear that mergers potentially enable
    companies to gain synergy, grow assets, and reduce cost-
    achieving efficiencies that may be passed along to the
    consumers at the gas pump. Clearly, this is a good thing.
    However, if you get bigger and fewer competitors, you may also
    gain a situation involving market power, and that is the
    ability to raise prices above competitive levels. Taken
    collectively, our models, at least at the wholesale price
    levels, showed an increase of anywhere from 1 to 7 cents for
    six out of the eight major mergers that we analyzed. Again, a
    retrospective look looking back at what happened after the
    mergers occurred.
        Our findings imply that the overall effects of market
    power, which does tend to increase prices, won out over the
    efficiency gains that you would expect that could perhaps
    decrease prices.
        In any study of this magnitude, you can expect to have many
    differences of opinion. The FTC, as you will hear this morning,
    will weigh in with their views. Although no econometric model
    can perfectly predict reality, we believe that our models and
    the facts and analyses that we did are methodologically sound
    and produce reasonable estimates, or at least starting points,
    for future discussions.
        Mr. Chairman, in summary, we believe our retrospective look
    and study back at the wave of mergers that occurred in the
    1990's will help you as you wrestle with the refining issues in
    this country, and we would hope that our study could influence
    what the regulatory antitrust agencies like the FTC do in the
    future to protect the competitive process and ultimately the
    consumers that have to buy gasoline at the pump.
        Thank you, Mr. Chairman.
        [The prepared statement of Jim Wells appears at the end of
    the hearing.]
        Mr. Hall. Thank you. The Chair recognizes Mr. Kovacic.

                     STATEMENT OF WILLIAM E. KOVACIC

        Mr. Kovacic. Mr. Chairman and members of the subcommittee,
    I want to thank you for the opportunity to present the FTC's
    testimony concerning competition policy in the U.S. refining
    industry.
        My written statement gives the Federal Trade Commission's
    views, and my spoken comments today are from my own views and
    not necessarily those of the Commission or its members.
        Competition policy unmistakenly plays a key role in
    protecting consumers of refined petroleum products such as
    gasoline. Since the early 1980's, the FTC has been the Federal
    Agency mainly responsible for competition policy issues in the
    petroleum sector. No industry has commanded closer attention
    from this Agency.
        The FTC promotes competition in refining in four ways.
    First, the Commission opposes mergers that promise to curb
    competition and demands divestitures and other relief to cure
    competitive problems. Second, the Agency prosecutes non-merger
    antitrust violations involving refiners. For example, the
    Agency is now litigating an administrative complaint against
    Unocal. This complaint alleges that Unocal manipulated
    California's regulatory process for establishing standards for
    reformulated gasoline. Third, the FTC uses a statistical model
    to detect unusual gasoline price movements nationwide and to
    spot possible antitrust violations. And, finally, the FTC
    performs research on key industry trends. Later this year, the
    Commission expects to publish separate reports on mergers and
    factors that affect gasoline prices.
        Collectively, these activities have given the FTC
    unequalled competition policy expertise in this sector and
    unmatched knowledge, I believe, of the institutional
    arrangements that determine the form and intensity of rivalry
    in this sector. It is from this perspective that we have read
    and evaluated GAO's report on petroleum industry mergers and
    concentration.
        I applaud the GAO's interest in evaluating merger outcomes.
    The evaluation of policy outcomes is a valuable ingredient of
    responsible public administration. To provide a suitable basis
    for informing policy, an evaluation must be analytically sound.
    And with respect to Jim Wells and my fellow Government
    colleagues at the GAO, the GAO report contains, we believe,
    fundamental methodological errors that deny its results
    reliability. Jim Wells is absolutely right: the study doesn't
    have to be perfect. But it has to be good enough to be
    reliable. You can be a few feet off, for example, in navigation
    in flying across the country from Washington to LAX. But be a
    few miles off, and you are in the Pacific Ocean. What we are
    really debating here is that degree of accuracy.
        Three crucial flaws, in our view, stand out. First, GAO's
    econometric analyses did not properly account for many factors
    that we believe affected prices in the transactions they
    examined. Second, GAO's study of how concentration affects
    prices do not use properly defined relavant markets--to use
    some antitrust jargon--required for good analysis. And, last,
    we believe that GAO failed to consider critical facts about
    individual transactions, such as the Exxon-Mobil consolidation,
    that are vital to assess price effects.
        We welcome rigorous analysis of antitrust policy. In this
    spirit, we have invited the GAO to join the FTC in co-hosting a
    public conference to consider the GAO report's findings and
    certainly indirectly, since it is our merger review that is at
    issue, our own work. To inform the proceedings, we call upon
    GAO to fully disclose its econometric methodology and the data
    it used to run its models. Participants at the conference would
    include our own colleagues as well as outside experts and
    advisors and other observers with a keen interest in this
    field.
        We see the event, as Jim has just mentioned, as a possible
    step forward. We see it as a way to educate policymakers and
    other interested observers about the way in which the industry
    operates, the way in which merger review takes place, and the
    way in which different choices about competition policy are
    formulated. Indeed, we welcome an absolutely unflinching
    assessment of our work. We have confidence in our competition
    policy program and the analytical techniques on which it rests,
    but if rigorous public debate showed that this confidence was
    misplaced, we would have the humility and the dedication to
    good public policy to make adjustments.
        I welcome your questions.
        [The prepared statement of William E. Kovacic follows:]

      Prepared Statement of William E. Kovacic, General Counsel, Federal
                                Trade Commission

                                I. INTRODUCTION

        Mr. Chairman and members of the Subcommittee, I am Bill Kovacic,
    General Counsel of the Federal Trade Commission. I am pleased to appear
    before you to present the Commission's testimony on FTC initiatives to
    protect competitive markets in the production, distribution and sale of
    gasoline.1
    ---------------------------------------------------------------------------
        \1\ This written statement represents the views of the Federal
    Trade Commission. My oral presentation and responses to questions are
    my own and do not necessarily represent the views of the Commission or
    any individual Commissioner.
    ---------------------------------------------------------------------------
        The petroleum industry plays a crucial role in our economy. Not
    only do changes in gasoline prices affect consumers directly, but the
    price and availability of gasoline also influence many other economic
    sectors. No other industry's performance is more visibly or deeply
    felt.
        The FTC's petroleum industry activities today reflect the sector's
    importance. The Commission fully exercises every tool at its disposal--
    including the prosecution of cases, the preparation of studies, and
    advocacy before other government bodies--to protect consumers from
    anticompetitive conduct and from unfair or deceptive acts or practices.
    In doing so, the FTC has built an unequaled base of competition and
    consumer protection experience and expertise in matters affecting the
    production and distribution of gasoline.
        The Commission's testimony today addresses the Subcommittee's
    inquiries in two parts. It first reviews the basic tools that the
    Commission uses to promote competition in the petroleum industry:
    challenges to potentially anticompetitive mergers, prosecution of
    nonmerger antitrust violations, monitoring industry behavior to detect
    anticompetitive conduct, and research to understand petroleum sector
    developments. This segment of the testimony highlights what we believe
    to be some of the flaws of a recent Government Accountability Office
    (``GAO,'' formerly known as the ``General Accounting Office'') report
    analyzing the effects of various petroleum industry mergers completed
    from 1997 through 2000. The review of the Commission's petroleum
    industry agenda highlights how the FTC is contributing to efforts to
    maintain and promote competition in the industry.
        The second part of this testimony reviews learning the Commission
    has derived from its review of recent gasoline price changes. Among
    other findings, this discussion highlights the paramount role that
    crude oil prices play in determining both the level and movement of
    gasoline prices in the United States. Changes in crude oil prices
    account for approximately 85 percent of the variability of gasoline
    prices.2 When crude oil prices rise, so do gasoline prices.
    Crude oil prices are determined by supply and demand conditions
    worldwide, most notably by production levels set by members of the
    Organization of Petroleum Exporting Countries (``OPEC''). As Figure 1
    illustrates, changes in gasoline prices historically have tracked
    changes in the price of crude oil.3 With crude oil prices in
    the range of $40 per barrel, it is not surprising that we are seeing
    higher gasoline prices nationwide.4
    ---------------------------------------------------------------------------
        \2\ A simple regression of the monthly average national price of
    gasoline on the monthly average price of West Texas Intermediate crude
    oil shows that the variation in the price of crude oil explains
    approximately 85 percent of the variation in the price of gasoline.
    Data for the period January 1984 to October 2003 were used. This is
    similar to the range of effects given in United States Department of
    Energy/Energy Information Administration, Price Changes in the Gasoline
    Market: Are Midwestern Gasoline Prices Downward Sticky?, DOE/EIA-0626
    (Feb. 1999). More complex regression analysis and more disaggregated
    data may give somewhat different estimates, but the latter estimates
    are likely to be of the same general magnitude.
        This percentage may vary across states or regions. See Prepared
    Statement of Justine Hastings before the Committee on the Judiciary,
    Subcommittee on Antitrust, Competition Policy and Consumer Rights, U.S.
    Senate, Crude Oil: The Source of Higher Gas Prices (Apr. 7, 2004). Dr.
    Hastings found a range of approximately 70 percent for California and
    91 percent for South Carolina. South Carolina uses only conventional
    gasoline and is supplied largely by major product pipelines that pass
    through the state on their way north from the large refinery centers on
    the Gulf. California, with its unique fuel specifications and its
    relative isolation from refinery centers in other parts of the United
    States, historically has been more susceptible to supply disruptions
    that can cause major gasoline price changes, independent of crude oil
    price changes.
        \3\ Figure 1 (covering the period 1949 through 2002) also
    illustrates that the real price of gasoline has fallen dramatically
    since its historic high in the early 1980s. The difference between the
    price of crude oil (per gallon of gasoline) and the price of a gallon
    of gasoline has remained fairly constant for the same time period,
    generally around $.80 per gallon. (All figures are in 2002 dollars.)
    This is dramatically lower than the difference for the years preceding
    1980.
        \4\ Crude oil prices have fallen from a high of approximately $42
    per barrel (May 24 and June 1) to approximately $38 per barrel (July
    2); this is a drop of approximately 9.5 cents per gallon. The price of
    gasoline has dropped from a national average of $2.05 per gallon (May
    27) to $1.91 per gallon (July 2). See Energy Information Administration
    (``EIA''), Weekly Petroleum Status Report; national average retail
    price of gasoline obtained from Oil Price Information Service.
    ---------------------------------------------------------------------------
        As a whole, the Commission's testimony develops two themes. First,
    the Commission places a premium on careful research, industry
    monitoring, and investigations to understand current petroleum industry
    developments and to identify accurately obstacles to competition,
    whether arising from private behavior or from public policies. The
    petroleum industry's performance is shaped by the interaction of
    extraordinarily complex, fast-changing commercial arrangements and an
    elaborate set of public regulatory commands. A well-informed
    understanding of these factors is essential if FTC actions are to
    benefit consumers.
        Second, the Commission is, and will continue to be, vigilant in
    challenging anticompetitive mergers and nonmerger antitrust violations
    in the petroleum industry and in urging other government bodies to
    adopt procompetitive policies for this sector. We will not hesitate to
    suggest to Congress how the existing framework of laws might be
    improved to facilitate Commission intervention that will improve
    consumer well-being. This testimony, at Section III, identifies various
    laws and regulations that increase the cost of producing gasoline and
    the price of gasoline.

    II. FTC ACTIVITIES TO MAINTAIN AND PROMOTE COMPETITION IN THE PETROLEUM
                                    INDUSTRY

    A. Merger Enforcement in the Petroleum Industry
        The Commission has gained much of its antitrust enforcement
    experience in the petroleum industry by analyzing proposed mergers and
    challenging transactions that likely would reduce competition, result
    in higher prices, or otherwise injure the economy.5 Since
    1981, the Commission has taken enforcement action against 15 major
    petroleum mergers.6 Four of the mergers were either
    abandoned or blocked as a result of Commission or court action. In the
    other 11 cases, the Commission required the merging companies to divest
    substantial assets in the markets where competitive harm was likely to
    occur.7
    ---------------------------------------------------------------------------
        \5\ Section 7 of the Clayton Act prohibits acquisitions where the
    anticompetitive effects may occur in ``any line of commerce in any
    section of the country.'' 15 U.S.C.  18.
        \6\ Figure 2 provides detailed information on all 15 of these
    Commission merger enforcement actions.
        \7\ In a number of other instances, the parties to a merger
    abandoned their transaction after the FTC opened an investigation into
    the transaction, but before formal Commission action.
    ---------------------------------------------------------------------------
        In all 15 cases, the agency sought to maintain the pre-merger
    levels of concentration in the relevant markets in which there was
    found to be a sufficient likelihood that the merger would have an
    anticompetitive effect. The Commission recently released data on all
    horizontal merger investigations and enforcement actions from 1996 to
    2003. These data show that the Commission has brought more merger cases
    at lower levels of concentration in the petroleum industry than in
    other industries. Unlike in other industries, the Commission has
    obtained merger relief in moderately concentrated petroleum
    markets.8
    ---------------------------------------------------------------------------
        \8\ Federal Trade Commission Horizontal Merger Investigation Data,
    Fiscal Years 1996-2003 (Feb. 2, 2004), Table 3.1, et seq.; FTC
    Horizontal Merger Investigations Post Merger HHI and Change in HHI for
    Oil Markets, FY 1996 through FY 2003 (May 27, 2004), available at
    http://www.ftc.gov/opa/2004/05/040527petrolactionsHHIdeltachart.pdf.
    ---------------------------------------------------------------------------
        1. Recent FTC Merger Investigations--Three recent merger
    investigations illustrate the FTC's approach to merger analysis in the
    petroleum industry. The first is the merger of Chevron and
    Texaco,9 which combined assets located throughout the United
    States. Following an investigation in which 12 states participated, the
    Commission issued a consent order against the merging parties requiring
    numerous divestitures to maintain competition in particular relevant
    markets, primarily in the western and southern United States. Among
    other requirements, the consent order compelled Texaco to: (a) divest
    to Shell and/or Saudi Refining, Inc. all of its interests in two joint
    ventures--Equilon 10 and Motiva 11--through which
    Texaco had been competing with Chevron in gasoline marketing in the
    western and southern United States; (b) divest the refining, bulk
    supply, and marketing of gasoline satisfying California's environmental
    quality standards; (c) divest the refining and bulk supply of gasoline
    and jet fuel in the Pacific Northwest; and (d) divest the pipeline
    transportation of crude oil from the San Joaquin Valley of California.
    ---------------------------------------------------------------------------
        \9\ Chevron Corp., Docket No. C-4023 (Dec. 18, 2001) (Consent
    Order).
        \10\ Shell and Texaco jointly controlled the Equilon venture, whose
    major assets included full or partial ownership in four refineries,
    about 65 terminals, and various pipelines. Equilon marketed gasoline
    through approximately 9,700 branded gas stations nationwide.
        \11\ Motiva, jointly controlled by Texaco, Shell, and Saudi
    Refining, consisted of their eastern and Gulf Coast refining and
    marketing businesses. Its major assets included full or partial
    ownership in four refineries and about 50 terminals, with the
    companies' products marketed through about 14,000 branded gas stations
    nationwide.
    ---------------------------------------------------------------------------
        A second important oil merger that the Commission recently
    challenged was the $6 billion merger between Valero Energy Corp.
    (``Valero'') and Ultramar Diamond Shamrock Corp.
    (``Ultramar'').12 Both Valero and Ultramar were leading
    refiners and marketers of gasoline that met the specifications of the
    California Air Resources Board (``CARB gasoline'') and were the only
    significant suppliers to independent stations in California. The
    Commission's complaint alleged competitive concerns in both the
    refining and bulk supply of CARB gasoline in California, and the
    Commission contended that the merger could raise the cost to California
    consumers by at least $150 million annually for every one-cent-per-
    gallon price increase at retail.13 To remedy the
    Commission's competitive concerns, the consent order settling the case
    required Valero to divest: (a) an Ultramar refinery in Avon,
    California; (b) all bulk gasoline supply contracts associated with that
    refinery; and (c) 70 Ultramar retail stations in Northern California.
    ---------------------------------------------------------------------------
        \12\ Valero Energy Corp., Docket No. C-4031 (Feb. 22, 2002)
    (Consent Order).
        \13\ The Commission also alleged competitive concerns in the
    refining and bulk supply of CARB gasoline for sale in Northern
    California, contending that a price increase of one cent per gallon
    would increase costs to consumers in that area by approximately $60
    million per year.
    ---------------------------------------------------------------------------
        As a third example, the Commission challenged the merger of
    Phillips Petroleum Company and Conoco Inc., alleging that the
    transaction would harm competition in the Midwest and Rocky Mountain
    region of the United States. To resolve that challenge, the Commission
    required the divestiture of: (a) the Phillips refinery in Woods Cross,
    Utah, and all of the Phillips-related marketing assets served by that
    refinery; (b) Conoco's refinery in Commerce City, Colorado (near
    Denver), and all of the Phillips marketing assets in Eastern Colorado;
    and (c) the Phillips light petroleum products terminal in Spokane,
    Washington.14
    ---------------------------------------------------------------------------
        \14\ Conoco Inc. and Phillips Petroleum Corp., Docket No. C-4058
    (Aug. 30, 2002) (Analysis of Proposed Consent Order to Aid Public
    Comment). Not all oil industry merger activity raises competitive
    concerns. For example, late last year, the Commission closed its
    investigation of Sunoco's acquisition of the Coastal Eagle Point
    refinery in the Philadelphia area without requiring relief. The
    Commission noted that the acquisition would have no anticompetitive
    effects and seemed likely to yield substantial efficiencies. Sunoco
    Inc./Coastal Eagle Point Oil Co., FTC File No. 031-0139 (Dec. 29, 2003)
    (Statement of the Commission). The FTC also considered the likely
    competitive effects of Phillips Petroleum's proposed acquisition of
    Tosco. After careful scrutiny, the Commission by a 5-0 vote declined to
    challenge the acquisition. The FTC statement closing the investigation
    set forth its reasoning in detail. Phillips Petroleum Corp., FTC File
    No. 001-0095 (Sept. 17, 2001) (Statement of the Commission).
        Acquisitions of firms operating mainly in oil or natural gas
    exploration and production are unlikely to raise antitrust concerns, as
    that segment of the industry is generally unconcentrated. Acquisitions
    involving firms with de minimis market shares or production capacity or
    operations that do not overlap geographically are also unlikely to
    raise antitrust concerns. For example, the mere fact that a transaction
    involves a firm that meets the Energy Information Administration's
    financial reporting system threshold of ``1% or more of the US
    reserves, production or refining capacity'' or the Oil and Gas
    Journal's listing of the 200 largest publicly traded oil and gas
    corporations does not imply that the transaction raises competitive
    concerns.
    ---------------------------------------------------------------------------
        2. The GAO Report--In May of this year, the GAO released a report
    that sought to analyze how eight petroleum industry mergers or joint
    ventures carried out during the mid- to late 1990s affected gasoline
    prices.15 The GAO reported that six of the eight
    transactions it examined caused gasoline prices to rise, while the
    other two transactions caused prices to fall.
    ---------------------------------------------------------------------------
        \15\ U.S. General Accounting Office, Energy Markets: Effects of
    Mergers and Market Concentration in the U.S. Petroleum Industry (May
    2004) (hereinafter ``GAO report'').
    ---------------------------------------------------------------------------
        The Commission reviewed a draft of the GAO report last
    summer.16 Although GAO subsequently made some changes in its
    methodology, the basic criticisms we made of the draft report apply
    equally to the GAO's final report. The GAO report still contains major
    methodological mistakes that make its quantitative analyses wholly
    unreliable. It relies on critical factual assumptions that are both
    unstated and unjustified, and it presents conclusions that lack a
    quantitative foundation. Simply stated, the GAO report is fundamentally
    flawed.17
    ---------------------------------------------------------------------------
        \16\ See Timothy J. Muris, Chairman, Federal Trade Commission,
    Letter to James E. Wells, Director, Natural Resources and Environment,
    U.S. General Accounting Office (Aug. 25, 2003), available at http://
    www.ftc.gov/opa/2004/05/040527petrolactionsFTCresponse.pdf.
        The letter of August 25 was approved by a 5-0 vote of the
    Commission.
        \17\ The criticisms discussed here and in the detailed staff
    appendix have taken into account the explanations GAO has provided in
    response to the concerns the FTC had earlier raised.
    ---------------------------------------------------------------------------
        The Commission appends to today's testimony a detailed FTC staff
    analysis of the GAO report. That analysis highlights the GAO report's
    many flaws. Three particularly significant problems are noted
    here.18 First, the GAO's models do not properly control for
    the numerous factors that cause gasoline prices to increase or
    decrease, and this failure to control for relevant variables
    significantly undermines any results of the GAO study. We cannot
    determine with precision the effects of this inadequate control on
    GAO's results, because GAO has refused to share with us the methodology
    and documentation (including data) to allow us to do so. Nevertheless,
    our Bureau of Economics has demonstrated that the GAO report did not
    account for several factors that affect gasoline prices, including
    changes in gasoline formulation and seasonal changes in demand. To the
    extent that these omitted variables are correlated with concentration
    or mergers or other variables, these omissions bias the GAO's estimates
    of the effects of concentration and mergers on wholesale gasoline
    prices.
    ---------------------------------------------------------------------------
        \18\ The Appendix explains in detail the additional analysis that
    our staff performed.
    ---------------------------------------------------------------------------
        A second problem is that any reliable price-concentration study
    must be based on one or more properly defined geographic markets. If a
    merger affects competition, it does so in the particular geographic
    market in which that competition occurs. Unless the affected geographic
    area is correctly delineated, the researcher cannot have confidence
    that his results have anything to do with measured changes in
    concentration. If the market is defined too broadly or too narrowly,
    the researcher cannot accurately represent that any change in prices
    may have been caused by the change in measured concentration.
        Through decades of experience, the Commission has developed
    substantial expertise in defining relevant geographic markets in which
    to measure concentration and competitive effects. Neither the draft GAO
    report nor the final report measures concentration in any properly
    defined geographic market. This problem is sufficient to deny the GAO
    report any validity in assessing the effect of concentration on prices.
        Third, the GAO report fails to consider critical facts about the
    individual mergers it studied--omissions that render its results
    particularly suspect. For example, the relatively large and
    statistically significant price increases that the GAO report
    associates with the Exxon/Mobil merger appear implausible on their
    face, when considered in conjunction with the extensive restructuring
    effectuated by the Commission's consent order. Among other remedial
    measures, as a condition for allowing the transaction to proceed, the
    FTC required large-scale divestitures of Exxon and Mobil assets
    (including 1,740 retail outlets in the Northeast and Mid-Atlantic
    states, pipeline interests, terminals, jobber supply contracts, and
    brand rights) in the regions in which the GAO identified merger-related
    price increases. The divestitures essentially eliminated the
    competitive overlap between Exxon and Mobil in gasoline marketing in
    New England and the mid-Atlantic states south to Virginia (all in PADD
    I) and also eliminated marketing overlaps in parts of Texas (PADD III).
    Particularly with respect to branded prices, therefore, we strongly
    suspect that the merger cannot explain the GAO report's finding of
    higher wholesale prices following the Exxon/Mobil merger.
        Despite these and other criticisms, we applaud the goal of the GAO
    inquiry--to evaluate the consequences of past decisions of the federal
    antitrust agencies. The Commission regards evaluations of past
    enforcement decisions as valuable elements of responsible antitrust
    policymaking. We welcome sound research to test our theoretical
    assumptions and analytical techniques. In the past the Commission has
    sponsored retrospective assessments of its work and has published the
    results, favorable and unflattering alike, because we believe such
    inquiries can improve our future competition policy programs. Over the
    past decade, we have sought the views of outsiders about how to
    strengthen this dimension of policymaking,19 and we have
    increased our attention to retrospectives as a result.20
    ---------------------------------------------------------------------------
        \19\ The value of ex post evaluations was an important theme of the
    hearings convened by the FTC in the mid-1990s on innovation and
    globalization. See William E. Kovacic, Evaluating Antitrust
    Experiments: Using Ex Post Assessments of Government Enforcement
    Decisions to Inform Competition Policy, 9 Geo. Mason L. Rev. 843, 855 &
    n. 50 (2001). The benefits of increased efforts to analyze enforcement
    outcomes were emphasized in a roundtable of prominent industrial
    organization economists hosted by the FTC in 2001. See Federal Trade
    Commission, Empirical Industrial Organization Roundtable (Sept. 11,
    2001), available at http://www.ftc.gov/be/
    empiricalioroundtabletranscript.pdf.
        \20\ See e.g., Federal Trade Commission, Fulfilling the Original
    Vision: The FTC at 90, at 29 (Apr. 2004) (describing FTC retrospective
    studies of hospital mergers and petroleum mergers), available at http:/
    /www.ftc.gov/os/2004/04/040402abafinal.pdf; Harold Saltzman, Roy Levy &
    John C. Hilke, Transformation and Continuity: The U.S. Carbonated Soft
    Drink Bottling Industry and Antitrust Policy Since 1980 (Bureau of
    Economics Staff Report, Federal Trade Commission, Nov. 1999)
    (discussing impact of FTC merger enforcement involving soft drink
    bottlers), available at http://www.ftc.gov/reports/softdrink/
    softdrink.pdf; Staff of the Bureau of Competition of the Federal Trade
    Commission, A Study of the Commission's Divestiture Process (1999)
    (examining implementation of selected FTC merger consent orders),
    available at http://www.ftc.gov/os/1999/9908/divestiture.pdf.
    ---------------------------------------------------------------------------
    B. Nonmerger Investigations into Gasoline Pricing
        In addition to scrutinizing mergers, the Commission aggressively
    polices anticompetitive nonmerger activity. When it appears that higher
    prices might result from collusive activity or from anticompetitive
    unilateral activity by a firm with market power, the agency
    investigates to determine whether unfair methods of competition have
    been used. If the facts warrant it, the Commission challenges the
    anticompetitive behavior, usually by issuing an administrative
    complaint.
        Several recent petroleum investigations deserve discussion. On
    March 4, 2003, the Commission issued an administrative complaint,
    stating that it had reason to believe that the Union Oil Company of
    California (``Unocal'') had violated Section 5 of the FTC Act. The
    Commission alleged that Unocal deceived the California Air Resources
    Board in connection with regulatory proceedings to develop the
    reformulated gasoline (``RFG'') standards that CARB adopted. Unocal
    allegedly misrepresented that certain technology was non-proprietary
    and in the public domain, while at the same time it pursued patents
    that would enable it to charge substantial royalties if CARB mandated
    Unocal's technology in the refining of CARB-compliant summer RFG. As a
    result of Unocal's activities, the Commission alleged, Unocal illegally
    acquired monopoly power in the technology market for producing the new
    CARB-compliant summer RFG. The Commission also alleged that Unocal
    undermined competition and harmed consumers in the downstream product
    market for CARB-compliant summer RFG in California.
        The Commission's complaint further charged that these activities,
    unless enjoined, could cost California's consumers hundreds of millions
    of dollars per year. The complaint cited testimony of Unocal's expert,
    who estimated that 90 percent of any royalty paid to Unocal for its
    technology would be passed on to drivers in the form of higher gasoline
    prices. This case was originally dismissed by an Administrative Law
    Judge, but the Commission has reversed the decision, reinstated the
    complaint, and remanded the case for a full trial.21
    ---------------------------------------------------------------------------
        \21\ Union Oil Company of California, Docket No. 9305 (Opinion of
    the Commission) (July 6, 2004), available at http://www.ftc.gov/os/
    adjpro/d9305/040706commissionopinion.pdf.
    ---------------------------------------------------------------------------
        Another major nonmerger investigation occurred during 1998-2001,
    when the FTC conducted a substantial investigation of the major oil
    refiners' marketing and distribution practices in Arizona, California,
    Nevada, Oregon, and Washington (the ``Western States'' investigation).
    The agency initiated the Western States investigation out of concern
    that differences in gasoline prices in Los Angeles, San Francisco, and
    San Diego might be due partly to anticompetitive activities. The
    Commission's staff examined over 300 boxes of documents, conducted 100
    interviews, held over 30 investigational hearings, and analyzed a
    substantial amount of pricing data. The investigation uncovered no
    basis to allege an antitrust violation. Specifically, the investigation
    detected no evidence of a horizontal agreement on price or output or
    the adoption of any illegal vertical distribution practice at any level
    of supply. The investigation also found no evidence that any refiner
    had the unilateral ability to raise prices profitably in any market or
    reduce output at the wholesale level. Accordingly, the Commission
    closed the investigation in May 2001.22
    ---------------------------------------------------------------------------
        \22\ FTC Press Release, FTC Closes Western States Gasoline
    Investigation (May 7, 2001), available at http://www.ftc.gov/opa/2001/
    05/westerngas.htm. In part, this investigation focused on ``zone
    pricing'' and ``redlining.'' See Statement of Commissioners Sheila F.
    Anthony, Orson Swindle and Thomas B. Leary, available at http://
    www.ftc.gov/os/2001/05/wsgpiswindle.htm, and Statement of Commissioner
    Mozelle W. Thompson, available at http://www.ftc.gov/os/2001/05/
    wsgpithompson.htm, for a more detailed discussion of these practices
    and the Commission's findings. See also Cary A. Deck & Bart J. Wilson,
    Experimental Gasoline Markets, Federal Trade Commission, Bureau of
    Economics Working Paper (Aug. 2003), available at http://www.ftc.gov/
    be/workpapers/wp263.pdf, and David W. Meyer & Jeffrey H. Fischer, The
    Economics of Price Zones and Territorial Restrictions in Gasoline
    Marketing, Federal Trade Commission, Bureau of Economics Working Paper
    (Mar. 2004), available at http://www.ftc.gov/be/workpapers/wp271.pdf.
    ---------------------------------------------------------------------------
        In performing these and other inquiries, the Commission
    distinguishes between short-term and long-term effects. While a
    refinery outage on the West Coast could significantly affect prices,
    the FTC did not find that it would be profitable in the long run for a
    refiner to restrict its output to raise the level of prices in the
    market. For example, absent planned maintenance or unplanned outages,
    refineries on the West Coast (and in the rest of the country) generally
    run at close to or full capacity. If gasoline is in short supply in a
    locality due to refinery or pipeline outages, and there are no
    immediate alternatives, a market participant may find that it can
    profitably increase prices by reducing its refinery output--generally
    for a short time only until the outage is fixed or alternative supply
    becomes available. This transient power over price--which occurs
    infrequently and lasts only as long as the shortage--should not be
    confused with the sustained power over price that is the hallmark of
    market power in antitrust law.''
        In addition to the Unocal and the West Coast pricing
    investigations, the Commission in 2001 issued a report on its nine-
    month investigation into the causes of gasoline price spikes in local
    markets in the Midwest in the spring and early summer of
    2000.23 The Commission found that a variety of factors
    contributed in different degrees to the price spikes. Primary factors
    included refinery production problems (e.g., refinery breakdowns and
    unexpected difficulties in producing the new summer-grade RFG gasoline
    required for use in Chicago and Milwaukee), pipeline disruptions, and
    low inventories. Secondary factors included high crude oil prices that
    contributed to low inventory levels, the unavailability of substitutes
    for certain environmentally required gasoline formulations, increased
    demand for gasoline in the Midwest, and, in certain states, ad valorem
    taxes. Importantly, the industry responded quickly to the price spike.
    Within three or four weeks, an increased supply of product had been
    delivered to the Midwest areas suffering from the supply disruption. By
    mid-July 2000, prices had receded to pre-spike or even lower levels.
    ---------------------------------------------------------------------------
        \23\ Midwest Gasoline Price Investigation, Final Report of the
    Federal Trade Commission (Mar. 29, 2001), available at  http://
    www.ftc.gov/os/2001/03/mwgasrpt.htm; see also Remarks of Jeremy Bulow,
    Director, Bureau of Economics, The Midwest Gasoline Investigation,
    available at http://www.ftc.gov/speeches/other/midwestgas.htm.
    ---------------------------------------------------------------------------
        The Commission's merger investigations also are relevant to the
    detection of nonmerger antitrust violations. FTC merger investigations
    since the mid-1990s uniformly have been major undertakings that have
    reviewed all pertinent facets of the relevant petroleum markets. These
    investigations have involved the review of thousands of boxes of
    documents in discovery, examination of witnesses under oath, and
    exhaustive questioning of outside experts. During these investigations,
    Commission staff have not only analyzed traditional merger issues but
    have also looked for evidence of potential anticompetitive effects
    related to unilateral market power, collusion, and ongoing illegal
    conduct.
        The discussion above covers but a few of the gasoline pricing
    investigations to which the Commission has devoted substantial time and
    resources. To date, we have identified no instances of collusion among
    petroleum companies or of illegal unilateral firm conduct. Of course,
    that does not mean that anticompetitive acts cannot occur, which is why
    the agency continues to be vigilant in pursuing its enforcement
    mission.

    C. Recent Commission Research on Factors That Can Affect Prices of
            Refined Petroleum Products
        Prices of any commodity may fluctuate dramatically for reasons
    unrelated to antitrust violations. A sudden surge in demand or an
    unexpected problem in the supply chain can cause prices to spike
    quickly. A change in the price of a necessary input, such as crude oil,
    also can affect the price of the final good dramatically.
        Such price changes are disruptive to both consumers and businesses
    but are not by themselves evidence of anticompetitive activity. They
    can occur in some regional gasoline markets because of a unique
    combination of short-run supply and demand conditions. The amount of
    gasoline that can be supplied to a particular region may be inflexible
    in the short run because of various limitations on refining and
    transportation capabilities or product requirements unique to that
    region. The demand for gasoline is inelastic.24 Therefore,
    in the short run, changes in price do not heavily influence the amount
    of gasoline purchased by consumers. Under these conditions, when a
    sudden supply shortage jolts the market, perhaps due to a refinery fire
    or a pipeline rupture, the normal consequence of even a relatively
    small shortage of supply is a sharp increase in price until the supply
    of the product desired can be increased.
    ---------------------------------------------------------------------------
        \24\ Individual firms may have little or no market power even if
    industry demand is inelastic. It is a mistake to equate low demand
    elasticity with the ability of a firm to exercise market power.
    Elasticity is a measure of the percentage change in one variable (e.g.,
    quantity demanded) brought about by a one percent change in some other
    variable (e.g., price). See Walter Nicholson, Microeconomic Theory:
    Basic Principles and Extensions 187-209 (4th ed. 1989).
    ---------------------------------------------------------------------------
        1. Gasoline Monitoring and Investigation Initiative--The Commission
    actively monitors wholesale and retail prices of gasoline. Two years
    ago, the FTC launched an initiative to monitor gasoline prices to
    identify ``unusual'' movements in prices 25 and then examine
    whether any such movements might result from anticompetitive conduct
    that violates Section 5 of the FTC Act. FTC economists developed a
    statistical model for identifying such movements. The agency's
    economists scrutinize price movements in 20 wholesale and over 350
    retail markets across the country. A map of these markets is attached
    at Figure 3.
    ---------------------------------------------------------------------------
        \25\ An ``unusual'' price movement in a given area is a price that
    is significantly out of line with the historical relationship between
    the price of gasoline in that area and the gasoline prices prevailing
    in other areas.
    ---------------------------------------------------------------------------
        Our gasoline monitoring and investigation initiative focuses on the
    timely identification of unusual movements in gasoline prices (compared
    to historical trends) to determine if a law enforcement investigation
    is warranted. If the FTC staff detects unusual price movements in an
    area, it researches the possible causes, including, if appropriate,
    consulting with the state Attorneys General, state energy agencies, and
    the Department of Energy's (``DOE'') Energy Information Administration.
    The FTC staff also monitors DOE's gasoline price ``hotline''
    complaints. If the staff concludes that the unusual price movement
    likely results from a ``natural'' cause (i.e., a cause unrelated to
    anticompetitive conduct), it does not investigate further.26
    The Commission's experience from its past investigations and the
    current monitoring initiative indicates that unusual movements in
    gasoline prices typically have a natural cause. FTC staff further
    investigates unusual price movements that do not appear to be explained
    by ``natural'' causes to determine whether anticompetitive conduct may
    be a cause. Cooperation with state law enforcement officials is an
    important element of such investigations.
    ---------------------------------------------------------------------------
        \26\ Natural causes include movements in crude oil prices, supply
    outages (e.g., from refinery fires or pipeline disruptions), or changes
    in and/or transitions to new fuel requirements imposed by air quality
    standards.
    ---------------------------------------------------------------------------
        Regional price spikes for gasoline have occurred in various parts
    of the country, and many areas have experienced substantial price
    increases for gasoline in recent months. As noted above, the FTC is
    monitoring wholesale and retail gasoline prices in cities throughout
    the country and will continue to analyze these data to seek
    explanations for pricing anomalies. A look at some recent price spikes
    illustrates the kinds of factors, other than crude oil prices, that
    affect retail price levels.
    a. ARIZONA
        In August 2003, gasoline prices rose sharply in Arizona. The
    average price of a gallon of regular gasoline in Phoenix rose from
    $1.52 during the first week in August to a peak of $2.11 in late
    August. Several sources caused these price movements. Most gasoline
    sold in Phoenix comes from West Coast refineries. A pipeline from Texas
    also brings gasoline to the Phoenix area, but it usually operates at
    capacity. The marginal supply comes from the West Coast.27
    ---------------------------------------------------------------------------
        \27\ Marginal supply is the last product brought into a market and
    effectively sets the equilibrium price. It is also the increment of
    product that can adjust in the short run to market conditions and thus
    ameliorate price spikes.
    ---------------------------------------------------------------------------
        Product supplies on the West Coast were already becoming tight in
    early August, following a number of unplanned refinery interruptions in
    California and an unplanned shutdown at a refinery in Washington. This
    placed upward pressure on prices on the West Coast and in Arizona. On
    July 30, 2003, Kinder Morgan's El Paso-to-Phoenix pipeline ruptured
    between Tucson and Phoenix. On August 8, Kinder Morgan shut down the
    pipeline, after its efforts to repair the rupture failed. This
    disruption immediately reduced the volume of gasoline delivered to
    Phoenix by 30 percent, and most of Arizona immediately became much more
    dependent on shipments from California for its gasoline supplies.
        Retail prices in Phoenix increased during the week immediately
    following the August 8 pipeline shutdown (the week ending August 16) to
    levels higher than predicted by historical relationships.28
    As California refineries increased supply shipments to Arizona
    (displacing refining capacity that could otherwise serve California
    markets), retail prices in Los Angeles increased above the predicted
    level during the week ending August 23. On August 24, Kinder Morgan
    opened a temporary by-pass of the pipeline section affected by the
    rupture, and prices quickly fell. The average price of regular gasoline
    began to drop immediately. By the end of August, gasoline prices in the
    Phoenix area were falling. They continued to drop through September and
    October.29 (See Figure 4.)
    ---------------------------------------------------------------------------
        \28\ Price increases in Phoenix were not large enough to equate
    short-run supply and demand. Gasoline was effectively rationed by
    queuing--long lines of motorists--and many stations ran out of
    gasoline. See Phoenix Gas Crisis Worsens, MSNBC News (Aug. 21, 2003)
    (only 45 percent of retail stations had product to sell), available at
    http://www.msnbc.com/local/AZSTAR/A1061452904.asp?0cv=BB10; Phoenix Gas
    Stations Running Dry After Pipeline Shut Down, Associated Press (Aug.
    18, 2003), available at http://www.cnn.com/2003/US/Southwest/08/18/
    phoenix.gas.crunch.ap/.
        \29\ In examining this pricing anomaly, the FTC staff consulted
    with the Attorney General offices in Arizona and California.
    ---------------------------------------------------------------------------
        Marked price increases in the wake of a sudden, severe drop in
    supply are a normal market reaction. Because gasoline is so important
    to consumers, a large price increase may be required to reduce quantity
    demanded so that it is equal to available supply. Price increases in
    turn attract additional supplies, which should then cause prices to
    decline. This response occurred in the Kinder Morgan rupture.
    b. ATLANTA
        Another recent price anomaly picked up by the monitoring project
    occurred in Atlanta, Georgia, and surrounding counties. This anomaly is
    not the traditional price spike that attracts the public's attention.
    Instead, it took the form of a small, sustained increase. Atlanta and
    its surrounding counties have experienced gasoline formulation changes
    in the past few years that have differentiated it from the rest of the
    Southeast. On April 1, 2003, an interim low-sulfur standard of 90 parts
    per million (``ppm'') took effect. Soon thereafter, Georgia required
    the 45-county area surrounding Atlanta to introduce a new 30 ppm low-
    sulfur gasoline by September 16. These formulation changes increased
    the cost of producing gasoline. After the 90 ppm standard was
    implemented, gasoline prices in Atlanta increased.
        After the 90 ppm standard was instituted in April, and even more
    frequently after the 30 ppm standard was instituted in September, the
    Commission's monitoring project picked up small anomalies in Atlanta
    gasoline pricing. Atlanta and the surrounding area have experienced
    slightly higher prices relative to historical levels because of the
    greater costs of making low-sulfur gasoline. This increase is
    illustrated at Figure 5.
    c. MID-ATLANTIC AREA
        A third pricing anomaly occurred in September and October of last
    year. Gasoline prices were generally falling nationwide at that time.
    The price of reformulated gasoline in the New York, New Jersey,
    Connecticut, and Philadelphia areas, however, declined more slowly than
    the price of gasoline in the rest of the country. The FTC monitoring
    model showed the price of gasoline in this region was unusually high
    even though prices were decreasing elsewhere. (See Figure 6.)
        The FTC staff's examination of this anomaly, which included
    consultation with each affected state's Attorney General, ultimately
    concluded that the elevated price in this area stemmed from a number of
    factors. In late August 2003, the Northeast was hit particularly hard
    by an increase in demand that drew down gasoline stocks in all regions
    of the United States.30 The August 14 blackout further
    affected the Northeast, temporarily shutting down seven refineries.
    While the blackout appeared to have little immediate impact on U.S.
    retail gasoline prices, the reduction in supply from four refineries in
    Ontario, Canada, whose operations were hampered by the power outage,
    significantly affected the price of gasoline in Ontario. Typically, the
    Northeastern states receive significant gasoline imports from Canada.
    Throughout much of August, however, wholesale prices in Toronto
    exceeded wholesale prices in Buffalo by approximately 25 cents per
    gallon, a sign that Canada was shipping less product into the
    Northeast. FTC staff confirmed a sizeable drop in exports of gasoline
    from Canada to the Northeast in August 2003.31 By the end of
    September, rack prices in Toronto and Buffalo had returned to rough
    equality, and imports from Canada returned to their usual level.
    ---------------------------------------------------------------------------
        \30\ DOE, Inquiry into August 2003 Gasoline Price Spike, at 35-42
    (Nov. 2003).
        \31\ FTC staff compiled the import data from tariff and trade data
    from the U.S. Department of Commerce, the U.S. Department of the
    Treasury, and the U.S. International Trade Commission.
    ---------------------------------------------------------------------------
        On top of the low inventories, both the switch from summer to
    winter grade gasoline and the switch in New York and Connecticut from
    MTBE-blended 32 reformulated gasoline to ethanol RFG caused
    a disincentive to build inventories in August and September. While
    refineries in the Northeast increased production during this period,
    important additional supply to this area comes by pipeline from the
    Gulf and imports from abroad. Both of these sources of supply require
    significant response times, however. Given the shipping lags and the
    impending switches in formulation, there was limited time--as well as a
    disincentive--to ship additional summer specification RFG to the
    Northeast.
    ---------------------------------------------------------------------------
        \32\ ``MTBE'' is Methyl Tertiary-Butyl Ether.
    ---------------------------------------------------------------------------
    d. WESTERN STATES
        FTC staff identified a pricing anomaly involving the Western United
    States during February and March 2004. Figures 7 through 10 show the
    actual and predicted bounds of the price of retail gasoline in Las
    Vegas and Reno, Nevada, and Los Angeles and San Francisco, California.
    Figures 11 and 12 show the actual and predicted range of the wholesale
    price of gasoline in Los Angeles and San Francisco,
    respectively.33
    ---------------------------------------------------------------------------
        \33\ Information for the wholesale price of gasoline is provided
    because Nevada receives its gasoline by pipeline from both Los Angeles
    and San Francisco.
    ---------------------------------------------------------------------------
        As shown on the graphs, the wholesale (rack) price of gasoline in
    California increased beginning in mid-February. By the third week in
    February, the wholesale prices were outside the predicted bounds. The
    retail prices in Nevada and California followed a similar path, but the
    daily data showed a more lagged response. As part of the monitoring and
    investigation initiative, FTC staff discussed the anomalies with the
    California Energy Commission, DOE's Energy Information Administration,
    the California Attorney General's Office and the Nevada Attorney
    General's Office. The FTC also examined additional sources of data.
        FTC staff found that a number of factors caused the price spike.
    Unanticipated refinery outages took place at a time when there were
    also relatively low levels of inventory. Some outages resulted when
    maintenance lasted longer than expected, while one outage resulted from
    a power failure. January through March is the normal time for refinery
    maintenance, when firms are preparing for the summer gasoline season.
    California refineries operate at near capacity most of the year but
    perform maintenance during the winter, during the downturn in
    demand.34
    ---------------------------------------------------------------------------
        \34\ Testimony of Pat Perez, California Energy Commission, before
    the California Attorney General's Task Force on Gasoline Prices
    (Mar.11, 2004), available at http://www.energy.ca.gov/papers/2004-03-
    11_PAT_PEREZ.PDF.
    ---------------------------------------------------------------------------
        Examining the gasoline inventory and production levels in
    California, as well as the prices in California relative to the Gulf
    Coast, illuminates the relevant sequence of events. Figure 13 shows (a)
    weekly gasoline production at the California refineries as a percentage
    of the previous year's gasoline production, (b) gasoline and blending
    stock inventories as a percentage of the previous year's inventories,
    (c) the Los Angeles and Houston rack (price) differential as a
    percentage, and (d) the average Los Angeles to Houston rack (price)
    differential as a percentage.35
    ---------------------------------------------------------------------------
        \35\ Houston is a major refining area. The price comparison is
    between the current price difference between Los Angeles and Houston
    and the historical difference. When the price differential between Los
    Angeles and Houston increases above the historical difference, it is
    important to research the cause of the deviation.
    ---------------------------------------------------------------------------
        Figure 13 shows that in the first few weeks of January, gasoline
    production in California was 10 to 20 percent higher than in January
    2003, leading to higher inventories.36 As production dropped
    in late January because of scheduled maintenance, inventories were
    drawn down. During January the rack price of gasoline in Los Angeles
    was below the normal Houston-Los Angeles differential, indicating lower
    relative prices in Los Angeles than in Houston, due to this increased
    production. As inventories dropped in early February, the rack price in
    Los Angeles began to increase, relative to Houston. In mid-February,
    the Tesoro refinery in San Francisco had a power outage that shut the
    refinery for a week,37 and Valero announced that restarting
    a refinery that had been undergoing maintenance would take an extra
    week. There were additional refinery outages as well.38 The
    combined effect of the decreased production and lower-than-expected
    inventories was that the Los Angeles rack price rose substantially
    relative to Houston, and Los Angeles retail prices also rose beyond
    what would be expected at a time of dramatically increasing crude oil
    prices. As the refineries were brought back online, the relative
    wholesale price of gasoline in California fell, and retail prices moved
    more in line with prices nationwide (a relative decrease, compared to
    the rest of the country).
    ---------------------------------------------------------------------------
        \36\ It is not unusual for annual ``week to week'' comparisons to
    show such differences. Data on weekly refinery production and output
    are available from the California Energy Commission, Weekly Fuels Watch
    Report Database, available at http://www.energy.ca.gov/database/fore/
    index.html.
        \37\ Oil & Gas Journal (Mar.1, 2004).
        \38\ Testimony of Pat Perez, supra note 34; see also California
    Energy Commission, Questions & Answers: California Gasoline Price
    Increases, available at http://www.energy.ca.gov/gasoline/gasoline--q-
    and-a.html.
    ---------------------------------------------------------------------------
        Restarting a refinery is a lengthy process that can take a week or
    more, and the loss of output from a refinery outage can be sizeable.
    Refiners have contractual obligations to supply branded stations, and a
    refinery with a major outage may have to purchase gasoline from its
    competitors at the current price. During the incident discussed above,
    three of the California refineries that experienced difficulties in
    restarting were forced to make unplanned purchases totaling a million
    barrels of gasoline on the spot market.39
    ---------------------------------------------------------------------------
        \39\ California Energy Commission, supra note 38.
    ---------------------------------------------------------------------------
        2. Conferences and Staff Reports Identifying Factors Affecting the
    Price of Gasoline--Because of increased public concern about the level
    and volatility of gasoline prices, the Commission constantly studies
    factors that can affect refined petroleum product prices. The
    Commission held public conferences in 2001 and 2002 40 that
    made important contributions to our knowledge about the factors that
    affect gasoline prices. The Commission is preparing a report on the
    proceedings of these conferences and related work.
    ---------------------------------------------------------------------------
        \40\ FTC Press Release, FTC to Hold Second Public Conference on the
    U.S. Oil and Gasoline Industry in May 2002 (Dec. 21, 2001), available
    at http://www.ftc.gov/opa/2001/12/gasconf.htm.
    ---------------------------------------------------------------------------
        The Commission also is updating its 1982 and 1989 petroleum merger
    reports to focus on mergers and structural change in the oil industry
    since 1985. In March, Commission staff economists released a
    retrospective study of the effects of the Marathon-Ashland joint
    venture in Kentucky.41 This paper examines the price effects
    of the Marathon-Ashland joint venture by comparing the wholesale and
    retail prices of gasoline in a number of regions unaffected by the
    merger to prices of gasoline in Louisville, Kentucky. The transaction
    does not seem to have affected the relative price of gasoline in
    Louisville.
    ---------------------------------------------------------------------------
        \41\ Christopher T. Taylor & Daniel S. Hosken, The Economic Effects
    of the Marathon-Ashland Joint Venture: The Importance of Industry
    Supply Shocks and Vertical Market Structure, Federal Trade Commission,
    Bureau of Economics Working Paper (Mar. 2004), available at http://
    www.ftc.gov/be/workpapers/wp270.pdf.
    ---------------------------------------------------------------------------
                     III. FACTORS AFFECTING GASOLINE PRICES

        Through its merger and nonmerger enforcement activity, and through
    its conferences, studies, and advocacy work, the FTC has examined in
    detail the central factors that may affect the level and volatility of
    refined petroleum product prices. Below we review just a few of those
    factors.
        The most important factor affecting both the level and movement of
    gasoline prices in the United States is the price of crude
    oil.42 Changes in crude oil prices account for approximately
    85 percent of the variability of gasoline prices.43 When
    crude oil prices rise, gasoline prices rise. (See Figure 1.) Crude oil
    prices are determined by supply and demand conditions worldwide, most
    notably by production levels set by OPEC countries.44 Other
    factors that affect the supply of and demand for crude oil, such as the
    fast-growing demand for petroleum in China, also influence the price of
    gasoline in the United States.
    ---------------------------------------------------------------------------
        \42\ While the impact of crude oil prices on gasoline prices is
    widely recognized, it is often alleged that gasoline prices are
    ``sticky downward''--that is, gas prices go up like ``rockets'' and
    come down like ``feathers'' in response to changes in oil prices. For a
    review of the empirical literature testing this hypothesis, see John
    Gewecke, Issues in the ``Rockets and Feathers'' Gasoline Price
    Literature, submitted in conjunction with the Federal Trade Commission
    Conference, Factors That Affect the Price of Refined Petroleum Products
    II (May 8, 2002), available at http://www.ftc.gov/bc/gasconf/comments2/
    gewecke2.pdf. This paper indicates there are serious and sometimes
    fundamental flaws with the papers showing asymmetric response.
        \43\ See note 2, supra.
        \44\ OPEC members today account for 40 percent of world crude oil
    production and 80 percent of world crude oil reserves. As a substantive
    matter, competitor cartels that limit supply or fix prices are illegal
    under U.S. antitrust laws. However, the U.S. antitrust agencies must
    account for considerations beyond the substantive merits of a case
    before bringing such a lawsuit. See Federal Trade Commission, Prepared
    Statement, Competitive Problems in the Oil Industry, Before the
    Committee on the Judiciary, United States House of Representatives
    (Mar. 29, 2000).
        The share of world crude oil production accounted for by U.S.-based
    companies declined from 10.8 percent in 1990 to 8.5 percent in 2003;
    the share of these firms is similarly low for world crude oil reserves.
    Recent large mergers among major oil companies have had little impact
    on concentration in world crude oil production and reserves. For
    example, Exxon and Mobil, which merged in 1999, had worldwide shares of
    crude oil production in 1998 of 2.1 percent and 1.3 percent,
    respectively; in 2001, the combined firm's share was 3.4 percent. The
    BP/Amoco merger combined firms with world crude oil reserves of 0.7
    percent and 0.2 percent in 1997; the combined firm's world crude oil
    reserve share in 2001, which reflects the acquisition of ARCO in 2000
    and the divestiture of ARCO's Alaska North Slope crude oil to Phillips,
    was 0.8 percent.
    ---------------------------------------------------------------------------
        Inventories of both crude oil and refined products also have an
    important effect on retail gasoline prices. At our August 2001
    conference,45 a representative of the Energy Information
    Administration reported that ``OPEC [production] cuts and high crude
    prices affect gasoline prices directly through the feedstock cost but
    also indirectly by reducing gasoline inventories.'' 46
    Participants also commented that average inventories for refined
    products have declined over time,47 contributing to price
    spikes as additional supply is less available quickly to meet demand.
    Lower inventory costs decrease the average cost of producing gasoline,
    to the benefit of consumers.48
    ---------------------------------------------------------------------------
        \45\ Transcripts of the conference and papers submitted to the
    Federal Trade Commission Public Conference: Factors that Affect Prices
    of Refined Petroleum Products, are available at http://www.ftc.gov/bc/
    gasconf/index.htm. The dates of the conferences were August 2, 2001,
    and May 8 and May 9, 2002.
        \46\ John Cook (EIA), Aug. 2 tr. at 52.
        \47\ Thomas Greene (California Attorney General Office), Aug. 2.
    tr. at 11 (``[i]n the 1990's, reserves and inventories [in California]
    have declined roughly 20-plus percent''); Rothschild (Podesta/Mattoon),
    Aug. 2 tr. at 82 (consistently below an average of 5 days of gasoline
    inventory); Mark Cooper (Cons. Fed. of Am.), written statement at 21.
        \48\ In a recent study of the petroleum inventory system, the
    National Petroleum Council concluded that the trend toward lower
    product inventories was ``the result of improved operating efficiencies
    partially offset by operational requirements for an increased number of
    product formulations to comply with environmental regulations,'' noting
    also that ``[s]ince holding inventory is a cost, there is an underlying
    continuous pressure to eliminate that which is not needed to meet
    customer demand or cannot return a profit to the holder.'' National
    Petroleum Council, U.S. Petroleum Product Supply--Inventory Dynamics,
    at 11 (Dec. 1998). The National Petroleum Council study also concluded
    that ``[c]ompetition has resulted in the consumer realizing essentially
    all of the cost reductions achieved in the downstream petroleum
    industry.'' Id. at 22.
    ---------------------------------------------------------------------------
        Participants in the FTC conference also noted that refineries and
    the pipelines used to transport gasoline to the pump are typically
    highly utilized. The annual average domestic refinery atmospheric
    distillation capacity utilization rate reached record levels in 1997
    (95.2 percent) and 1998 (95.6 percent) after rising fairly steadily
    since the early 1980s.49 In more recent years, annual
    average distillation capacity utilization has eased somewhat, falling
    to 92.5 percent for 2003. However, refinery distillation capacity
    utilization for the four-week period ending June 18, 2004 (the most
    recent period for which data are available) was 95.7
    percent.50
    ---------------------------------------------------------------------------
        \49\ EIA, Annual Energy Review 2002, Table 5.9.
        \50\ EIA, Weekly Petroleum Status Report, June 23, 2004, Table 2.
    Annual capacity utilization for 2003 is based on average of reported
    monthly capacity utilization rates.
    ---------------------------------------------------------------------------
        Although it is efficient to run these capital-intensive facilities
    at high rates of capacity utilization, supply disruptions from
    unexpected refinery outages or pipeline failures may not be easily or
    immediately compensated for by other supply sources due to capacity
    limitations, resulting in substantial market price effects in some
    cases.
        Total refinery distillation capacity has been increasing in recent
    years, however. Total distillation capacity was 15.43 million barrels
    per day (``MMBD'') in 1995.51 As of June 2004, industry
    distillation capacity was 16.89 MMBD.52 While no new U.S.
    refineries were built during this period, the increase of over 1.4 MMBD
    of industry capacity at existing facilities represents a 9.5 percent
    increase since 1995. This is equivalent to adding more than 12 average-
    sized refineries to industry supply.53 Over time, there has
    been a noticeable shift toward running larger refineries.54
    While some refineries have closed since 1995, these mainly were small,
    older refineries with limited gasoline production
    capacity.55 Despite these closures, refining capacity in
    each PADD has increased since 1995.56
    ---------------------------------------------------------------------------
        \51\ EIA, Annual Energy Review 2002, Table 5.9.
        \52\ EIA, Weekly Petroleum Status Report, June 23, 2004, Table 2.
        \53\ The average size of a refinery in 2003 was 112.5 thousand
    barrels per day (``MBD''). The average size of a refinery in 1995 was
    88.2 MBD.
        \54\ See Figure 14, Size Distribution of Operating Refineries 1986
    and 2003.
        \55\ See Figure 15, Refinery Closures, 1995 to 2003, showing crude
    oil distillation capacity of closed refineries.
        \56\ See EIA, Petroleum Supply Annual 1996 (Table 36); EIA, Weekly
    Petroleum Status Report, Table 2, U.S. Petroleum Activity, January 2003
    to present.
    ---------------------------------------------------------------------------
        Pipeline capacity also is stretched in some regions of the country
    for at least parts of the year, although various pipeline expansion
    projects now underway may relieve some pressure. In addition to
    capacity increases and upgrades at the refinery level, there have been
    increases in product pipeline capacities in recent years.57
    ---------------------------------------------------------------------------
        \57\ For example, the FTC examined bulk product supply conditions
    affecting the Midwest in its investigation of price spikes affecting
    that area in the spring of 2000. Since that time product pipeline
    capacity from the Gulf to the Midwest has increased significantly. The
    Centennial pipeline, with a capacity of 210 MBD, opened in 2002. See
    Marathon Oil Company, Marathon Ashland Petroleum, LLC, available at
    http://www.marathon.com/Our_Business/Marathon_Ashland_Petroleum_LLC/.
        Explorer, another major pipeline bringing refined products from the
    Gulf to the Midwest, added 110 MBD of capacity in an expansion project
    that was completed in 2003. See Willbros Group Inc., Explorer Mainline
    Expansion, available at http://www.willbros.com/pdf/0277.pdf.
    ---------------------------------------------------------------------------
        Conference participants indicated that the interaction of
    environmental quality requirements and gasoline supplies may also
    affect gasoline prices. It is clear that environmental regulations have
    yielded substantial air quality benefits. Since 1970, emissions of the
    six principal air pollutants--nitrogen dioxide, ozone, sulfur dioxide,
    particulate matter, carbon monoxide, and lead--have been cut by 25
    percent, even as vehicle miles increased by 149 percent.58
    These regulations add to the cost of refining crude oil, and thus to
    gasoline prices. The Environmental Protection Agency estimates that the
    cost of producing a gallon of reformulated gasoline is 4 to 8 cents per
    gallon more than the cost of producing conventional
    gasoline.59 These costs may be even higher during supply
    disruptions, when significant marginal costs are incurred as firms
    attempt quickly to alter previously determined production runs.
    ---------------------------------------------------------------------------
        \58\ Environmental Protection Agency, Air Quality and Emissions
    Trends Report (2002).
        \59\ Robert Larson (EPA), May 8 tr. at 74.
    ---------------------------------------------------------------------------
        In addition, several participants at the FTC conferences reported
    that the proliferation of different environmentally mandated gasoline
    blends has reduced the ability of firms to ship gasoline from one
    region to another in response to supply disruptions.60
    (Figure 16 illustrates the different fuel blends required in the United
    States.61) The FTC staff's analysis of pricing anomalies,
    discussed earlier, provides support for these concerns. As part of its
    work to improve public understanding of the possible role of
    environmentally mandated fuels in contributing to price volatility and
    price spikes, Commission staff provided comments to the EPA in
    connection with that agency's preparation of the EPA Staff White Paper,
    a response to the President's National Energy Report (May 2001). The
    President's Report directed the EPA Administrator to ``study
    opportunities to maintain or improve the environmental benefits of
    state and local `boutique' fuels programs, while exploring ways to
    increase the flexibility of the fuels distribution infrastructure,
    improve fungibility, and provide added gasoline market liquidity.''
    62 The FTC staff commented that the EPA might find it
    beneficial to use a framework similar to the one the FTC uses to
    analyze mergers, to determine the competitive effects likely to result
    from changes in fuel mandates in particular relevant
    markets.63 The FTC staff offered suggestions to the EPA
    concerning how it might perform such an analysis.
    ---------------------------------------------------------------------------
        \60\ E.g., John Felmy (American Petroleum Institute), Aug. 2 tr. at
    26; Benjamin Cooper (``Ass'n of Oil Pipe Lines), Aug. 2 tr. at 102.
    According to one participant, ``[t]ight specifications for reformulated
    gasoline sold in [California] and limited pipeline interconnections . .
    . isolate the California gasoline market from gasoline markets in the
    rest of the country,'' thus contributing to higher prices in the state.
    Richard Gilbert (U. Cal. Berkeley), written statement at 3-4.
        \61\ A number of different fuel blend requirements have been
    introduced since passage of the Clean Air Act of 1990. For example,
    regulations governing fuel blends in California have been introduced
    and implemented in 1992, 1996 and 2003 (CARB I, II, and III.).
    Additionally, RFG Phase 1 (1995) and RFG Phase 2 (2000) affect various
    other states. Tier 2 low-sulfur gasoline regulations are being phased
    in now. Additionally, various regional specifications have been phased
    in over the last decade.
        \62\ Study of Unique Gasoline Fuel Blends (``Boutique Fuels''),
    Effects on Fuel Supply and Distribution and Potential Improvements, EPA
    Staff White Paper at 1-2.
        \63\ The FTC's experience shows that economically relevant gasoline
    markets are regional for refining and transportation, and local for
    gasoline distribution or retail sales. For example, a refinery that
    does not--or cannot in the short run--produce the type of gasoline
    currently in short supply in a certain region cannot be considered to
    be in that market for purposes of resolving short-run price spikes. FTC
    Staff Comments, Study of Unique Gasoline Fuel Blends (``Boutique
    Fuels''), Effects on Fuel Supply and Distribution and Potential
    Improvements, Dkt. No. A-2001-20, Before the Environmental Protection
    Agency at 4 (Jan. 30, 2002).
    ---------------------------------------------------------------------------
        Other federal and state laws and regulations were identified by
    conference participants as affecting gasoline prices. For example, a
    federal statute known as the Jones Act 64 increases the cost
    of transporting petroleum products by requiring that any product
    transported by vessel between U.S. ports be carried in domestically-
    built ships staffed by U.S. crews, which is more expensive than
    carriage by foreign-built, foreign-staffed ships. A recent government
    estimate of the total welfare cost of the Jones Act for all tanker
    shipping is $656 million per year, based on the assumption that a
    foreign ship has operating costs of only 59 percent of a Jones Act
    ship.65 The observed cost of transportation of refined
    petroleum products from the Gulf Coast to the West Coast, 10-25 cents
    per gallon,66 implies that the Jones Act imposes an
    additional cost of at least 4 cents per gallon when it is necessary to
    transport gasoline using Jones Act ships.
    ---------------------------------------------------------------------------
        \64\ Sec. 27 of the Merchant Marine Act of 1920, as amended, 46
    App. U.S.C.  883; see also 19 C.F.R. 4.80, 4.80b.
        \65\ The Economic Effects of Significant U.S. Import Restraints,
    U.S. International Trade Commission, Pub. No. 3519 (June 2002).
        \66\ California Energy Commission, Gulf Coast to California
    Pipeline Feasibility Study (Aug. 2003).
    ---------------------------------------------------------------------------
        A number of states have also adopted statutes or regulations that
    substantially influence gasoline prices. Several states have
    divorcement statutes that require the unbundling of retail sales from
    upstream refining operations. Careful economic analyses of divorcement
    statutes have concluded that such statutes can increase consumer
    prices.67 Other regulatory statutes that appear to have
    increased gasoline prices include bans on self-service sales
    68 and restrictions on below-cost sales,69 which
    appear simply to protect retailers from competition from more efficient
    competitors.70 The FTC staff has provided numerous comments
    on specific sales-below-cost legislation, noting that (a) economic
    studies, legal studies, and court decisions indicate that belowcost
    pricing that leads to monopoly or anticompetitive harm occurs
    infrequently; (b) belowcost sales of motor fuel that lead to monopoly
    or anticompetitive harm are especially unlikely; and (c) alleged
    instances of anticompetitive below-cost sales are best addressed by
    federal statutes against anticompetitive conduct to avoid chilling
    procompetitive and pro-consumer conduct.71
    ---------------------------------------------------------------------------
        \67\ See Michael G. Vita, Regulatory Restrictions on Vertical
    Integration and Control: The Competitive Impact of Gasoline Divorcement
    Policies, 18 J. Reg. Econ. 217 (2000) (finding that retail gasoline
    prices are two to three cents per gallon higher in states with
    divorcement laws); Asher A. Blass & Dennis W. Carlton, The Choice of
    Organizational Form in Gasoline Retailing and the Cost of Laws that
    Limit that Choice, 44 J. L. & Econ. 511 (2001) (estimating that
    divorcement increases costs of operation by about three to four cents
    per gallon) .
        \68\ See Vita, supra note 67 (noting that in 1993--at that time the
    last year for which data were available--the price of regular unleaded
    gasoline in those states that banned self-service was three cents per
    gallon higher than in states that allowed self-service); see also R.
    Johnson & C. Romeo, The Impact of Self-Service Bans in the Retail
    Gasoline Market, 82 Rev. Econ & Stat. 625 (2000) (finding the cost of
    self-service bans to be three to five cents per gallon).
        \69\ The Minnesota Department of Commerce recently ordered Kwik
    Trip, Inc., and Murphy Oil USA Inc. to Acease and desist'' from selling
    gasoline at too low a price. The allegation in both cases was that the
    respondent had Aengaged in the offer and sale of gasoline below the
    minimum allowable price.'' Minnesota Department of Commerce,
    Enforcement Actions May 2004, available at http://www.state.mn.us/mn/
    externalDocs/Commerce/Enforcement_Actions_May
    _2004_050704120541_EnfAct053104.htm; see also Mark Brunswick, Selling
    Gas For Too Little Can Be Costly; State Regulations Are Penalizing Some
    Retailers Who Don't Charge Enough For Fuel, Minneapolis Star-Tribune,
    at 1B (June 2, 2004).
        \70\ See, e.g., Star Fuels Mart, LLC v. Sam's East, Inc., 2004 U.S.
    App. LEXIS 5215, at *17 n.3 (10th Cir. Mar. 19, 2004) (despite no
    evidence of harm to competition under a Sherman Act standard, upholding
    temporary injunction granted under the Oklahoma Unfair Sales Act
    forbidding defendant from selling fuel below cost because ``[t]he
    purpose of the OUSA . . . is simply to prevent loss leader selling and
    to protect small businesses'').
        Hypermarkets are transforming gasoline retailing. Hypermarkets,
    which are high-volume retail outlets mostly owned by or leased from
    grocery stores, mass merchandise retailers, large convenience stores,
    or membership clubs, have substantial economies of scale that enable
    them to sell at low prices. They may pump up to one million gallons of
    fuel a month. Some hypermarkets can reduce their costs further by doing
    their own wholesaling, and some already buy their gasoline directly
    from refineries through long-term contracts. As of the fourth quarter
    of 2002, the national market share for hypermarkets was approximately
    six percent. See Energy Analysts International, Evolution of the High
    Volume Gasoline Retailer (Feb. 13, 2003).
        \71\ See Letter from Susan Creighton, Director, FTC Bureau of
    Competition, et al., to Michigan State Representative Gene DeRossett
    (June 17, 2004), available at http://www.ftc.gov/os/2004/06/
    040618staffcommentsmichiganpetrol.pdf; Letter from Susan Creighton,
    Director, FTC Bureau of Competition, et al., to Kansas State Sen. Les
    Donovan (Mar. 12, 2004), available at http://www.ftc.gov/be/
    v040009.pdf; Letter from Susan Creighton, Director, FTC Bureau of
    Competition, et al., to Demetrius Newton, Speaker Pro Tempore of the
    Alabama House of Representatives (Mar. 12, 2004), available at http://
    www.ftc.gov/be/v040005.htm; Letter from Susan Creighton, Director, FTC
    Bureau of Competition, et al., to Wisconsin State Rep. Shirley Krug
    (Oct. 15, 2003), available at http://www.ftc.gov/be/v030015.htm; Letter
    from Joseph J. Simons, Director, FTC Bureau of Competition, et al., to
    Eliot Spitzer, Attorney General of New York (July 24, 2003), available
    at http://www.ftc.gov/be/nymfmpa.pdf; Letter from Joseph J. Simons,
    Director, FTC Bureau of Competition, et al., to Roy Cooper, Attorney
    General of North Carolina (May 19, 2003), available at http://
    www.ftc.gov/os/2003/05/ncclattorneygeneralcooper.pdf; Competition and
    the Effects of Price Controls in Hawaii's Gasoline Market: Before the
    State of Hawaii, J. Hearing House Comm. On Energy and Environmental
    Protection et al. (Jan. 28, 2003) (testimony of Jerry Ellig, Deputy
    Director, FTC Office of Policy Planning), available at http://
    www.ftc.gov/be/v030005.htm; Letter from Joseph J. Simons, Director, FTC
    Bureau of Competition, et al., to Gov. George E. Pataki of New York
    (Aug. 8, 2002), available at http://www.ftc.gov/be/v020019.pdf; Letter
    from Joseph J. Simons, Director, FTC Bureau of Competition, and R. Ted
    Cruz to Hon. Robert F. McDonnell, Commonwealth of Virginia House of
    Delegates (Feb. 15, 2002), available at http://www.ftc.gov/be/
    V020011.htm.IV. ConclusionCompetition policy helps ensure that the
    petroleum industry is, and remains, competitive. The FTC has expended
    substantial effort and resources to enforce the antitrust laws and to
    scrutinize behavior in this industry. We will continue to do so in the
    future. Higher prices for petroleum products deeply affect the quality
    of life in the United States and strongly influence the Nation's
    economic performance. Understanding and publicizing developments in
    this sector, and attacking conduct that violates the antitrust laws,
    are competition policy priorities second to none for the Federal Trade
    Commission. I would be pleased to answer your questions.

        Mr. Hall. Mr. Kovacic, thank you. I will recognize myself
    for 5 minutes. Mr. Caruso, in your testimony, you state
    refiners today must make huge environmental investments to stay
    in business. Just generally, if you would, explain what these
    investments are and how they might affect an individual company
    or their board of directors to say, ``To heck with it, we are
    going to shut down,'' or ``How can we expand and stay in
    business?''
        Mr. Caruso. Well, I think there are at least two aspects to
    the investment. One, of course, as Mr. Holmstead pointed out,
    considers the number of changes in the specifications required
    for RFG as well as Tier 2 standards, so that the actual
    configuration within the refineries have had to be changed to
    meet these requirements. And then, of course, there are
    increasingly stringent requirements, oftentimes by State and
    local regulators, to make sure that the refinery emissions, et
    cetera, are up to the standard. So, there are two aspects of
    that.
        And the reason this is so important in the outlook for the
    refinery capacity in this country is that we had a large number
    of small refineries built in this country. The peak amount of
    capacity was in 1981 when we had about 350 refineries. We are
    down to 149 now. And many small refineries closed just because
    they weren't efficient and they were living on tax credits. But
    the other reason was that the requirements to invest to meet
    these new standards and requirements were just not possible for
    them to do and earn an appropriate rate of return, so many
    small refiners have closed and, indeed, the need to become
    larger has clearly been demonstrated in that the average
    capacity in this country per refinery has been creeping up
    while the total number of refineries has declined
    significantly.
        Mr. Hall. Do you find any reticence or reluctance on the
    part of those who operate the refineries, to initiate or pursue
    the need for more refineries? Are they satisfied to set where
    they are and with the lack of refineries have some effect on
    the price?
        Mr. Caruso. I think we have seen pretty clearly, certainly
    in the last 10 years, that a number of refiners have expanded
    capacity to take advantage of this growing marketplace, and so
    I think they are looking for business opportunities but,
    clearly, they have to have the incentives. The rate of return
    that we witnessed in the 1990's in particular was extremely
    low, and, therefore, you saw what I think was a rational
    economic decision to, in some cases, close, in other cases
    either get bigger or leave an area. And so, I think that also,
    led to incentives to some of the mergers that have taken place,
    to take advantage of economies of scale in various regions.
        So, I think the refiners are looking for opportunities, but
    clearly it has to be a better use of that money than to invest
    it in another aspect of this business or another business.
        Mr. Hall. Or do you see refineries whose management is not
    pleased with the treatment they get from the Federal Government
    in a lot of instances, not enough incentives? I think this
    committee held a hearing on that very thing several weeks ago,
    to give incentives to upgrade the facilities where they are,
    among other reasons, to people that are more amenable to less
    complaints than they would be if they went to a new area to
    open up. You have all those things, I guess, to look into.
        I think my time is about up. At this time, I recognize Mr.
    Green for 5 minutes.
        Mr. Green. Thank you, Mr. Chairman. Mr. Caruso--Mr.
    Waxman--I don't know if we still have those graphs, but did you
    see his EIA production estimates based on the energy bill? Did
    you feel like that was correct in the production estimates, if
    the Energy Bill actually passed?
        Mr. Caruso. Yes. I am glad you asked that question because
    I would like to clarify that. The EIA analyzed the Conference
    Energy Bill; those components of that Conference Energy Bill
    that were quantifiable and able to be used in our National
    Energy Modeling System. Unfortunately, there were a number of
    other provisions in the bill which were not quantifiable
    because the amount of money or the timing wasn't clear. There
    were some things such as the electric reliability provisions,
    the MTBE liability waiver, the R&D incentives for deep
    drilling, all were in the bill but were not quantifiable and
    not subjuct to EIA analysis.
        So, the answer is that what Congressman Waxman showed was
    accurate, that was directly from our study.
        Mr. Green. That was based on the Conference Committee. And
    the Conference Committee, granted, didn't have an expansion of
    domestic production. Obviously, the Conference Committee didn't
    have ANWAR and didn't have any of the other potential in the
    Continental United States. So, I looked at that, and I agree,
    our Energy Bill didn't go far enough, at least from where I
    sat.
        One month ago, the House approved our Refinery
    Revitalization Act to streamline permitting for mothballed
    refineries in economically depressed areas. Is that the best
    answer to increase refining capacity, or should we focus
    attention on expanding capacity at the existing refineries--I
    think I am following up a little bit on the chairman's report--
    as the market has been attempting to do in the last decade?
        Mr. Caruso. We have not made a specific study of H.R. 4517,
    but clearly I think our view is that we are going to need a
    substantial increase in refining capacity in this country over
    the next 10 to 20 years, and two of the most important things
    are providing the economic incentives, the return on
    investment, and the other one perhaps equally important is
    greater certainty. I think the most important thing for
    investors is to know what the rules and regulations are going
    to be, and I think that is the second aspect I would emphasize.
        Mr. Green. Thank you. Mr. Holmstead, what is the Agency
    doing on the Agency level to clarify the New Source Review
    regulations in order to provide that certainty to both affected
    communities that I represent, but also refinery managers in
    these investments, and what could the EPA do more for that
    certainty?
        Mr. Holmstead. We have taken two separate actions to really
    fundamentally clarify the New Source Review program to provide
    that certainty, and in a way that I think is particularly
    important for refineries. We have actually encouraged them to
    use something that we call ``plantwide applicability limits,''
    which basically says to the refinery, ``you have a cap on the
    overall pollution in your facility, and within that cap you are
    free to manage it and to grow and to do it however you want.''
    And in our experience, that is a very effective mechanism that
    we hope to be able to use, and there are people I think around
    the country beginning to take advantage of that.
        Another reform that we had hoped to provide has to do with
    the replacement of equipment at refineries. We finalized that
    rule, but that rule is now being stayed by the D.C. Circuit.
        Mr. Green. In my last 30 seconds, one refiner on the next
    panel will talk about complaints about novel interpretations of
    the New Source Review. Is the EPA trying to reach out to these
    manufacturers to help them through the process? Again, the
    certainty that Mr. Caruso talked about, if you have novel
    interpretations, it is really hard to quantify that, again, for
    the community, the investors or the managers.
        Mr. Holmstead. I think there have been legitimate
    complaints about the New Source Review program, and a lot of
    the program wasn't established in regulation. There have been
    guidance documents and different interpretations, and so for
    those issues for which there are literally thousands of pages
    of guidance documents, we have clarified them in regulation. We
    have been involved in addressing these issues for the last 2
    years. And there are still some other reforms that we plan to
    do, having to do with such things as key bottlenecking changes
    at refineries. So, there will be additional reforms coming out
    in the future.
        Mr. Green. Mr. Chairman, I appreciate that, and I hope
    maybe our subcommittee could look into that over a period of
    time, to see maybe if the chairman and I could understand it,
    maybe our petrochemical engineers could, too. Thank you.
        Mr. Hall. Thank you, Mr. Green, for almost staying within
    your 5 minutes. Mr. Whitfield.
        Mr. Whitfield. Thank you, Mr. Chairman.
        Dr. Mark Cooper is going to be on the second panel, and in
    his testimony he made some reference to how ``the domestic
    energy market has become concentrated in the hands of a few
    companies, particularly in certain geographical areas of the
    country.'' And he said that it ``has become so concentrated
    that competitive market forces are weak, and the long-term
    strategic decisions by the industry about production capacity
    interact with short-term management of stocks to create a tight
    supply situation that provides ample opportunity to push prices
    up quickly.'' How many of you agree with that comment?
        [Hands.]
        Mr. Kovacic.
        Mr. Kovacic. From what we have seen in looking at literally
    dozens of transactions in the sector over the past 20 years and
    in conducting investigations that focus on conduct as well as
    doing empirical research, there is no question but that there
    may be specific instances in which firms unilaterally can make
    choices that affect the supply balance.
        What we found generally is that those tend to be transient
    rather than long-standing, and as I read Mark's work, both his
    statement for today but also his earlier work, I think he
    dramatically underestimates the extent to which there are
    significant supply responses by individual market participants,
    market by market.
        So, I would say that there are some instances in which the
    phenomenon he describes might come to pass, but I think he
    exaggerates the duration of those effects, and I think Mark's
    work does not account for what we see as being a significant
    degree of competitive dynamism market by market.
        Mr. Whitfield. Mr. Wells, the GAO did a study on mergers
    and the impact. I have not read it, but you made some reference
    to it, and this is kind of tied in with what Dr. Cooper stated.
    What are your views?
        Mr. Wells. Clearly, the GAO study analysis in the various
    models that we built showed concentration numbers, measured
    exactly with the FTC and Department of Justice guidelines that
    were published in 1992, indicated that, I believe, in almost
    all 50 States there was an increase in market concentration,
    primarily statistically correlated to a reduction in the
    numbers of entries entering into the marketplace as well as the
    existing participants. The numbers would show that they went
    from moderately increased concentration to even highly
    concentrated. So, all the numbers statistically pointed to us
    that there was an increase that had an impact on prices.
        Mr. Whitfield. Significant impact on prices?
        Mr. Wells. Prices of cents per gallon, yes, sir.
        Mr. Whitfield. Cents per gallon.
        Mr. Wells. Yes, sir.
        Mr. Whitfield. How many cents per gallon?
        Mr. Wells. It ranged from 1 to 7 cents per gallon. Again,
    we modeled this for the different types of gasoline and they
    had different geographic consequences on prices depending on
    the marketplace.
        Mr. Whitfield. Now, the Federal Trade Commission disagreed
    with your methodology and findings, and what efforts did you
    all make to reconcile those differences, or did you make any
    efforts?
        Mr. Wells. Well, clearly this is the second exchange that I
    have had a chance to sit with my friend, Bill, next door to me,
    about the differences in methodology. We continue to believe an
    analytical sound methodology was used, and given the current
    state of economics, we welcome the opportunity to debate and
    discuss the merits of the methodologies that we used. I know
    there was some discussion about the major flaws in the GAO
    report. I don't want to take the time today, but we have
    answers to why we don't believe that there are flaws in the
    report. We have received requests from the FTC to consider
    holding a public conference. We welcome the opportunity to
    continue the debate and the dialog about methodology we used,
    but I think it is important for the committee and the members
    to understand that the FTC does their study and does their
    analysis a particular way, and they are looking at pre-merger
    approval, and they look at analysis involving each company's
    request for approval. The GAO study that was put together is a
    retrospect look where we go back in, long after the merger has
    taken place, and analyze a time period before the merger
    occurred and after the merger occurred. So, it is two different
    type of studies, and we look forward to and welcome the
    opportunity to work with the FTC, to understand the
    methodologies used, both what they use and what we use, but
    clearly our goal is to move the ball forward in terms of where
    do we go from here in the future in analyzing future requests
    for mergers.
        Mr. Whitfield. Mr. Holmstead, do you have any thoughts on
    this at all?
        Mr. Holmstead. No, I am not really qualified.
        Mr. Whitfield. From what he is saying, the reformulated gas
    adds 4 to 8 cents a gallon, and he is saying mergers go
    anywhere from 1 cent to 7 cents a gallon. What about you, Mr.
    Caruso, do you have any thoughts on this?
        Mr. Caruso. We haven't done any specific analysis on that.
        Mr. Whitfield. Do they have reformulated gas in Europe, or
    boutique fuels in Europe?
        Mr. Holmstead. They certainly don't have reformulated gas.
    I am really not very familiar with their gasoline regulation.
        Mr. Whitfield. What is the explanation of why fuel prices
    in Europe are $4 and $5, much more expensive than here. What is
    the reason?
        Mr. Holmstead. I believe it is primarily tax policy. I
    think there are very high taxes on----
        Mr. Whitfield. A lot more taxes there than here. Okay. Mr.
    Wells, there was some comment about your report, or did your
    report consider the effects on gasoline prices that State laws
    such as Minnesota's, which require a minimum markup on
    gasoline, may have? Did you all look at that at all?
        Mr. Wells. Could you repeat the question? The State of
    Minnesota?
        Mr. Whitfield. Yes. It is my understanding that in
    Minnesota they require a minimum markup on gasoline. Are you
    familiar with that, or not?
        Mr. Wells. The analysis we use would be the prices that
    were posted at the wholesale level by the refineries, offered
    for sale, that the suppliers and distributors at the retail
    level would have paid, so that would have included that markup,
    if it was included at the wholesale level.
        Mr. Whitfield. I will ask Mr. Caruso, do you consider that
    an appropriate analysis?
        Mr. Caruso. Again, we have not made a study of the GAO's
    work or the mergers themselves. We tend to defer to the FTC
    when it comes to anti-competitive analysis, or the Department
    of Justice for antitrust behavior.
        Mr. Whitfield. Okay. Mr. Chairman, I will yield back the
    balance of my time.
        Mr. Hall. I thank the gentleman. Mr. Dingell, the Chair
    recognizes you for 5 minutes.
        Mr. Dingell. Mr. Chairman, I thank you. This question is to
    Mr. Holmstead.
        Mr. Holmstead, on June 22 of this year, I sent
    Administrator Leavitt a letter requesting whether any of the
    200 or so refineries that have closed since 1980 are seeking
    permits from EPA or from the authorized States, that are
    necessary to reopen or to restart the refinery. This is, I
    think, a simple, straightforward request. EPA has failed to
    answer the letter. What is the answer to the question?
        Mr. Holmstead. I just became aware of your letter this
    morning. I don't know the answer, but I can promise you that we
    will get it to you----
        Mr. Dingell. When will I get an answer?
        Mr. Holmstead. I assume we can get it to you certainly
    within a week.
        Mr. Dingell. Are you, as you sit there, aware of any
    refineries that have been denied permits which would be
    necessary to reopen?
        Mr. Holmstead. I am not aware of any closed refinery that
    has come in seeking a permit like that.
        Mr. Dingell. Mr. Chairman, I thank you very much. Thank
    you, sir.
        Mr. Hall. Thank you, Mr. Dingell. The Chair recognizes Mr.
    Allen.
        Mr. Allen. Thank you, Mr. Chairman. Mr. Holmstead, I would
    like you to address a statement made by Mr. Cavaney from API.
    It is in his written testimony, and he says, ``For years,
    getting permission to build a new refinery or expand existing
    refineries in the United States has been an extremely
    difficult, inefficient, and inordinately time-consuming
    process.'' That is what he says.
        Let us start with new refineries. In September 2000, Carol
    Browner was here, and she was asked how many permit
    applications had received to build new refineries. She said
    that EPA might have received one application in 25 years.
        Mr. Holmstead, can you tell us how many permit applications
    to build new refineries that EPA has received since the year
    2000?
        Mr. Holmstead. As far as I know, there is one application
    for a new refinery. We are aware of one company that has come
    in seeking a permit for a new refinery. What is hard to know is
    how many other people have considered that and then decided to
    look elsewhere. That is the kind of information we just don't
    have.
        Mr. Allen. And that one is in Arizona?
        Mr. Holmstead. Yes.
        Mr. Allen. As far as you know, is the application of the
    Arizona project on track?
        Mr. Holmstead. I don't know. As you know, Mr. Allen, those
    permits are handled by the State, so I don't have any specific
    information about that.
        Mr. Allen. Let me just ask you about permit applications
    for refinery expansion. In the year 2000, Administrator Browner
    testified that EPA had had 12 permit applications for
    expansions in the last 2 years. Of those, seven had been issued
    and five were pending with the expectation they would be
    wrapped up in a timely manner. She further testified that most
    permits for refinery expansions were issued within 12 months,
    and about half were issued within 5 months.
        So, Mr. Holmstead, under the Bush Administration, is EPA
    granting refinery expansion permits in this same timely manner?
        Mr. Holmstead. Again, most of those permits are actually
    granted by States. They have their own programs that are
    approved by EPA. I have no reason to believe that it is
    anything different from that. I do know that--and I think you
    mentioned this before, Mr. Allen--it is typically easier to
    expand an existing site than it is to get a new greenfield
    refinery just because there tends to be a lot of other issues
    besides Federal permits. There is the ``Not in My Backyard''
    kinds of issues and a lot of opposition to a geenfield plant.
    So, I think typically it is easier to expand an existing
    refinery than it is to do a new one.
        Mr. Allen. Thank you. A couple more questions just to
    follow up on Mr. Dingell's question. Several of us wrote a
    letter to you on May 13. You remember you appeared before the
    committee before, and when asked about a mercury provision, you
    indicated that it was not possible to perform an analysis--it
    would have been scientifically indefensible to perform an
    analysis recommended by your Clean Air Working Group.
        Several of us, including Mr. Waxman, Ms. Schakowsky and I
    sent a letter to the EPA Administrator on May 13, and we asked
    a series of questions. We received a letter back, but it didn't
    answer the questions. And then to follow, another separate set
    of letters was sent within a few days after that. I sent a
    letter--I am sorry--April 29 was the first letter, May 13 was
    the second letter. It has been over 2 months and we haven't
    received any answer to the questions raised in the May 13
    answer. A non-responsive answer to the April 29 letter, no
    answer at all to the May 13 letter.
        To repeat Mr. Dingell's question, when can we expect an
    answer from EPA?
        Mr. Holmstead. Again, I am happy to answer any questions
    you may have today. On the substance as to where that letter
    exactly stands in our process, we get many, many letters, but I
    promise to go back and find out where that is, and we will get
    that to you as soon as we can.
        Mr. Allen. Well, can I ask you for a commitment today that
    you will contact us tomorrow and give us a deadline for when
    you can get that material to us?
        Mr. Holmstead. Yes. I can check where it is and we can call
    your office tomorrow and let you know when we can get that to
    you.
        Mr. Allen. I would appreciate that. Thank you. Thank you,
    Mr. Chairman.
        Mr. Hall. The gentleman's time has expired. Thank you for
    staying within the time.
        The Chair will recognize Mr. Sullivan and ask Mr. Sullivan
    if he will yield to the ranking member for one question?
        Mr. Sullivan. Yes, Mr. Chairman.
        Mr. Green. Thank you, Mr. Chairman. To follow up my
    colleague from Maine, about the only one new refinery since
    2000--and I know along the Houston ship channel where we have
    so many, there has been a great deal of effort to try and wring
    every gallon or every barrel you can out. Does EPA have access
    to the number of expansions of refineries around the country
    that would come in and ask for additional permitting, although
    I know it is done on the State level, but do you have access to
    that?
        Mr. Holmstead. We wouldn't necessarily have access to that,
    and I am sorry, it has been something that we have tried to
    remedy in our system. Even though it is a Federal program, it
    is implemented by the States, so we don't routinely track
    applications for State permts. The reason I know about the one
    refinery is it is a pretty big deal and not many happen, so we
    know about that one. But in terms of individual permits that
    are sought for expansions, we don't have that number.
        Mr. Green. Because we have increased capacity 7 percent
    even with a smaller number of refineries, so somehow we are
    wringing more gas out of a smaller number. Thank you.
        Mr. Hall. Mr. Sullivan.
        Mr. Sullivan. Thank you, Mr. Chairman. I have a question
    for Mr. Kovacic. In your testimony, you state ``Lower inventory
    costs decrease the average cost of producing gasoline, to the
    benefit of consumers.'' Is that universally recognized as true?
        Mr. Kovacic. I think it is, Congressman. There has been a
    significant development, I would say, over the past decade or
    so, in the economic and business school literature, that
    emphasizes just-in-time inventory systems. The suggestion is
    that rather than making major expenditures, capital and
    operational, to maintain stocks of goods, be it petroleum, be
    it clothing, be it manufacturing, if you can organize your
    system in a way that makes sure that what it is you need shows
    up at the time you need it, you can shrink your costs by
    reducing outlays for storage, and in this case, storage for
    gasoline. So, I would say the trend that we have seen across
    industries toward just-in-time techniques is a general
    affirmation of the principle that just-in-time systems and
    other mechanisms that reduce the cost of storing gasoline or
    other products tend to reduce costs.
        Mr. Sullivan. Does that mean it is in the best interest of
    consumers for refiners to have lower inventories then, would
    you say?
        Mr. Kovacic. I think your question correctly points out
    that there can be a tradeoff here--that is, the reduction in
    inventories can limit the ability of the system, as a whole, to
    respond to specific disruptions. That is a cost of using these
    just-in-time systems. Our impression is that on the whole,
    looking across different markets and experiences, it has tended
    to reduce the cost of supplying gasoline, but I do know that in
    the hearings we held on price factors in 2001 and 2002, this
    tension was identified as a matter of concern. From our
    perspective, it is an issue that warrants our further
    attention. We would say, on the whole, the answer is ``yes,''
    but as your question suggests, it is something that is worth
    continuing attention because the adoption of these systems is a
    comparatively recent phenomenon in the sector.
        Mr. Sullivan. Dr. Mark Cooper, who will testify on the next
    panel of witnesses, says that companies purposely do not hold
    inventories so that prices will increase. Do you agree?
        Mr. Kovacic. We don't. Again, it is so difficult to deal
    with the broadest generalizations and say ``always'' or
    ``never,'' but I don't think we have identified systematic
    evidence that suggests that this is a pervasive pattern of
    behavior. From Mark's research and his work, if he identifies
    that, of course we would look at that.
        In our Midwest gas study, which is perhaps the most
    detailed treatment of some possibilities for unilateral action
    to restrict output and raise prices, we did identify decisions
    by individual refiners to produce less rather than produce
    more. At the same time we found instances in which other
    refiners at the same time chose to produce more. So, while
    there might be individual episodes of that kind of behavior, we
    have not seen anything that suggests that it is a systematic
    pattern.
        Mr. Sullivan. Mr. Chairman, one more question, if I could.
    Based upon the investigations of the FTC, in today's market,
    does competition encourage or discourage high inventory levels,
    and why?
        Mr. Kovacic. I would say the tendency is probably to
    discourage the maintenance of high inventory levels. Again,
    this is a consequence of years of recent experience, the kind
    of teaching that executives receive in business schools when
    they hear about inventory management, the general popularity of
    the just-in-time techniques all have tended to push companies
    in the direction more recently of holding fewer inventories.
    Our provisional assessment at the moment is that it is every
    much as likely that it reduces cost rather than increases
    vulnerability. But I wouldn't suggest that larger question
    about the tension that may exist between cost reduction and
    possible instances of vulnerability arising from restricted
    flexibility to respond to specific disruptions is not a genuine
    issue. That remains a continuing matter of concern for us.
        Mr. Sullivan. Thank you very much, I have no further
    questions.
        Mr. Hall. The gentleman's time has expired. Mr. Issa would
    be recognized next. He was called to another committee. And,
    Mr. Holmstead, I am aware that you have a meeting at 1:15. We
    will try to release you as soon as we can.
        Mr. Issa wanted these two questions asked. Which refiners
    have received waivers under the hardship provision of the Tier
    2 sulfur program, and do any serve the New York Metropolitan
    Area?
        Mr. Holmstead. I do have a list of the refineries that have
    received those hardship waivers. I have it here in front of me.
    I am not aware that any of them serve the New York City area.
    We have got two small refineries in Texas, two in Kansas, one
    in Wyoming, and one in Pennsylvania, and another one in
    Virginia. So, I would be happy to provide this for the record.
        Mr. Hall. Would you mind submitting the list for us to give
    the Reporter?
        Mr. Holmstead. I will do that.
        Mr. Hall. And he said, what is the timeframe on a decision
    regarding New York's oxygenate waiver?
        Mr. Holmstead. We are going through that information right
    now, and the Administrator has said publicly that we will do
    that as quickly as we can. We don't have a specific date at
    this point.
        Mr. Hall. I will waive my further questions. Are there
    other questions of Mr. Holmstead?
        Mr. Allen. Mr. Chairman, I would like to ask one additional
    question.
        Mr. Hall. We will recognize you for one question.
        Mr. Allen. Mr. Green was talking about expansion of
    existing refineries and New Source Review requirements.
    Department of Justice recently file a lawsuit, working with
    EPA, against a rural electric co-op. Would it be your opinion
    that New Source Review has been a discouragement to expansion
    of existing refineries?
        Mr. Holmstead. I would say it is a fair criticism, that a
    lot of the uncertainty about how New Source Review works at
    existing plants has been a significant issue. We have tried to
    clarify that. Our rules are fairly clear, though, that unless a
    company takes what we call a ``plantwide applicability limit,''
    then they would have to go through New Source Review if they
    are expanding the plant in a way that would significantly
    increase emissions. So, what we are trying to do is make sure
    that we implement the law, but do it in a way that really does
    provide certainty. In that way, so a refinery, or any business
    owner, will know exactly what the rules are for them.
        Mr. Hall. We're going to let Mr. Allen ask you one more
    question.
        Mr. Allen. Thank you, Mr. Chairman, I will be quick. Going
    back to the topic we were discussing before, the letters I
    referred to dealt with EPA's refusal to perform part of the
    analysis that we think is required under the Clean Air Act.
        Your mercury proposal under Section 112 would require only
    a roughly 29 percent reduction in mercury emissions by 2008,
    and this is based only on the use of technologies aimed at
    other pollutants, not mercury.
        We have heard repeatedly in this committee and elsewhere
    that mercury-specific control technology such as activated
    carbon injection can, for example, that are in use in other
    industries, have been demonstrated on power plants, are being
    offered by vendors now, and, in fact, are under contract for
    installation now. So, two quick questions. Have you received
    any advice, written or oral, from the Office of General
    Counsel, on whether your refusal to analyze the use of
    activated carbon technology, or other technology, will harm
    EPA's ability to succeed in defending its mercury proposal, if
    it is finalized? And if you have received any such advice, can
    you tell us what the opinion of the Office of General Counsel
    attorneys has been?
        Mr. Holmstead. As you can imagine, I am not at liberty to
    talk about legal advice that I have received from our General
    Counsel's office. What I can say is we have spent many, many
    hours meeting with vendors of technology, meeting with our
    experts, and meeting with experts at DOE. In all of our
    proposals, we have taken into account exactly where that
    technology stands.
        You are correct in pointing out that ACI technology has
    been installed on some other types of plants, but they are
    plants that our experts tell us are very different from power
    plants. The kinds of demonstration projects that have been done
    are a few days at a full-scale plant, and what all of our
    experts tell us is that there are many technical hurdles still
    to be overcome.
        We are optimistic that that technology will be available,
    as well as perhaps other technologies. In terms of something
    that could be installed on a number of power plants in the 2008
    timeframe, however, we have not seen anything to suggest that
    that is possible.
        Mr. Allen. I was under the impression that ACI was in place
    in a Southern Company plant.
        Mr. Holmstead. There is an ongoing study at one Southern
    Company plant. My understanding is that has been on now for
    almost a year, but we have not seen the data from that study
    yet. I have heard anecdotal evidence that they have had some
    problems with it and they are still trying to evaluate the
    long-term prospects for that. But that is the only one that I
    am aware of, and we have not yet seen data from that study.
        Mr. Allen. If your position is you can't give us the
    opinion, you can tell us whether or not you have received
    advice from the Office of General Counsel.
        Mr. Holmstead. I can tell you that we have had extensive
    discussions with the Office of General Counsel, and there is
    nothing that they have told me to suggest that the way we have
    looked at this technology in any way would affect our opinion
    of how we would move forward with this rule.
        Mr. Allen. Thank you, Mr. Chairman.
        Mr. Hall. Thank you. Thank you, you have been a great
    panel. Thank you. We will dismiss this panel. We will have the
    second panel. Thank you very much, and those that back you up.
        Mr. Edwards, we will recognize you, Senior Vice President,
    Supply, Trading and Wholesale Marketing, Valero Energy
    Corporation. Recognize you for 5 minutes, sir.

       STATEMENTS OF GENE EDWARDS, SENIOR VICE PRESIDENT, SUPPLY,
      TRADING AND WHOLESALE MARKETING, VALERO ENERGY CORPORATION;
       ARJUN NARAYAMA MURTI, MANAGING DIRECTOR, GOLDMAN, SACHS &
    COMPANY; MARK COOPER, DIRECTOR OF RESEARCH, CONSUMER FEDERATION
     OF AMERICA; BOB SLAUGHTER, PRESIDENT, NATIONAL PETROCHEMICAL
      AND REFINERS ASSOCIATION; A. BLAKEMAN EARLY, ENVIRONMENTAL
    CONSULTANT, AMERICAN LUNG ASSOCIATION; RED CAVANEY, PRESIDENT,
        AMERICAN PETROLEUM INSTITUTE; ERIC SCHAEFFER, DIRECTOR,
       ENVIRONMENTAL INTEGRITY PROJECT; AND BILL DOUGLASS, CEO,
                         DOUGLASS DISTRIBUTING

        Mr. Edwards. Mr. Chairman, members of the subcommittee,
    thank you for this opportunity to testify regarding the issue
    of refining capacity and appropriate U.S. policy response.
        Valero is a Fortune 500 independent petroleum refining and
    marketing company based in San Antonio, with over 20,000
    employees. We have 14 North American refineries that process
    nearly 2.4 million barrels a day of crude in the production of
    premium, clean-burning fuels such as reformulated gasoline,
    CARB Phase II gasoline, and low-sulfur diesel.
        Mr. Chairman, today Valero's refineries run above 95
    percent utilization. Valero is doing everything we can do to
    meet consumers' growing demand for transportation fuel.
    However, such a high utilization rate leaves no reserve
    capacity for demand peaks or when refineries shut down for
    maintenance or stop production because of unscheduled outages.
        Increasing supply is a top priority for Valero, and
    suggestions that merger activity within the refining sector
    hinder refinery expansion has not been the Valero experience.
    As a ``pure play'' refinery, Valero is in a good position to
    evaluate trends in the sector, our model stresses the expansion
    of our refining base, and seeks out the most economic crude in
    the marketplace.
        Valero has experienced rapid growth since 1997, mostly by
    acquiring distressed refining assets and making substantial
    investments to enhance their capacity and improve environmental
    performance. There is no doubt that without Valero stepping in
    and buying some of these facilities, some would have shut down.
        Our Texas City refinery is a good example of what we have
    done. Since acquiring the Texas City refinery in 1997, the
    company has increased the plant's total refining capacity from
    165,000 barrels a day to 245,000 barrels a day, investing more
    than $750 million in the facility. In total since 1997, Valero
    has added more than 250,000 barrels a day of refining capacity
    through expansion projects throughout our system. At the same
    time, we have reduced emissions and produced cleaner burning
    fuels.
        While our economies of scale have enabled us to increase
    supply, the Government sometimes creates an atmosphere of
    uncertainty that undermines such a course. We agree with the
    President's energy report that the Government needs to take
    steps to ensure America has adequate refining capacity. The
    report calls for more regulatory certainty to refinery owners,
    and streamline the permitting process, where possible, to
    ensure that regulatory overlap is limited.
        Unfortunately, what is too often overlooked is the fact
    that most environmental regulations today reduce supply, and to
    stay in business refineries must direct more of their capital
    to comply with environmental regulations, leaving less for
    expansion projects. For example, at Valero, from 2004 to 2005,
    we will spend $1.8 billion per year, of which $1.5 billion per
    year is related to turnaround, reliability, regulatory, and
    environmental projects, which only leaves about $300 million
    per year for strategic projects.
        Tier 2 investments alone will cost us $1.7 billion over the
    2002 through 2008 time period. And even with the good margins
    we are seeing today, this is consuming most of the cashflow
    from operations.
        How do we fix the problems with refining? First, adopt
    energy legislation. The imbalance between refining capacity and
    demand did not emerge overnight, and won't be resolved quickly.
    Domestic refining industry finds itself in the same position as
    the domestic oil and gas producers of 20 years ago. Without
    proper attention to the role of the domestic refiner and
    shaping energy policy, you will see the Nation's dependence on
    imported petroleum products increase.
        The current Administration and Congress are off on the
    right foot. The Conference Committee has concluded
    comprehensive energy legislation and the House has adopted the
    report. We only await Senate action on H.R. 6. H.R. 6 contains
    a carefully balanced fuel provision. While the removal of the 2
    percent oxygen standard allows for more rational decisionmaking
    in the fuels market, the inclusion of a narrow safe harbor for
    MTBE liability provides much needed certainty to an industrial
    sector seeking to make capital investments in refinery
    expansions. By contrast, fuel additive liability suits quash
    innovation, depress capital, and deter new market entrants as
    the Council of Economic Advisors has reported.
        Beyond passage of the energy bill, Valero also recommends
    the following policy action. Regulation should be assessed
    based on the cumulative impact. Desulfurization of diesel is a
    good example. Tier 2 diesel reductions are followed in rapid
    succession by off-road requirements, marine and rail fuel
    requirements. The cumulative impact is a challenging for
    supply.
        Regulations should be reviewed based on the potential
    energy impact. Rules should not be changed in the middle of the
    game. The best example here is the 1999 error in interpretation
    of the New Source Review. The recently concluded EPA
    clarification rules should be implemented, and the EPA should
    develop an NSR rule to facilitate refinery debottlenecking as
    soon as possible.
        Last, given the past history of low return on investment,
    the Government should consider giving the refineries' favorable
    tax treatment for investments made to comply with environmental
    standards. As EAI data shows, refineries' return on investment
    from 1980 to 2002 generally range from zero to 10 percent and
    averaged about 5 percent. Congress should consider, or could
    consider, some combination of tax credits for environmental
    compliance or an enhanced depreciation for such investment.
    This is needed to counterbalance the fact that foreign
    refineries do not have to invest in environmental regulation to
    the degree that the U.S. does.
        Thank you much for this opportunity to testify, and I look
    forward to your questions.
        [The prepared statement of Gene Edwards follows:]
     Prepared Statement of Gene Edwards, Senior Vice President of Supply,
           Trading and Wholesale Marketing, Valero Energy Corporation
        Chairman Hall, Congressman Boucher, and Members of the
    Subcommittee, thank you for this opportunity to testify regarding the
    issue of refining capacity and appropriate U.S. policy response. My
    name is Gene Edwards, and I am Senior Vice President of Supply, Trading
    and Wholesale Marketing at Valero Energy Corporation.
        Valero is a Fortune 500 company based in San Antonio, with over
    20,000 employees that has experienced significant growth since 1997.
    One of the top U.S. refining companies, Valero has an extensive
    refining system with a throughput capacity of more than 2.4 million
    barrels per day. The company's geographically diverse refining network
    stretches from Canada to the U.S. Gulf Coast and West Coast to the
    Caribbean. Valero is recognized throughout the industry as a leader in
    the production of premium, clean-burning fuels such as reformulated
    gasoline, CARB Phase II gasoline, low-sulfur diesel and oxygenates. A
    marketing leader, Valero has approximately 4,500 retail sites branded
    as Valero, Diamond Shamrock, Ultramar, Beacon and Total. The company
    markets on a retail and wholesale basis through a bulk and rack
    marketing network in 40 U.S. states, Canada, Latin America and the
    Caribbean region.
        Valero is proud of its record of environmental achievement, which
    goes beyond its commitment to produce cleaner-burning fuels and
    additives. Investing millions of dollars in pollution prevention and
    waste minimization, Valero was the first petroleum refiner ever to
    receive the prestigious Texas Governor's Award for Environmental
    Excellence and was recognized during the Clean Air Celebration for its
    ``outstanding environmental stewardship and leadership.''

                     CURRENT STATE OF THE REFINING INDUSTRY

        The United States has long recognized the importance of domestic
    refining to its economy. Many people in various states across the
    country have found high-paying jobs in the refining sector, and the
    energy sector plays a vital role in the gross domestic product of the
    U.S.
        One factor determining the current supply/demand balance is the
    lack of new U.S. refinery capacity relative to demand. According to the
    Bush Administration's National Energy Policy (NEP), released in May
    2001,
              During the last ten years, overall refining capacity grew by
            about 1 to 2 percent a year as a result of expansion in the
            capacity of existing, larger refineries. Although there was
            significant, sustained improvement in margins during 2000,
            those gains arose out of a very tight supply situation and high
            volatile prices. Industry consolidation has been a key response
            to this poor profitability. (May 17, 2001 at 7-13)
        Today refineries run at about 95 percent utilization, as compared
    to other industries' utilization rates of around 82 percent. Such a
    high rate leaves little reserve capacity that can be used when demand
    peaks or another source of supply shuts down. Thus, when refineries
    close for maintenance or stop production because of accidents, supplies
    tighten, with predictable price implications. This is particularly true
    in states like California, where the supply of gasoline is often
    extremely tight. As a spokesman for the Western States Petroleum
    Association put it, ``Refineries need to produce at nearly full
    capacity to match the demand of a large state that puts an emphasis on
    gasoline and other petroleum products.'' (Desert Sun, April 4, 2004)
        Some have suggested that a logical way to address the supply issue
    is to build more or expand existing refineries. But, companies can no
    longer build new refineries due to the great expense of permitting and
    the near-impossibility of finding a building site. No new refinery has
    been built in the United States since 1976. In California, the state
    hit hardest by high gasoline prices, no new refinery has been built
    since 1969. (Houston Chronicle, March 27, 2004)

                             THE VALERO EXPERIENCE

        Mr. Chairman, some have suggested that merger activity within the
    refining sector complicates the picture for expanding refining
    capacity. This has definitely not been the Valero experience. As a
    ``pure play'' refiner, Valero is in a good position to evaluate trends
    in the sector; our model stresses the expansion of our refining base,
    and seeks out the most economical crude in the marketplace. Being an
    independent refiner, we do not engage in oil and gas exploration and
    development, and while marketing of gasoline is important to Valero, it
    only represents about 10 percent of the Corporation's assets.
        Valero has experienced rapid growth since 1997, mostly by acquiring
    at-times undervalued refining assets and making investments in those
    refineries to enhance their capacity and improve environmental
    performance. Our Texas City refinery is a good example. Since acquiring
    the Valero Texas City refinery in 1997, the company has added 73 jobs
    at the refinery, which today employs 477 individuals. Valero has also
    increased the plant's total refining capacity from 165,000 barrels per
    day (BPD) to 243,000 BPD, investing more than $750 million in the
    facility. The refinery has also gained recognition as one of the
    nation's safest work sites after being one of the first nine U.S.
    refineries to be accepted into the Occupational Safety and Health
    Association's (OSHA) Voluntary Protection Program as a Star Site.
        Similarly, when Valero recently announced the acquisition of the
    former Orion facility outside of New Orleans, Louisiana, we identified
    approximately $25 million in expansion and upgrade opportunities that
    will enable the refinery to process additional heavy feedstocks,
    increase throughput capacity, upgrade its product yields and improve
    on-stream reliability. Our experience with other facilities has been
    similar: acquisitions have allowed realization of economies of scale,
    resulting in increased capacity.

             THE GOVERNMENT'S ROLE IN ADDRESSING CAPACITY CONCERNS

        Clearly, as a general matter, capacity utilization in the refining
    sector is quite high. Valero has been able to make capacity expansions
    and upgrade at various facilities. However, the government can and does
    sometimes create an atmosphere of uncertainty that undermines the
    realization of the goal of rationalizing refining capacity. Responding
    to this problem, the National Energy Policy Development Group (NEPD)
    recommended that the government ``take steps to ensure America has
    adequate refining capacity to meet the needs of consumers.'' This would
    include providing ``more regulatory certainty to refinery owners and
    streamline the permitting process where possible to ensure that
    regulatory overlap is limited.'' (NEPD at 10)
        Unfortunately, the one thing that all of the new environmental
    regulations have in common is that they reduce supply. And, to make
    matters worse, refiners must direct much of their capital investments
    to meet environmental regulations so there is less capital available
    for much-needed expansion projects. In fact, increasingly stringent
    environmental regulations, often adopted in piecemeal fashion, have
    created operational constraints and have sharply curtailed the
    flexibility of refiners to expand. Over the course of the last decade,
    the National Petroleum Council estimated that total investments to
    comply with the Clean Air Act Amendments in the refining sector
    exceeded the total book value of the refineries brought into compliance
    by $6 billion dollars. Things are even worse today. Refiners face near
    simultaneous implementation of reductions in gasoline sulfur and air
    toxic constituents, changes to diesel fuel to reduce sulfur to ultra-
    low levels, and, perhaps, limitations on the use of clean-fuel
    additives like MTBE. At the same time, the U.S. Environmental
    Protection Agency has made it increasingly difficult for refiners to
    expand capacity based upon novel and restrictive interpretations of the
    New Source Review (NSR) program.
        The Tier II diesel standards may prove particularly challenging.
    The program is being implemented in a way that is going to cause some
    logistical issues and high price volatility. On-road diesel sulfur
    specifications go to 15 ppm by June 2006. Off-road diesel sulfur
    specifications go from 2000 ppm to 500 ppm by mid-2007, and to 15 ppm
    in 2010. Home heating oil remains unchanged at 2000 ppm. Railroads and
    Marine fuels will go to 15 ppm in 2012. Rather than create all the
    grade segregations, the EPA should have had an overall distillate pool
    sulfur that ramps down over time. The current program will result in a
    balkanized diesel fuel market that mirrors some of the difficulties
    discussed in the context of so-called boutique gasolines.
        The conditions that have caused our current stretched capacity in
    refining are not likely to resolve themselves in the near future
    without careful planning and a balanced energy policy that takes
    refining issues into account. During the summer driving season,
    refiners struggle to make up inventory deficits created by the need to
    produce more home heating oil this past winter. Also, unusually high
    natural gas prices last winter directed natural gas into direct usage
    and away from feedstock usage. As a result, less MTBE and alkylate were
    made, thus further depriving the summer driving season of some of its
    usual cushion in gasoline inventories. The tight market for MTBE is
    already fueling predictions of another summer of high gasoline prices.
        And, of course, as state actions and market forces result in MTBE
    phase-outs, further stress is placed on supply. DOE's Office of Policy
    and the Oak Ridge National Laboratory specifically found that an MTBE
    ban is equivalent to a loss of 300,000 barrels per day of premium
    blendstock.
        Federal energy legislation contains an ethanol mandate, part of a
    carefully balanced fuels package. However, the existence of this
    mandate is not a mechanism likely to address supply concerns. An
    ethanol mandate actually will make it harder for refiners to provide
    cleaner fuels to consumers at acceptable prices. Due to ethanol's high
    blending vapor pressure, pentanes are backed out of the gasoline pool,
    further decreasing supply. An ethanol mandate will hinder refiners'
    ability to optimize the quality and volume of cleaner-burning gasoline.
    This will increase refining costs, and negatively impact both gasoline
    supplies and price. According to the California Energy Commission, the
    costs of substituting ethanol-blended gasoline in that state could
    increase refining costs by up to 7 cents per gallon. Based on our
    review at the Valero Benicia Refinery, an MTBE ban, coupled with
    ethanol blending reduces production volume by 8%.

       HOW DO WE FIX THE PROBLEM WITH REFINING? ADOPT ENERGY LEGISLATION.

        Suffice it to say, the imbalance between refining capacity, supply
    and demand did not emerge overnight, and it won't be solved overnight.
    The domestic refining industry finds itself in the same position as the
    domestic oil and gas producers of twenty years ago. Without proper
    attention to the role of the domestic refiner in shaping energy policy,
    you will see the nation's dependence on imported petroleum products
    increase. The current Administration and the Congress are off on the
    right foot: a Conference Committee has concluded comprehensive energy
    legislation and the House has adopted the report. We await only final
    Senate action on H.R. 6.
        H.R. 6 contains a carefully balanced fuels provision. While the
    removal of the two-percent oxygen standard allows for more rational
    decision-making in the fuels market, the inclusion of a ``safe harbor''
    for MTBE liability provides much needed certainty to an industrial
    sector seeking to make capital investments in refinery expansions.
    There can be no doubt that taking punitive action against refiners for
    meeting a government standard through use of a government-approved
    product is not only unfair, but makes the capacity situation even
    worse. A refiner's ability to address supply concerns is directly
    related to the refiner's ability to utilize capital, develop new fuels,
    and help maintain a competitive marketplace. By contrast, fuel-additive
    liability suits quash innovation, depress capital, and deter new market
    entrants.
        Not only is the tort system extraordinarily costly, but without
    some stability in liability risk, powerful disincentives have been
    created to continued manufacturing of additives. According the Council
    of Economic Advisors (CEA), ``At higher levels of expected liability
    costs, . . . firms will choose to forgo innovation or to withhold a
    product from market, resulting in a net negative effect of expected
    liability costs on innovation.'' (April 2002 report)
        There can be little doubt that as our economy expands and our
    population grows, the need for innovation in fuels will increase as
    well. Under such circumstance, the adoption of the narrow liability
    protections in H.R. 6 becomes a critical piece of the puzzle in
    addressing refinery issues. Distinguished University of Texas Business
    and Engineering Professor Margaret Maxey wrote, ``Litigation is out of
    control, and the situation will deteriorate further if Congress fails
    to give makers of the fuel additive MTBE liability protection in
    lawsuits involving leaking fuel tanks. The priority should be to make
    reforms that put a cap on present and future costs, not only to
    safeguard the development of clean-fuel additives, but to encourage
    innovation generally. Without some restraints in today's climate of
    infectious litigation, powerful disincentives will inhibit the
    continued manufacture of products where technology itself is at risk.''
    (Houston Chronicle, Nov. 18, 2003).
        Beyond currently pending energy legislation, there are several
    additional concrete steps that could be taken to address refining
    issues:

     Address the cumulative impact of regulations. There is a tendency to
            view each regulation imposed upon refining in a vacuum,
            particularly when measuring primary and secondary economic
            impacts. However, as we observed above, the plain fact is that
            the refining sector has numerous, overlapping regulations. Most
            recently, compliance deadlines have come one on top of another.
            When EPA, DOE and the Office of Management and Budget conducts
            their reviews of each regulation, the cumulative impact of
            regulations on the supply, distribution, and cost on
            transportation fuels should be fully considered before taking
            action.
     Ensure thorough review of regulations. Preparation of an Energy
            Impact Statement for major rules could help ensure that energy
            supply impacts are fully understood and balanced with
            environmental goals. Proper use of cost-benefit analysis to
            ensure cost-effectiveness of regulations is another essential
            tool.
     Do not change the rules in the middle of the game. Retroactive
            reinterpretation of regulatory programs such as EPA's NSR
            enforcement activities constitute rulemaking without due
            process and opportunity for comment. Also, changes in
            requirements that negate good faith compliance investments
            waste scarce capital resources that are much needed for other
            projects such as refining capacity expansions. To deter unwise
            government intervention, Congress should also consider enacting
            measures which compensate impacted parties when the reversal of
            federal rule or regulations strand business with useless
            equipment which was built specifically to comply with federal
            law.
     Reform the permitting and New Source Review processes in order to
            facilitate capacity expansion and maintenance. By questioning
            state permitting decisions and policy over the past 20 years,
            EPA will only further slow down the permitting process and
            divert state resources towards reviewing past decisions.
            Fortunately, the U.S. EPA has now finalized two sets of rules
            dealing with NSR: one suite of reforms addressing many refining
            needs; another addressing equipment replacement. The refining
            sector awaits promulgation of a de-bottlenecking rule that can
            further assist in enhancing refining capacity. Implementation
            of these rules are critical at this time as state permitting
            authorities and refiners work together to expedite the
            permitting processes for important upcoming environmental
            regulations, such as the Tier II gasoline sulfur reduction
            requirements. In short, NSR should apply only if emissions
            actually increase significantly. Any interpretation that would
            result in perpetual exposure to NSR cannot be defended; and
     Consider tax incentives to encourage environmental improvements. The
            costs associated with environmental compliance often make the
            difference between a competitive refinery operating in the
            U.S., and one that closes. Valero alone spends on the order of
            $100 million per year in environmental compliance expenditures.
            The real cost of these environmental standards is lost
            international competitiveness for U.S. refiners. The Office of
            Technology Assessment has found that the cost to the domestic
            refining industry for pollution abatement is substantial and is
            higher than for most other industries. API has calculated that
            petroleum refining could account for a disproportionate 17% of
            the national environmental expenditure in the year 2000. Given
            the typically low return on capital investment (ROI) in the
            refining section, such tax treatment is justified. Data from
            the Energy Information Administration shows EIA shows that US
            Refining/Marketing ROI from 1980 to 2002 generally ranges from
            0% to 10% and looks to average about 5%. Although by no means a
            complete solution, the Congress could consider some combination
            of tax credits for environmental compliance or enhanced
            depreciation for such investments.

                                   CONCLUSION

        While these responses to current refining difficulties are by no
    means comprehensive, they represent a start. President Bush recently
    remarked that, ``the solution for our energy shortage requires long-
    term thinking and a plan that we'll implement that will take time to
    bring to fruition.'' At Valero, we couldn't agree more. However, any
    plan, in order to succeed in providing the American consumer with
    reliable and affordable motor fuel supplies, must take into account the
    current state of the US refining industry and of our product
    distribution infrastructure.
        Thank you very much for this opportunity to testify.

        Mr. Hall. Thank you very much.
        Mr. Arjun Murti, the Chair recognizes you for your opening
    statement, sir.

                    STATEMENT OF ARJUN NARAYANA MURTI

        Mr. Murti. Thank you, Mr. Chairman and members of the
    subcommittee, for this opportunity to testify before you today
    about the issues surrounding the U.S. refining industry. My
    name is Arjun Murti, I am the Managing Director at Goldman,
    Sachs, where I am a Senior Equity Investment Analyst covering
    the integrated oil, refining and marketing, and exploration and
    production sectors.
        If steps are not taken to add new energy infrastructure or
    reduce demand, this country appears headed for its next big
    energy crisis like we saw in the late 1970's, a period of much
    higher and more volatile prices, which is a situation made
    worse by the ongoing geopolitical turmoil in key oil-exporting
    countries.
        We think the probabilities are significantly higher that at
    some point this decade, this country is more likely to see $60-
    $80 oil and $2.50-$3 a gallon gasoline than it is to revert
    back to the nice $15-$25 oil and the $1-$1.25 gallon gasoline
    we have had for most of the 1980's and 1990's.
        Economic growth, especially in the United States and China,
    is straining the limits of existing global refining capacity as
    demand growth has basically eaten through all the spare
    capacity we have not just in refining, but in global crude oil
    availability, in OPEC utilization, as well as U.S. natural gas
    supply that was built up during the energy investment boom
    period of the 1970's. We basically need to add supply or reduce
    demand.
        On the demand side, however, history unfortunately suggests
    demand adjustments will only occur after a crisis, not before.
    For example, from 1980 to 1983, we did have decline in oil
    demand for 4 years both in the U.S. and globally, but it took
    long gas lines, an Arab oil embargo, and a deep recession, not
    to mention a crude oil spike to $80 a barrel in real terms in
    1979, before consumers changed their behavior.
        Since you basically can only run your car on gasoline and
    can't switch to another fuel, and given consumer preferences
    for large, powerful, comfortable, but unfortunately gas-
    guzzling SUVs, we think oil demand is essentially not elastic
    relative to the price. We think it would be logical for the
    U.S. Government to consider pro-actively implementing policies
    that encourage a reduction in the long-term growth of oil
    demand such as disincentivizing the use of sport utility
    vehicles by the mass population. But given that that is
    probably not such a popular step, we are going to have to turn
    to the supply side.
        When you look at supply, we think significant amounts of
    new refining capacity will be needed, though this is also
    likely to be a long-term proposition because of inadequate
    historical profitability in the refining sector. In the 1990's,
    the return on capital averaged just 6.5 percent, which is
    highly inadequate to stimulate investment. You have also got
    things like environmental permitting and ``Not In My Back
    Yard`` concerns. I would say that is secondary, though, to the
    profitability question.
        Our supply/demand analysis shows that the United States
    will need to add the equivalent of a new 260,000 barrel a day
    refinery every other year, starting in 2 years, in order to
    meet trend oil demand growth, and we have accounted for 150,000
    barrels of ongoing debottlenecking. We think the earliest this
    country might see a new refinery is 2014, which is essentially
    a way of saying ``not anytime soon.''
        Now, three things we think are needed to ensure new
    refinery capacity is added. First and foremost, refining
    margins and U.S. gasoline prices need to be a lot higher than
    they have in the past in order to provide adequate returns on
    capital for the refining sector. Poor historic returns in
    refining have incentivized both oil companies and investors to
    invest in other sectors. There has been a lot of investment in
    the technology sector, not surprising--Microsoft, Intel, Dell--
    hugely better profitability than any oil company. Companies
    invested in health care, not surprising--Merck, Pfizer,
    Bristol-Meyers--significantly better profitability than the
    energy sector. The refining sector has had one of the worst
    returns on capital of any economic sector within the U.S.
    industry. Companies and investors also need to have confidence
    that windfall profit taxes will not be reintroduced, which
    would detract from confidence in the profits and returns that
    could be earned.
        The second big thing we need is stability in the four key
    crude oil exporting countries--Saudi Arabia, Iraq, Venezuela,
    and Iran. This is important because our refineries use 10
    million barrels a day of imported crude oil, and if there are
    disruptions where the crude is not available, you are not going
    to be able to run your refineries and you won't get gasoline.
        Essentially, we think new Government institutions that are
    representative of the underlying population and a proactive
    growth are needed in those countries.
        The last point is about streamlining environmental
    permitting and NIMBY issues. You are not going to have a lot of
    permits until people first have confidence that the returns on
    capital are good enough to justify investment.
        Today, we believe investors will react unfavorably to an
    announcement by any of the major oil companies or independent
    refiners to announcing a new-build refinery in the U.S. Even if
    funding were available--and they could probably get the
    funding--the likely negative stock price reactions, in our
    view, would keep company management from pursuing refinery new-
    builds in the current investment climate.
        Mr. Chairman and members of the committee, I thank you for
    the opportunity to testify, and would welcome any questions at
    the right time.
        [The prepared statement of Arjun N. Murti follows:]

    Prepared Statement of Arjun N. Murti, Managing Director, Goldman, Sachs
                                     & Co.

        Mr. Chairman and Members of the Subcommittee, thank you for the
    opportunity to testify before you today about the short-term and long-
    term issues surrounding the US refining industry.
        My name is Arjun Murti. I am a Managing Director of Goldman Sachs,
    where I am the Senior Equity Research Analyst covering the integrated
    oil, refining & marketing, and exploration & production sectors. The
    views presented here today are my own and do not necessarily reflect
    the view of Goldman, Sachs & Co.

        ENERGY SUPPLY INCLUDING US REFINING CAPACITY IS RUNNING ON EMPTY

        Spare US refining capacity, global crude oil availability, and US
    natural gas supply have steadily eroded over the past 20 years, owing
    to growing demand and inadequate investment (see Exhibit 1). As such,
    consumers and businesses should expect higher and more volatile energy
    prices in the future, until adequate new infrastructure is built. Both
    price volatility and overall price levels are further increased by
    ongoing geopolitical turmoil in key oil exporting countries. Note, we
    do not believe the world is running out of oil so to speak, rather we
    see this as a lack of adequate investment.
        Growing energy demand has naturally occurred as global economic
    growth has been robust, especially in the US and Asia. China is now the
    second largest oil consumer after the US in absolute terms, with oil
    import growth rising dramatically in recent years and forecast to rise
    inexorably into the future (see Exhibit 2). It is noteworthy that the
    two largest demand centers (the US and China) are on opposite sides of
    the world, with most of the remaining oil resource ``in the middle'' in
    the Middle East and Russia.
        Energy demand growth over the past 20 years has been met by the
    steady ``exploitation'' of the large investments made during the last
    energy boom period in the 1970s. Global refining capacity expanded
    significantly during the 1970s and early 1980s, but has since grown at
    a pace well below oil demand (see Exhibit 3). After 20 years of living
    off of cheap energy, spare capacity throughout the energy industry is
    greatly diminished.

        STATE OF US REFINING INDUSTRY LINKED TO CRUDE OIL IMPORT MARKETS

        Total US consumption of refined oil products (i.e., gasoline,
    diesel, jet fuel, heating oil, residual fuel oil) is 15.6 mln b/d.
    Domestic refining supply is 14.3 mln b/d and we import 1.2 mln b/d of
    refined products. However, in order for our refineries to run at
    utilization rates in excess of 90%, we currently import roughly 10 mln
    b/d of crude oil with only 5.6 mln b/d coming from domestic crude
    sources (see Exhibit 4).
        Given the substantial US crude oil import needs, the state of the
    US refining industry is closely linked to the state of crude oil import
    markets. If a disruption occurs that limits crude oil imports, refinery
    utilization by necessity will fall, or at least once local crude oil
    inventories are depleted. As such, any steps taken to expand the US
    refining industry has to be consistent with policies that ensure
    adequate crude oil imports. Given that this testimony is focused on the
    refining industry, we have chosen not to expand on the state of crude
    oil markets. For more details, please refer to other published research
    by Goldman Sachs, including our June 8, 2004 report, ``The
    sustainability of higher oil prices: Revenge of the old economy, Part
    II.''
        Going forward, we estimate that refined product demand will grow
    1.6% per year, or about 260,000 b/d per year, over the remainder of
    this decade. The estimate reflects expected trend oil demand growth
    relative to expected trend GDP growth forecast by Goldman Sachs
    economists. In our view, continued debottlenecking in refining capacity
    is likely, but will be insufficient to meet desired demand growth,
    resulting in increased refined product imports (i.e., gasoline, diesel,
    jet fuel, heating oil, and residual fuel oil) in the absence of steps
    taken to further accelerate domestic capacity gains (see Exhibit 5). If
    natural debottlenecking slows, as some are forecasting, refined product
    imports will need to increase at an even faster rate in order for
    desired demand growth to be satisfied.
        If US refining capacity does not grow in the future, crude oil
    import growth would be limited to offsetting the rate of decline in
    domestic supply, which we estimate to be around 3% per year. However,
    if the US economy continues to grow, resulting increases in oil
    consumption would need to be met by growing refined product imports.
    Either way, US imports of crude oil plus refined products will need to
    grow in the future, essentially at the rate of oil consumption growth
    plus the decline in domestic crude oil supply.
    growing us dependency on oil imports inevitable: lack of spare capacity

                     RAISES OUR VULNERABILITY TO DISRUPTION

        Geologically the US is very mature, with an inadequate amount of
    remaining oil reserves to meet a perpetually growing economy. As such,
    rising US dependency on oil imports is inevitable. Oil import
    dependency is not inherently a problem, but is a greater challenge
    today given three new developments:
        1. Geopolitical turmoil. Rapid population growth, the lack of a
    diversified and growing economic base, and the lack of representative
    governments has increased geopolitical turmoil in four key oil
    exporting countries--Saudi Arabia, Iraq, Venezuela, and Iran. As such,
    the risk of a supply disruption is at the highest levels seen since the
    oil embargo years of the 1970s. Geopolitical and economic stability is
    needed in these key oil exporting countries before the risk premium in
    oil prices will likely subside. Stability likely involves the
    establishment of new government institutions in these countries that
    are representative of the underlying population and that are pro-
    economic growth. Supporting partnerships between western oil companies
    and host governments in these key oil exporting countries to develop
    the country's resources would also be helpful.
        2. China. China has emerged as the second largest oil consumer in
    the world (after the US), with a rapidly growing thirst for oil imports
    given its own inadequate resource base. Aside from competing with the
    US over energy supply, the challenge is compounded by the fact that
    China is on the opposite side of the world as the US and shipping
    capacity is also in tight supply.
        3. No spare capacity. Spare capacity in crude oil, shipping, and
    refining markets is essentially gone.
        In an environment where (1) spare crude oil capacity is minimal,
    (2) the US is dependent on oil imports, and (3) key oil exporting
    countries are facing a high amount of geopolitical turmoil, US
    consumers and businesses should be prepared for energy prices that are
    higher in absolute terms and more volatile than the levels seen during
    the 1980s and 1990s.

    DOMESTIC REFINING CAPACITY GROWTH PREFERABLE TO GROWING REFINED PRODUCT
                                    IMPORTS

        In our view, there are a number of reasons why policies that
    encourage growth in domestic refining capacity and imports of crude oil
    are preferable over growth in imports of refined products.
        Over time, foreign refining capacity, like US refining capacity,
    will be increasingly dependent on crude oil imports from
    geopolitically-challenged countries. By importing refined products, the
    US then becomes subject to two sources of disruption: first at the
    crude oil exporting country and then again potentially at the refined
    product exporting country.
        A recent example of this issue is Venezuela, where a national
    protest strike in early 2003 disrupted both crude oil and gasoline
    exports from Venezuela to the US as well as crude oil exports to
    Caribbean refineries that in turn export finished gasoline to the US.
    Since the strike officially ended, crude oil supply from Venezuela has
    not fully recovered to pre-strike levels, and gasoline exports to the
    US (which meet our strict environmental standards) also remain well
    below pre-strike levels due to ongoing post-strike operational issues
    at Venezuelan refineries (see Exhibit 6).
        From an environmental perspective, US environmental standards tend
    to be consistent with western European countries, but significantly
    stricter than most of the rest of the world. The benefits of the
    stricter environmental standards should be obvious to anyone that
    travels to cities elsewhere in the world that have lower standards.
    There is no guarantee that foreign refineries will make the necessary
    investments to comply with US environmental standards. As such, the US
    could face the choice (actually, in the not too distant future), where
    it has to choose between limiting refined product imports and accepting
    the consequences of $3 per gallon gasoline prices or weakening
    environmental standards (or both).
        Other benefits of growing domestic refining capacity include the
    fact that the cost of importing crude oil is less than the cost of
    importing refined products, given the need for a margin in order to
    refine crude oil into usable end products. Finally, a growing US
    refining industry will result in increased manufacturing and
    construction sector employment in the US.

      HIGHER RETURNS ON CAPITAL NEEDED TO STIMULATE ADEQUATE US REFINING
                                CAPACITY GROWTH

        In order to stimulate growth in domestic refining capacity, we
    believe refining margins will need to be significantly higher than
    historic levels. Returns on capital employed (ROCE) in the US refining
    industry were poor during most of the past 10 years (see Exhibit 7).
    This is primarily because refining margins, which are the spread
    between refined product selling prices (i.e., the price of gasoline,
    diesel, jet fuel, heating oil, and residual fuel oil) and the cost of
    crude oil, have been low.
        Low refining margins were caused by the significant excess capacity
    that existed during most of the 1980s and 1990s following the
    investment boom period of the 1970s. With low refining margins and
    returns on capital, refining capacity growth has been essentially
    stagnant save some amount of debottlenecking that naturally occurs
    every year.
        With low returns on capital, it should not be surprising that
    capital investment in US refining capacity has been at very low levels
    (see Exhibit 8). We are forecasting an increase in capital spending in
    2004-2006, but this is almost entirely driven by the need to meet new
    environmental regulations for gasoline and diesel in the US.

     AT $30-$80 PER BBL CRUDE OIL, $1.80-$3.00 PER GALLON GASOLINE PRICES
                                     NEEDED

        We estimate that it would cost between $2 to $3 billion to build
    just one new 260,000 b/d refinery in the US. Note, we forecast US
    refined product demand growth will be around 260,000 b/d per year for
    the foreseeable future. The lead time to start-up is estimated at
    around 3 years after all environmental and other approvals have been
    attained. Including likely permitting and NIMBY delays, we believe the
    earliest this country will likely see a new refinery is 2014, if not
    longer. Government steps to streamline and expedite environmental
    permitting and construction approval processes perhaps in certain
    ``industrial zones'' that would not face NIMBY issues, in our view,
    would accelerate the development of new refining capacity.
        In order to generate an acceptable minimum after-tax internal rate
    of return of 10%, we estimate that over the next 25 years Gulf Coast
    3:2:1 refining margins (widely considered to be the US benchmark
    refining margin) would need to average around $7.75 per bbl at the $2
    billion new build refinery cost and $9.50 per bbl at the $3 billion
    construction cost (see Exhibit 9). This compares with the 1990-2000
    average Gulf Coast 3:2:1 refining margin of $3.18 per bbl.
        Translating the required refining margin into an average US
    gasoline selling price at the pump requires three additional
    assumptions: the price of crude oil, the so-called marketing margin
    (i.e., the spread between the gasoline selling price at the pump and
    the price paid to the refinery), and federal and state government
    taxes. If we assume $30 per bbl for the price of West Texas
    Intermediate (WTI) crude oil (the US benchmark crude oil price), the
    average marketing margin experienced over the past 10 years, and no
    change to government taxes, we estimate the average gasoline selling
    price in the US will need to be around $1.80 per gallon at the $2
    billion new refinery construction cost and $1.95 per gallon at the $3
    billion construction cost. This compares with the 1990-2000 average US
    gasoline selling price at the pump of $1.15 per gallon.
        If we assume $50 per bbl for WTI oil and no changes to our
    marketing margin or tax assumptions, the average gasoline pump price
    would need to be $2.05 per gallon at the $2 billion refinery
    construction cost and $2.25 per gallon at the $3 billion construction
    cost.
        Finally, assuming an $80 per bbl WTI crude oil price and making no
    change to our marketing margin or tax assumptions, the average gasoline
    pump price would need to be $2.70 per gallon at the $2 billion refinery
    construction cost and $3.00 per gallon at the $3 billion construction
    cost.
        We note that in real terms (i.e., in 2003 US dollars), WTI oil
    prices remained between $50-$80 per bbl from 1979-1984, including
    averaging a full-year above $80 per bbl (see Exhibit 10). Over the
    remainder of this decade, we believe the probability of moving to a
    $50-$80 per bbl price band is significantly higher than the chances of
    reverting back to a $15-$25 per bbl band. As such, irrespective of
    whether we add new refining capacity, US consumers and businesses
    should be prepared to pay a lot more for energy than they did during
    the 1980s and 1990s. The price paid, however, will be higher, if
    domestic refining capacity does not grow.

    POOR HISTORIC RETURNS SUGGESTS INDUSTRY WILL BE CAUTIOUS BEFORE ADDING
                                  NEW CAPACITY

        Given the poor health of the US refining industry for most of the
    past two decades, refining margins will likely need to be well in
    excess of so-called replacement cost levels before companies move to
    add new grassroots refining capacity. Such caution will likely be
    evident, even if rules are changed to streamline environmental and
    project approval processes and NIMBY concerns do not materialize. As a
    result, we believe the government should resist the temptation to
    implement ``windfall profits'' taxes should oil prices move materially
    higher from current levels, as such taxes would further disincentivize
    capacity growth and contribute to investor skepticism over investing in
    the oil and refining sector.
        We believe investors would react unfavorably to an announcement by
    any of the major integrated oil (e.g., Exxon Mobil, ChevronTexaco,
    ConocoPhillips, BP, Royal Dutch/Shell) or independent refining
    companies (e.g., Valero Energy, Marathon Oil, Sunoco, Premcor, Tesoro
    Petroleum, Amerada Hess, Frontier Oil) to build a new refinery in the
    US.
        In an era of low interest rates, healthy corporate balance sheets,
    and capital availability, financing would likely not be an issue for at
    least the first few refineries proposed. However, the likely negative
    stock price reactions, in our view, would keep oil company managements
    from pursuing refinery new builds in the current investment climate.

    CAN THE US LOWER ITS GROWTH RATE IN OIL DEMAND WITHOUT NEEDING A MAJOR
                                    CRISIS?

        In addition to understanding supply-side adjustments and required
    price levels to stimulate sufficient supply growth, we believe demand-
    side adjustments should also be pursued, preferably proactively rather
    than reactively. History, unfortunately, suggests that demand-side
    adjustments will occur only after a crisis, not before.
        We note that the last major effort made to improve fuel economy and
    overall energy efficiency was in the 1980s following the energy crisis
    years in the 1970s. In response to the $80 per bbl (in 2003 US dollars)
    oil price spike in 1979, oil demand growth actually fell for the four
    years from 1980-1983 (see Exhibit 11). In addition to very high energy
    prices, economic growth was weak and unemployment and interest rates
    high during this period.
        The lack of fuel switching options for transportation fuels and
    consumer preferences for large, powerful, and comfortable vehicles are
    the key reasons oil demand price elasticity is low, in our view. Very
    simply, most Americans would rather own a large, gas-guzzling SUV and
    pay more for gasoline than an embarrassingly cramped but fuel-efficient
    Mini. To change that behavior in the absence of government policies in
    the 1970s required the inconvenience of gas lines and a super spike in
    oil prices that truly took a large chunk of change out of consumer
    wallets and pocketbooks. We do not believe it is in anyone's interest
    to wait for crisis conditions to again emerge to stimulate a new round
    of conservation measures. However, that is the path upon which we
    appear to be headed.
        In our view, it would be logical for the US government to
    proactively implement policies that encourage a reduction in the growth
    rate of oil demand. We note that the cost of waiting will likely result
    in much greater economic damage over the long term than the short-term
    inconvenience of no longer being able to buy an inexpensive SUV as an
    example.
        Examples of logical demand reduction choices, in our view, include
    but are not limited to the following (not intended to be an exhaustive
    list by any means):

     Disincentivize the use of SUVs for mass markets.
     Encourage market adoption of hybrid vehicles (e.g., Prius) that offer
            improved fuel economy with minimal (or no) government
            subsidies.
     Introduce incentives to use mass transportation in major population
            centers (e.g., tax city driving during certain hours of the day
            using an ``EZ Pass''-styled tax collection mechanism).
        The lower the growth rate for oil demand, the less supply growth
    will be needed.

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        Mr. Hall. Thank you, sir.
        Mr. Cooper.

                        STATEMENT OF MARK COOPER

        Mr. Cooper. Thank you, Mr. Chairman. I appreciate the
    opportunity and applaud the committee for inviting consumers to
    present their point of view. I think I have attracted a little
    attention with mine, judging from the previous questions.
        When the first signs of trouble in the gasoline market
    emerged in the year 2000, CFA began to examine the underlying
    causes of the problem. In three reports and about half a dozen
    pieces of testimony to Congress, we have examined the complex
    interaction of factors underlying the price volatility of the
    past 4 years. Increasing demand here in America and around the
    world have tightened markets, for sure. This reinforces the
    pricing power of international producers. Domestic markets are
    tight, too, because refining capacity is tight and stocks have
    been kept at very low level. In our view, as you heard from
    previous questions, consolidation in the industry interacted
    with environmental policy to reduce capacity.
        A 2003 study for the Rand Corporation summarized a
    fundamental change in the behavior of the refining industry,
    and I quote: ``Relying on existing plants and equipment to the
    greatest extent possible, even if that ultimately meant
    curtailing output of certain refined products, discussants
    openly questioned the once universal imperative of a refinery
    not `going short'--that is, not having enough product to meet
    demand. Rather than investing in operating refineries to ensure
    that markets are fully supplied all the time, refiners
    suggested that they were focusing, first, on ensuring that
    their branded retailers are adequately supplied by curtailing
    sales to the wholesale market.''
        Now, these business decisions interacted with environmental
    requirements, as the Federal Trade Commission found in its
    study of the 2000 price spike in the Midwest, and I quote: ``A
    significant part of the reduction in the supply of RFG was
    caused by the investment decision of three firms. When
    determining how they would comply with restrictive EPA
    regulations for summer grade RFG that took effect in Spring
    2000, three Midwest refiners each independently concluded it
    was profitable to limit capital expenditures to upgrade their
    refineries only to the extent necessary to supply their branded
    gas stations and contractual obligations. As a result of these
    decisions, these three firms produced in the aggregate 23
    percent less summer-grade RFG. Consequently, these three firms
    were able to satisfy only the needs of their branded gasoline
    stations and their contractual obligations, and could not
    produce summer-grade RFG to sell on the spot market, as they
    had done in prior years.'' Now, these fundamental shifts in
    behavior and business decisions had an impact. Mr. Widen, on
    the Senate side, has weighed the corporate documents which said
    we have to get rid of excess capacity. They are on his Web
    site. You can visit it.
        The GAO study now shows you the effect of that impact. In
    fact, we think the GAO significantly underestimates the problem
    for at least four reasons. First of all, it addressed only 2001
    data. Those are early results. At the time, the domestic spread
    was up a nickel or a dime. Today, it is 30 cents a gallon more
    than it was in the 1990's.
        Second of all, the GAO only looks at the wholesale price,
    and obviously there is market power all the way down the supply
    chain. But more importantly, the GAO treats stock and capacity
    as exogenous--that is, they assume that the declining stocks
    and the tight capacity happens someplace else, were not the
    result of strategic policies. And there is a massive price
    increase associated with that.
        In point of fact, the GAO shows what happens when an
    industry like this becomes concentrated, an industry in which
    ``just in time'' means ``never there when you really need it.''
    You cannot run gasoline like soybeans because you need a
    constant flow, and surges in demand cannot be met with any
    substitutes. This is an industry that has to be looked at
    differently.
        I digressed a little bit from my initial discussion, but
    the members seem to be really interested in our view of what is
    happening in the industry.
        When we started looking at this industry 3 years ago, we
    developed a balanced policy to look at where we would get the
    gasoline that the American public needs. And, frankly, we
    looked very hard at this question of closing refineries because
    those are the best opportunities for expanding capacity. Why
    were those 50 or 60 refineries closed in the 1990's? Senator
    Widen's document suggests they were strategic business
    decisions to tighten the market. Those are the smoking guns
    that are there. The effects are now clear to us.
        So, we asked 3 years ago for an inventory of closed
    refineries. Why were they closed? What would it take to get
    them open? And we particularly encouraged new entry into this
    business, to take those sites and let other people develop them
    as refineries.
        The interesting thing is we have heard a lot in this
    hearing and the last hearing I testified on refineries, about
    the 100 or so that closed in the 1980's. In fact, if you go
    back to our 2001 document, you will discover that we looked
    very carefully at that. When I first came to Washington to
    represent consumer interest, we vigorously supported the small
    refiner buyer, that tax subsidy that kept the little guys in
    business, because we realized that a few pennies a gallon to
    keep the independent refiner there would have a tremendous
    disciplining effect on the marketplace.
        So, you are darn right, we want more refineries. We want
    them in places where they have been closed because that
    minimizes the environmental impact, and we want independent
    refiners who would discipline the price in this industry. Thank
    you.
        [The prepared statement of Mark Cooper follows:]

       Prepared Statement of Mark Cooper, Director of Research, Consumer
    Federation of America, on Behalf of Consumer Federation of America and
                                Consumers Union

        Mr. Chairman and Members of the Committee, my name is Dr. Mark
    Cooper. I am Director of Research of the Consumer Federation of
    America. The Consumer Federation of America (CFA) is a non-profit
    association of 300 groups, which was founded in 1968 to advance the
    consumer interest through research, advocacy and education. I am also
    testifying on behalf of Consumers Union, the independent, non-profit
    publisher of Consumer Reports.
        I greatly appreciate the opportunity to appear before you today to
    discuss the problem of rising gasoline prices and gasoline price
    spikes, and the impact that environmental regulations may have on these
    increases. Over the past two years, our organizations have looked in
    detail at the oil industry and the broad range of factors that have
    affected rising oil and gasoline prices. We submit two major studies
    conducted by the Consumer Federation of America on this topic for the
    record.\1\
    ---------------------------------------------------------------------------
        \1\ Cooper, Mark, Ending the Gasoline Price Spiral (Washington
    D.C.: Consumer Federation of America July 2001). Cooper, Mark, Spring
    Break in the Oil Industry: Price Spikes, Excess Profits and Excuses
    (Washington D.C.: Consumer Federation of America, October 2003.)
    ---------------------------------------------------------------------------
        Three years ago, the analysis we provided in one of these reports,
    Ending the Gasoline Price Spiral, showed that the explanation given by
    the oil industry and the Administration for the high and volatile price
    of gasoline is oversimplified and incomplete. This explanation points
    to policies that do not address important underlying causes of the
    problem and, therefore, will not provide a solution.

     Blaming high gasoline prices on high crude oil prices ignores the
            fact that over the past few years, the domestic refining and
            marketing sector has imposed larger increases on consumers at
            the pump than crude price increases would warrant.
     Blaming tight refinery markets on Clean Air Act requirements to
            reformulate gasoline ignores the fact that in the mid-1990s the
            industry adopted a business strategy of mergers and
            acquisitions to increase profits that was intended to tighten
            refinery markets and reduce competition at the pump.
     Claiming that the antitrust laws have not been violated in recent
            price spikes ignores the fact that forces of supply and demand
            are weak in energy markets and that local gasoline markets have
            become sufficiently concentrated to allow unilateral actions by
            oil companies to push prices up faster and keep them higher
            longer than they would be in vigorously competitive markets.
     Eliminating the small gasoline markets that result from efforts to
            tailor gasoline to the micro-environments of individual cities
            will not increase refinery capacity or improve stockpile policy
            to ensure lower and less volatile prices, if the same handful
            of companies dominate the regional markets.
        Thus, the causes of record energy prices involve a complex mix of
    domestic and international factors. The solution must recognize both
    sets of factors, but the domestic factors must play an especially large
    part in the solution, not only because they are directly within the
    control of public policy, but also because careful consideration of
    what can and cannot be done leads to a very different set of policy
    recommendations than the Administration and the industry have been
    pushing, or the Congress is considering in the pending energy
    legislation.
        Because domestic resources represent a very small share of the
    global resources base and are relatively expensive to develop, it is
    folly to exclusively pursue a supply-side solution to the energy
    problem. The increase in the amount of oil and gas produced in America
    will not be sufficient to put downward pressure on world prices; it
    will only increase oil company profits, especially if large subsidies
    are provided, as contemplated in pending energy legislation. Moreover,
    even if the U.S. could affect the market price of basic energy
    resources, which is very unlikely, that would not solve the larger
    structural problem in domestic markets.
        the underlying structural problem in domestic petroleum markets
        Our analysis shows that energy markets have become tight in America
    because supply has become concentrated and demand growth has put
    pressure on energy markets. This gave a handful of large companies
    pricing power and rendered the energy markets vulnerable to price
    shocks. While the operation of the domestic energy market is complex
    and many factors contribute to pricing problems, one central
    characteristic of the industry stands out--it has become so
    concentrated in several parts of the country that competitive market
    forces are weak. Long-term strategic decisions by the industry about
    production capacity interact with short-term (mis)management of stocks
    to create a tight supply situation that provides ample opportunities to
    push prices up quickly. Because there are few firms in the market and
    because consumers cannot easily cut back on energy consumption, prices
    hold above competitive levels for significant periods of time.
        The problem is not a conspiracy, but the rational action of large
    companies with market power. With weak competitive market forces,
    individual companies have flexibility for strategic actions that raise
    prices and profits. Individual companies can let supplies become tight
    in their area and keep stocks low, since there are few competitors who
    might counter this strategy. Companies can simply push prices up when
    demand increases because they have no fear that competitors will not
    raise prices to steal customers. Individual companies do not feel
    compelled to quickly increase supplies with imports, because their
    control of refining and distribution ensures that competitors will not
    be able to deliver supplies to the market in their area. Because there
    are so few suppliers and capacity is so tight, it is easy to keep track
    of potential threats to this profit maximizing strategy. Every accident
    or blip in the market triggers a price shock and profits mount.
    Moreover, operating the complex system at very high levels of capacity
    places strains on the physical infrastructure and renders it
    susceptible to accidents.
        It has become evident that stocks of product are the key variables
    that determine price shocks. In other words, stocks are not only the
    key variable; they are also a strategic variable. The industry does a
    miserable job of managing stocks and supplying product from the
    consumer point of view. Policymakers have done nothing to force them to
    do a better job. If the industry were vigorously competitive, each firm
    would have to worry a great deal more about being caught with short
    supplies or inadequate capacity and they would hesitate to raise prices
    for fear of losing sales to competitors. Oil companies do not behave
    this way because they have power over price and can control supply.
    Mergers and acquisitions have created a concentrated industry in
    several sections of the country and segments of the industry. The
    amount of capacity and stocks and product on hand are no longer
    dictated by market forces, they can be manipulated by the oil industry
    oligopoly to maximize profits.
        Much of this increase in industry profits, of course, has been
    caused by an intentional withholding of gasoline supplies by the oil
    industry. In a March 2001 report, the Federal Trade Commission (FTC)
    noted that by withholding supply, industry was able to drive prices up,
    and thereby maximize profits.\2\ The FTC identified the complex factors
    in the spike and issued a warning.
    ---------------------------------------------------------------------------
        \2\ Federal Trade Commission, Midwest Gasoline Price Investigation,
    March 29, 2001.
    ---------------------------------------------------------------------------
              The spike appears to have been caused by a mixture of
            structural and operating decisions made previously (high
            capacity utilization, low inventory levels, the choice of
            ethanol as an oxygenate), unexpected occurrences (pipeline
            breaks, production difficulties), errors by refiners in
            forecasting industry supply (misestimating supply, slow
            reactions), and decisions by firms to maximize their profits
            (curtailing production, keeping available supply off the
            market). The damage was ultimately limited by the ability of
            the industry to respond to the price spike within three or four
            weeks with increased supply of products. However, if the
            problem was short-term, so too was the resolution, and similar
            price spikes are capable of replication. Unless gasoline demand
            abates or refining capacity grows, price spikes are likely to
            occur in the future in the Midwest and other areas of the
            country.\3\
    ---------------------------------------------------------------------------
        \3\ Federal Trade Commission, Midwest Gasoline Price Investigation,
    March 29, 2001, pp. i . . . 4.
    ---------------------------------------------------------------------------
        A 2003 Rand study of the refinery sector reaffirmed the importance
    of the decisions to restrict supply. It pointed out a change in
    attitude in the industry, wherein ``[i]ncreasing capacity and output to
    gain market share or to offset the cost of regulatory upgrades is now
    frowned upon.'' \4\ In its place we find a ``more discriminating
    approach to investment and supplying the market that emphasized
    maximizing margins and returns on investment rather than product output
    or market share.'' \5\ The central tactic is to allow markets to become
    tight.
    ---------------------------------------------------------------------------
        \4\ Peterson, D.J. and Serej Mahnovski, New Forces at Work in
    Refining: Industry Views of Critical Business and Operations Trends
    (Santa Monica, CA: RAND Corporation, 2003), p. 16.
        \5\ Peterson and Mahnovksi, p. 42.
    ---------------------------------------------------------------------------
              Relying on . . . existing plants and equipment to the
            greatest possible extent, even if that ultimately meant
            curtailing output of certain refined product . . . openly
            questioned the once-universal imperative of a refinery not
            ``going short''--that is not having enough product to meet
            market demand. Rather than investing in and operating
            refineries to ensure that markets are fully supplied all the
            time, refiners suggested that they were focusing first on
            ensuring that their branded retailers are adequately supply by
            curtaining sales to wholesale market if needed.\6\
    ---------------------------------------------------------------------------
        \6\ Peterson and Mahnovksi, p. 17.
    ---------------------------------------------------------------------------
        The Rand study drew a direct link between long-term structural
    changes and the behavioral changes in the industry, drawing the
    connection between the business strategies to increase profitability
    and the pricing volatility. It issued the same warning that the FTC had
    offered two years earlier.
              For operating companies, the elimination of excess capacity
            represents a significant business accomplishment: low profits
            in the 1980s and 1990s were blamed in part on overcapacity in
            the sector. Since the mid-1990s, economic performance industry-
            wide has recovered and reached record levels in 2001. On the
            other hand, for consumers, the elimination of spare capacity
            generates upward pressure on prices at the pump and produces
            short-term market vulnerabilities. Disruptions in refinery
            operations resulting from scheduled maintenance and overhauls
            or unscheduled breakdowns are more likely to lead to acute
            (i.e., measured in weeks) supply shortfalls and price
            spikes.\7\
    ---------------------------------------------------------------------------
        \7\ Peterson and Mahnovski, p. xvi.
    ---------------------------------------------------------------------------
        The spikes in the refiner and marketer take at the pump in 2002,
    2003, and early 2004, were larger than the 2000 spike that was studied
    by the FTC. The weeks of elevated prices now stretch into months. The
    market does not correct itself. The roller coaster has become a
    ratchet. The combination of structural changes and business strategies
    has ended up costing consumers billions of dollars. Until the Federal
    government is willing to step in to stop oil companies from employing
    this anti-consumer strategy, there is no reason to believe that they
    will abandon this practice on their own.

                       A COMPREHENSIVE DOMESTIC SOLUTION

        As we demonstrated in a report last year, Spring Break In the U.S.
    Oil Industry: Price Spikes, Excess Profits and Excuses,\8\ the
    structural conditions in the domestic gasoline industry have only
    gotten worse as demand continues to grow and mergers have been
    consummated. The increases in prices and industry profits should come
    as no surprise.
    ---------------------------------------------------------------------------
        \8\ Cooper, Mark, Spring Break in the Oil Industry: Price Spikes,
    Excess Profits and Excuses (Washington D.C.: Consumer Federation of
    America, October 2003.
    ---------------------------------------------------------------------------
        We all would like immediate, short-term relief from the current
    high prices, but what we need is an end to the roller coaster and the
    ratchet of energy prices. That demands a balanced, long-term solution.
    Breaking OPEC's pricing power would relieve a great deal of pressure
    from consumers' energy bills, but the short-term prospects are not
    promising in that regard either. There, too, we need a long-term
    strategy that works on market fundamentals.
        Three years ago, we outlined a comprehensive policy to implement
    permanent institutional changes that would reduce the chances that
    markets will be tight and reduce the exposure of consumers to the
    opportunistic exploitation of markets when they become tight. Those
    policies made sense then; they make even more sense today. The Federal
    government has done little to move policy in that direction since it
    declared an energy crisis in early 2001.
        To achieve this reduction of risk, public policy should be focused
    on achieving four primary goals:

     Restore reserve margins by increasing both fuel efficiency (demand-
            side) and production capacity (supply-side).
     Increase market flexibility through stock and storage policy.
     Discourage private actions that make markets tight and/or exploit
            market disruptions by countering the tendency to profiteer by
            withholding of supply.
     Promote a more competitive industry.

    Expand Reserve Margins by Striking a Balance Between Demand Reduction
            and Supply Increases
        Improving vehicle efficiency (reduction in fleet average miles per
    gallon) equal to economy wide productivity over the past decade (when
    the fleet failed to progress) would have a major impact on demand. It
    would require the fleet average to improve at the same rate it did in
    the 1980s. It would raise average fuel efficiency by five miles per
    gallon, or 20 percent over a decade. This is a mid-term target. This
    rate of improvement should be sustainable for several decades. This
    would reduce demand by 1.5 million barrels per day and return
    consumption to the level of the mid-1980s.
        Expanding refinery capacity by ten percent equals approximately 1.5
    million barrels per day. This would require 15 new refineries, if the
    average size equals the refineries currently in use. This is less than
    one-third the number shut down in the past ten years and less than one-
    quarter of the number shut down in the past fifteen years.
    Alternatively, a ten percent increase in the size of existing
    refineries, which is the rate at which they increased over the 1990s,
    would do the trick, as long as no additional refineries were shut down.
        Placed in the context of redevelopment of recently abandoned
    facilities or expansion of existing facilities, the task of adding
    refinery capacity does not appear daunting. Such an expansion of
    capacity has not been in the interest of the businesses making the
    capacity decisions. Therefore, public policies to identify sites, study
    why so many facilities have been shut down, and establish programs to
    expand capacity should be pursued.

    Expanding Storage and Stocks
        It has become more and more evident that private decisions on the
    holding of crude and product in storage will maximize short-term
    private profits to the detriment of the public. Increasing
    concentration and inadequate competition allows stocks to be drawn down
    to levels that send markets into price spirals.
        The Strategic Petroleum Reserve is a crude oil stockpile that has
    been developed as a strategic developed for dire emergencies that would
    result in severe shortfalls of crude.\9\ It could be viewed and used
    differently, but it has never been used as an economic reserve to
    respond to price increases. Given its history, draw-down of the SPR is
    at best a short-term response.
    ---------------------------------------------------------------------------
        \9\ Gove, Philip Babcock, Webster's Third New International
    Dictionary (Springfield MA: 1986), p. 2247, ``a reserve supply of
    something essential as processed food or a raw material) accumulated
    within a country for use during a shortage caused by emergency
    conditions (as war).''
    ---------------------------------------------------------------------------
        Private oil companies generally take care of storage of crude oil
    and product to meet the ebb and flow of demand.\10\ The experience of
    the past four years indicates that the marketplace is not attending to
    economic stockpiles. Companies do not willingly hold excess capacity
    for the express purpose of preventing price increases. They will only
    do so if they fear that a lack of supply or an increase in brand price
    would cause them to lose business to competitors who have available
    stocks. Regional gasoline markets appear to lack sufficient competition
    to discipline anti-consumer private storage policies.
    ---------------------------------------------------------------------------
        \10\ Gove, Webster's Third International, p. 2252, ``The holding
    and housing of goods from the time they are produced until their
    sale.''
    ---------------------------------------------------------------------------
        Public policy must expand economic stocks of crude and product.
    Gasoline distributors (wholesale and/retail) can be required to hold
    stocks as a percentage of retail sales. Public policy could also either
    directly support or give incentives for private parties to have
    sufficient storage of product. It could lower the cost of storage
    through tax incentives when drawing down stocks during seasonal peaks.
    Finally, public policy could directly underwrite stockpiles. We now
    have a small Northeast heating oil reserve. It should be continued and
    sized to discipline price shocks, not just prevent shortages.
    Similarly, a Midwest gasoline stockpile should be considered.

    Reducing Incentives for Market Manipulation
        In the short term, government must turn the spotlight on business
    decisions that make markets tight or exploit them. Withholding of
    supply should draw immediate and intense public scrutiny, backed up
    with investigations. Since the federal government is likely to be
    subject to political pressures not to take action, state government
    should be authorized and supported in market monitoring efforts. A
    joint task force of federal and state attorneys general could be
    established on a continuing basis. The task force should develop
    databases and information to analyze the structure, conduct and
    performance of gasoline and natural gas markets.
        As long as huge windfall profits can be made, private sector market
    participants will have a strong incentive to keep markets tight. The
    pattern of repeated price spikes and volatility has now become an
    enduring problem. Because the elasticity of demand is so low--because
    gasoline and natural gas are so important to economic and social life--
    this type of profiteering should be discouraged. A windfall profits tax
    that kicks in under specific circumstances would take the fun and
    profit out of market manipulation.
        Ultimately, market manipulation, including the deliberate
    withholding of supply, should be made illegal. This is particularly
    important for commodity and derivative markets.

    Promoting a Workably Competitive Market
        Further concentration of these industries is quite problematic. The
    Department of Justice Merger Guidelines should be rigorously enforced.
    Moreover, the efficiency defense of consolidation should be viewed
    skeptically, since inadequate capacity is a problem in these markets.
    The low elasticity of supply and demand should be considered in
    antitrust analysis.
        Restrictive marketing practices, such as zonal pricing and
    franchise restrictions on supply acquisition, should be examined and
    discouraged. These practices restrict flows of product into markets at
    key moments.
        Consideration of expanding markets with more uniform reformulation
    requirements should not involve a relaxation of clean air requirements.
    Any expansion of markets should ensure that total refinery capacity is
    not reduced.
        Every time energy prices spike, policymakers scramble for quick
    fixes. Distracted by short-term approaches and focused on placing blame
    on foreign energy producers and environmental laws, policymakers have
    failed to address the fundamental causes of the problem. In the four
    years since the energy markets in the United States began to spin out
    of control we have done nothing to increase competition, ensure
    expansion of capacity, require economically and socially responsible
    management of crude and product stocks, or slow the growth of demand by
    promoting energy efficiency. We have wasted four years and consumers
    are paying the price with record highs at the pump.
        [Additional material submitted is retained in subcommittee files:]

        Mr. Hall. Thank you, Dr. Cooper.
        The Chair recognizes Mr. Slaughter.

                       STATEMENT OF BOB SLAUGHTER

        Mr. Slaughter. Thank you, Mr. Chairman. The first thing I
    would like to do is thank you for holding this hearing. As head
    of the refining association that basically all refiners belong
    to in the United States, with very few exceptions, we thank you
    for looking at our issues.
        The first map shows the dispersal of refineries currently
    around the United States, both large and small. We do have 149
    operating refineries, with 60 different refining companies
    operating them.
        The second chart just again shows the importance of crude
    oil cost to the cost of making gasoline. Crude oil accounts for
    40 percent of the total cost, and taxes for 21, which leaves 61
    cents of the cost of making a gallon of gasoline essentially
    outside the control of refiners.
        We do know crude costs are up well over 50 percent since
    April 2003. Great competition for barrels around the world. A
    lot of growth in Asia. We have OPEC decisions affecting the
    market in uncertainty in many producing countries.
        The refining number does include costs and profits, it is
    currently at 31 cents, but it varies considerably. This is a
    higher number than usual.
        On Chart 3 shows the correlation of crude prices and
    gasoline costs, basically, again, underscoring that crude is a
    very important factor.
        U.S. demand is also very high, as has been testified here,
    in the 9 million barrels a day range, perhaps moving to 9.4.
    Refiners are responding to this by running at 95, 96, 98
    percent in some cases, utilization of their facilities, having
    provided 2.6 percent more gasoline in January and May of this
    year than in the same period 1 year ago. This is despite
    several difficulties, including MTBE bans in a sixth of the
    U.S. gas market, with a corresponding loss of volume that
    occurs when you try to replace MTBE with ethanol.
    Unfortunately, the factors on the last two charts you have seen
    are largely beyond policy control.
        The next chart shows what we call the ``regulatory
    blizzard.'' It shows the 14 major regulatory programs that the
    industry has to comply with in the 2000 to 2010 timeframe. Over
    $20 billion of investment capital--and you see we are roughly
    at midpoint in a number of those, particularly the diesel and
    gasoline sulfur-reduction programs, which amount to nothing
    less than the redesign of two-thirds of the product slate for
    refiners across the country, removing 90 percent of the sulfur
    from gasoline and 95 percent of the sulfur from diesel. Very
    expensive programs. We are always concerned about supply
    impacts, but very much committed to these programs.
        The refining industry is, I want to say, an extremely well-
    regulated industry. Even financial transactions, as has been
    discussed this morning, are extremely transparent. The
    Enforcement Office at EPA recently said in a document, ``Few
    industries are as complex as petroleum refining.'' Few
    regulatory programs are as complex as the Clean Air Act, which,
    for us, has been more telling as to what we will have to do
    than any energy policy passed for the last 20 years. And so we
    are glad to be here talking to an authorizing subcommittee for
    the Clean Air Act, which is the most important statute that
    regulates us.
        Just to point out a fact, looking at things and the
    regulating universe, large refineries can have 500,000
    different components and small refineries 60,000 different
    components that are regulated by different programs basically
    under the auspices of EPA. So, it is an extremely complex
    business that requires a lot of capital.
        If I could see the next chart that shows the divergence
    between U.S. demand for petroleum products and the domestic
    petroleum product supplied by the refining industry. You will
    see a divergence. U.S. refining capacity is down 10 percent
    since 1981, but the demand for petroleum products is up 25
    percent. The outlook is for continued divergence through 2025.
    As is well noted, there have been no new refineries built in
    the last 25, 26 years. Capacity growth has been slow at
    existing facilities, if at all, and we encourage people to do
    everything they can to encourage capacity growth at existing
    facilities because that is where the lion's share of any
    capacity growth we are able to do is going to come from.
        What has been said, though, given this chart this morning,
    and stressed, the incremental barrel of product comes from
    abroad, with increasing competition for those imports around
    the world. People who supply imports to the United States may
    not invest if we don't take into account the impact of our new
    specifications on them. So, it affects both our supply of
    imports as well as refined products. But very importantly, you
    have got to keep an attractive investment climate for the
    refining industry because you want people to continue to be
    able to make these large investments in domestic refining
    capacity. That means we need to be more careful with the cost
    of environmental programs. We need to move ahead, but balance
    the environmental objectives with the energy supply objectives,
    and accept the need to encourage capacity of domestic refiners.
    That means taking a sharper pencil than we have in the past, to
    the cost of some of particularly the environmental regulations.
    The refining industry has spent roughly $50 billion on
    environmental regulations over the last decade.
        I do want to state industry is not asking for a rollback of
    existing environmental regulations. We have invested money
    particularly, a great deal of money, in the gasoline sulfur and
    diesel sulfur reductions, and are absolutely committed to their
    implementation, but we believe that environmental policy does
    include real cost, significant cost, in the billions of
    dollars, and can be done more efficiently.
        I will be glad to take any questions that the committee
    has. Thank you.
        [The prepared statement of Bob Slaughter follows:]

    Prepared Statement of Bob Slaughter, President, National Petrochemical
                             & Refiners Association

                                    OVERVIEW

        Mr. Chairman and members of the Subcommittee, thank you for the
    opportunity to appear today to discuss the factors impacting current
    gasoline markets, especially U.S. refining capacity and boutique fuels.
    I am Bob Slaughter, President of NPRA, the National Petrochemical &
    Refiners Association.
        NPRA is a national trade association with 450 members, including
    those who own or operate virtually all U.S. refining capacity, and most
    U.S. petrochemical manufacturers.
        To summarize our message today, we urge policymakers in Congress
    and the Administration to support policies that encourage the
    production of an abundant supply of petroleum products for U.S.
    consumers. We believe that a diverse and healthy domestic refining
    industry is a necessary foundation to attain that objective. We also
    believe that government actions, especially in the environmental area,
    can and must do a better job of balancing energy supply impacts and
    other policy objectives.
        NPRA supports requirements for the orderly production and use of
    cleaner-burning fuels to address health and environmental concerns,
    while at the same time maintaining the flow of adequate and affordable
    gasoline and diesel supplies to the consuming public. Refiners have
    made important contributions to national efforts to improve the
    environment.
        Since 1970, clean fuels and clean vehicles account for about 70% of
    U.S. emission reductions from all sources, according to EPA. Over the
    past 10 years, U.S. refiners have invested about $47 billion in
    environmental improvements, much of that to make cleaner fuels. And
    also according to EPA, the new Tier 2 low sulfur gasoline program,
    which began in January 2004, will have the same effect as removing 164
    million cars from the road when fully implemented in 2006.
        As for current gasoline market conditions, there are no silver
    bullet solutions to the current tight supply/demand balance. The two
    most significant factors in today's gasoline market are the high price
    of crude oil and strong year to date demand for gasoline because of the
    improving U.S. economy. U.S. refineries are responding quite
    effectively to this challenge by producing record amounts of gasoline
    and distillates so far this year.
        Here is a summary of the key factors affecting the current gasoline
    market:

     Higher crude oil costs (This year WTI crude oil has twice crossed the
            $40 per barrel threshold.);
     Increased consumer demand (The Energy Information Administration
            (EIA) calculates current gasoline demand at a near record 9.4
            million b/d);
     Implementation of state MTBE bans and an ethanol mandate in
            California, Connecticut, & New York (These states represent
            one-sixth of U.S. gasoline sales.);
     Rollout of Tier 2 gasoline with reduced sulfur, a new standard which
            earlier this year may have temporarily affected gasoline
            imports; and
     The annual changeover to summer fuel formulations beginning in early
            spring.
        Refiners understand that increased costs for gasoline can cause
    difficulties for consumers, despite the fact that gasoline prices have
    actually declined over the past two decades when adjusted for
    inflation. However, NPRA urges Congress, the Administration, and the
    motoring public to have continued patience with the free market system.
    Refiners are working hard to meet strong demand for their products
    while complying with extensive regulatory controls that affect both
    refining facilities and products.
        To summarize our policy recommendations, we first urge Congress to
    pass the Conference Report on HR 6. This is the most important action
    that can be taken to improve U.S. energy security. Putting the
    conference report on the President's desk is the best way to move
    energy policy forward into the 21st century. Congress should also
    support the New Source Review (NSR) reforms which have been considered
    by two Administrations. These reforms will encourage capacity
    expansions and efficient operation of existing refineries by
    encouraging installation of new technologies. Congress should resist
    any new ``federal fuel recipes'' or hasty action on the subject of
    boutique fuels. Even the experts can't agree on the definition of a
    ``boutique fuel.'' We need more data before acting on this issue, and
    the study in H.R. 6 is a necessary first step. Congress should also act
    to repeal the 2% RFG oxygenation requirement and support California and
    New York's waiver requests pending repeal.

     TODAY'S GASOLINE MARKET: REFINERS FACE HIGH FEEDSTOCK PRICES; STRONG
                                     DEMAND

        The most significant factor affecting gasoline costs is the higher
    price of crude oil. This input currently accounts for 40% of the cost
    of a gallon of gasoline, while taxes add another 21% to the price.
    Thus, over 60% of the retail cost of gallon of gasoline is attributable
    to two components that are beyond the control of refiners. (See
    Attachment 1)
        Higher crude oil prices, set on international markets, are
    responsible for most of the increased gasoline costs. When crude oil
    prices are above $40 per barrel, refiners are paying around $1.00 for
    each gallon of crude oil used to make a gallon of gasoline. Thus, crude
    oil and gasoline costs closely track each other. (See Attachment 2)
        Since April of 2003, crude oil prices have escalated roughly 52%.
    Factors driving crude prices include: (1) high demand, spurred by
    significant economic growth in Asia, (2) decisions by OPEC regarding
    output, and (3) recurring uncertainties about worldwide crude and
    product production capabilities due to political instability in some
    producing nations.
        According to the International Energy Agency (IEA), economic
    expansion is behind the largest increase in world oil demand in 16
    years. In the U.S., oil demand is up 2.8 percent over a year ago.
    International demand is projected to be up 2.9 percent this year.
    China's demand saw a 23 percent year-on-year increase during the second
    quarter. Last year, China's crude oil imports grew 36 percent, making
    China the second largest importer of crude oil in the world, after the
    United States. India and other Asian countries have also seen strong
    demand growth.
        A tight supply/demand balance in the U.S. gasoline market is a
    second significant factor affecting current gasoline costs. As the U.S.
    economy improves, Americans are consuming more gasoline, with demand up
    almost three percent compared with last year. U.S. refiners are
    producing record amounts of the fuel, but strong demand and an earlier
    reduction in gasoline imports have tightened supply. Thus, even with
    refineries running flat-out at 96% average capacity utilization rates,
    strong demand has kept gasoline inventories below average.
        Gasoline demand currently averages approximately 9 million barrels
    per day. Domestic refineries produce about 90 percent of U.S. gasoline
    supply, while about 10 percent is imported. Increased gasoline demand
    can be met only by increasing domestic refinery production or by
    relying on more foreign gasoline imports. Unfortunately, the need for
    more domestic gasoline production capacity has run up against
    government policies and public attitudes that make it difficult and
    sometimes impossible to increase domestic refining capacity.
    public policy should encourage a healthy domestic refining industry and

                            U.S. CAPACITY EXPANSION

        Domestic refining capacity is a scarce asset. Currently 149 U.S.
    refineries, owned by almost 60 companies, operate in 33 states. (See
    Attachment 3) Their total crude oil processing capacity is 16.9 million
    barrels per day. In 1981, there were 325 refineries in the U.S. with a
    capacity of 18.6 million barrels per day. Thus, while U.S. demand for
    petroleum products has increased over 20% in the last twenty years,
    U.S. refining capacity has decreased by 10%. (See Attachment 4) No new
    refinery has been built in the United States since 1976, and it is
    unlikely that one will be built here in the foreseeable future, due to
    the combined impact of economic, government policy and ``not in my
    backyard'' NIMBY public attitudes. (Major economic factors include
    siting costs, environmental requirements, and industry profitability.)
    During this time, however, refiners have upgraded and modernized
    existing facilities by installing new technologies and enhanced
    emissions controls. The result is that refineries have improved their
    environmental performance, despite the many challenges posed by major
    investments in new fuels programs. Of course, refiners will continue to
    invest to improve the environmental performance of these facilities.
        U.S. refining capacity increased slightly in the past decade, with
    minimal increase in the past three years. Because new refineries have
    not been built, refiners have sought to increase capacity at existing
    sites to offset increasing demand and the closure of some U.S.
    refineries. Unfortunately, it is becoming harder to add capacity at
    existing sites, due in part to more stringent environmental regulations
    and the impact of a complex and often lengthy permitting process.
    Proposed refinery projects can become difficult and contentious at the
    state or local level, even when necessary to produce cleaner fuels
    under new regulatory programs. One NPRA member company encountered more
    than a year's wait for an ethanol tank necessary to comply with
    California's de facto ethanol mandate. In another instance, a group of
    investors has been trying to build a new refinery in Arizona where
    population and product demand are growing fast. So far, they have
    little to show for their determined efforts.

        NPRA believes that two policy initiatives in particular could help
    address some of the obstacles to capacity expansion.
        First, Congress should enact legislation that streamlines the
    permitting process for refinery expansion projects, new refineries, and
    other key refining projects. Congress should consider declaring
    expansion of U.S. refining capacity a national priority, and provide
    guidelines for consideration of refining permits. These guidelines
    should provide significant but finite opportunities for public input
    and enforceable deadlines for decisions. The legislation should also
    create incentives for federal, state and local permitting authorities
    to make refining-related projects a priority. EPA or other federal
    authorities could be directed to offer assistance to states to assist
    them in permit review.
        Second, NPRA urges policymakers to support New Source Review (NSR)
    reform so that domestic refiners can continue to meet the growing
    public demand for gasoline and comply with new environmental programs.
    These reforms have been under consideration since 1996 by two
    Administrations, and reflect significant public review and comment. The
    two reforms which have been completed respond to a widespread consensus
    that the unreformed program lacked clarity and certainty, discouraging
    refiners and other manufacturers in their attempts to modernize or even
    to repair existing facilities. NSR reforms should facilitate new
    domestic refining capacity expansions. They will encourage the
    installation of more technologically-advanced equipment and provide
    greater operational flexibility while maintaining a facility's
    environmental performance. Unfortunately, the much-needed NSR reforms
    are currently caught up in litigation, when refiners and U.S. consumers
    are most in need of their immediate implementation.
        It is clearly in our nation's best interest to manufacture the vast
    majority of petroleum products for U.S. consumption in domestic
    refineries. Nevertheless, we currently import more than 62% of the
    crude oil and petroleum products we consume. Limited U.S. refining
    capacity affects the U.S. supply of refined petroleum products and the
    flexibility of the supply system, particularly in times of unforeseen
    disruption or other stress. Unfortunately, the U.S. Energy Information
    Administration (EIA) currently predicts ``substantial growth'' in
    refining capacity in the Middle East, Central and South America, and
    the Asia/Pacific region, not the U.S.

        THE DOMESTIC REFINING INDUSTRY IS DIVERSE AND HIGHLY COMPETITIVE

        Today's U.S. refining industry is highly competitive. Despite this
    fact, some have suggested that past mergers are responsible for higher
    prices. The data do not support such claims. Companies have become more
    efficient and continue to compete fiercely. There are almost 60
    refining companies in the U.S., and the largest refiner accounts for
    only about 13% of the nation's total refining capacity. The Federal
    Trade Commission (FTC) thoroughly evaluates every industry merger or
    acquisition and subjects these proposals to a strict review for any
    adverse impact on competition.
        Once the transaction is complete, the FTC continues to subject the
    industry to a high level of ongoing scrutiny. State and federal
    investigations of price spikes have consistently cleared the industry
    of any wrongdoing. For example, after a 9-month FTC investigation into
    the causes of price spikes in local markets in the Midwest during the
    spring and summer of 2000, former FTC Chairman Robert Pitofsky stated,
    ``There were many causes for the extraordinary price spikes in Midwest
    markets. Importantly, there is no evidence that the price increases
    were a result of conspiracy or any other antitrust violation. Indeed,
    most of the causes were beyond the immediate control of the oil
    companies.'' On April 25, 2002, Chairman Pitofsky appeared before the
    Senate Commerce Committee. His testimony detailed the Commission's
    efforts to review proposed oil industry mergers, including requiring
    significant assets sales to eliminate competitive concerns. He said,
    ``. . . the merger wave reflects a dynamic economy which, on the whole,
    is a positive phenomenon.''
        A recent U.S. General Accounting Office (GAO) report concluded that
    mergers and acquisitions have increased average wholesale gasoline
    prices by one-half cent per gallon. However, even this modest figure is
    strongly suspect. FTC chairman Timothy J. Muris strongly criticized the
    reliability of the GAO report, citing ``major methodological mistakes
    that make its quantitative analyses wholly unreliable; . . . critical
    factual assumptions that are both unstated and unjustified; and . . .
    conclusions that lack any quantitative foundation.''
        Other evidence appears to undermine the GAO's conclusions. A
    comparison of EIA price data for the six years before the mergers
    (1990-1996) and a similar period after (1997-2003), indicates a
    reduction of five cents on average in retail prices occurred during the
    latter period.
        Merger critics sometimes suggest that the industry can affect
    prices because it has become much more concentrated, with a handful of
    companies controlling most of the market. This is untrue. According to
    data compiled by the U.S. Department of Commerce and by Public Citizen,
    in 2003 the four largest U.S. refining companies controlled a little
    more than 40% of the nation's refining capacity. In contrast, the top
    four companies in the auto manufacturing, brewing, tobacco, floor
    coverings and breakfast cereals industries controlled between 80% and
    90% of the market.

    REFINERS ARE WORKING HARD TO KEEP PACE WITH GROWING DEMAND FOR GASOLINE
                               AND OTHER PRODUCTS

        Refiners are addressing supply challenges and working hard to
    supply sufficient volumes of gasoline and other petroleum products to
    the public. During the four-week period ending July 2, 2004, the EIA
    reported that refiners produced 8.7 million barrels per day of
    gasoline, a 2.6% increase over the same period last year.
        Refineries are running at record levels, producing record amounts
    of gasoline and distillate for this time of year. Refiners have
    operated at an average utilization rate of 96% since before the start
    of the summer driving season. To put this in perspective, peak
    utilization rates for other manufacturers average about 82%. At times
    during the summer, refiners operate at rates close to 98%. However,
    such high rates cannot be sustained for long periods.
        In addition to coping with the higher fuel costs and growing
    demand, refiners are implementing a transition to cleaner gasoline
    across most of the nation. The sulfur level in gasoline was reduced
    from an average of 300 parts per million (ppm) to a corporate average
    of 120 ppm effective January 1, 2004, giving refiners an additional
    challenge in both the manufacture and distribution of fuel. Average
    gasoline sulfur content will be further reduced to 90 ppm on January 1,
    2005, and to 30 ppm on January 1, 2006 (California already has a 30 ppm
    sulfur cap). Refiners across the industry are investing $8 billion
    dollars to achieve these significant reductions in gasoline sulfur, a
    source of harmful air emissions. The industry is investing another $8-
    10 billion to achieve equally significant reductions in the sulfur
    content of diesel fuel.
        Of equal importance, California, New York and Connecticut bans on
    use of MTBE went into effect January 1. This is a major change
    affecting one-sixth of the nation's gasoline market. Where MTBE was
    used as an oxygenate in reformulated gasoline, it accounted for as much
    as 11% of RFG supply at its peak, and substitution of ethanol for MTBE
    does not replace all of the volume lost by removing MTBE. (Ethanol's
    properties limit its ability to substitute for lost MTBE volume; it
    actually replaces less than 50% of the volume lost when MTBE is
    removed.) That missing portion of supply must be replaced by additional
    production of gasoline or gasoline blendstocks.
        Apparently due to these changes in gasoline specifications, the
    volume of gasoline imports declined roughly 7% year-to-date, although
    import volumes have recently increased. Gasoline imports account for
    about 10% of the U.S. market. They are especially important to PADD 1
    (the East Coast) where imports constitute 20% of supply. As U.S. fuel
    specifications change, foreign refiners may not be able to supply the
    U.S. market without making expensive upgrades at their facilities. They
    may eventually elect to do so, but a time lag may occur, with
    potentially adverse impacts on gasoline supply in the meantime.
        Refiners have also completed the annual switch to summer gasoline
    blends, a process which was complicated by the new ethanol mandate in
    markets like New York, Connecticut and California that previously
    experienced little ethanol use. These complications reflect the need to
    adjust the gasoline blend for increased emissions of ozone precursors
    in warm weather. Even without this complication, the seasonal switching
    sometimes impacted the market in recent years because storage tanks
    must be completely drained to accommodate summer fuel.
        Obviously, refiners face a daunting task in rationalizing all these
    changes to provide the fuels that consumers and the nation's economy
    depend on. But they are succeeding. And regardless of recent press
    stories, we need to remember that American gasoline and other petroleum
    products remain a bargain when compared to the price consumers pay for
    those products in other large industrialized nations.

          REFINERS ARE HEAVILY REGULATED; THEY FACE A BLIZZARD OF NEW
          ENVIRONMENTAL REQUIREMENTS FOR BOTH FACILITIES AND PRODUCTS.

        Refiners currently face the massive task of complying with fourteen
    new environmental regulatory programs with significant investment
    requirements, all in the same 2002--2010 timeframe. (See Attachment 5)
    For the most part, these regulations are undertaken pursuant to the
    Clean Air Act. Some will require additional emission reductions at
    facilities and plants, while others require further changes in clean
    fuel specifications. NPRA estimates that refiners are in the process of
    investing about $20 billion to sharply reduce the sulfur content of
    gasoline and both highway and off-road diesel (These costs do not
    include significant additional investments needed to comply with
    stationary source regulations affecting refineries). And refiners may
    also face additional investment requirements to deal with limitations
    on ether use, as well as compliance costs for controls on Mobile Source
    Air Toxics and other limitations.
        On the horizon are still other potential environmental regulations
    which could force additional large investment requirements. They are:
    the challenges posed by increased ethanol use, possible additional
    changes in diesel fuel content involving cetane, and potential
    proliferation of new fuel specifications driven by the need for states
    to comply with the new eight-hour NAAQS ozone standard. The new 8-hour
    standard could also result in more regulations affecting facilities
    such as refiners and petrochemical plants. The industry must also
    supply two new mandatory RFG areas (Atlanta and Baton Rouge) under the
    ``bump up'' policy of the current one-hour ozone NAAQS.
        These are only some of the pending and potential air quality
    challenges that the industry faces. Refineries are also subject to
    extensive regulations under the Clean Water Act, Toxic Substances
    Control Act, Safe Drinking Water Act, Oil Pollution Act of 1990,
    Resource Conservation and Recovery Act, Emergency Planning and
    Community Right-To-Know (EPCRA), Comprehensive Environmental Response,
    Compensation, and Liability Act (CERCLA), and other federal statutes.
    The industry also complies with OSHA standards and many state statutes.
    A complete list of federal regulations impacting refineries is included
    with this statement. (See Attachment 6)
        The American Petroleum Institute (API) estimates that, since 1993,
    about $89 billion (an average of $9 billion per year) has been spent by
    the oil and gas industry to protect the environment. This amounts to
    $308 for each person in the United States. And more than half of the
    $89 billion was spent in the refining sector.

    A KEY GOVERNMENT ADVISORY PANEL URGED REGULATORS TO PAY MORE ATTENTION
                               TO SUPPLY CONCERNS

        In 2000, the National Petroleum Council (NPC) issued a landmark
    report on the state of the refining industry. Given the limited return
    on investment in the industry and the capital requirements of
    environmental regulations, the NPC urged policymakers to pay special
    attention to the timing and sequencing of any changes in product
    specifications. Failing such action, the report cautioned that adverse
    fuel supply ramifications could result. Unfortunately, this warning has
    been widely disregarded. On June 22, 2004, Energy Secretary Abraham
    asked NPC to update and expand its refining study with a completion
    date of September 30, 2004. Information in this new study could be used
    to improve energy policy. Unfortunately, there is little evidence that
    the NPC's 2000 recommendations were implemented.
        Some policymakers seem to recoil from the obvious fact that clean
    fuel proposals that do much good also involve significant costs. They
    are not free. Those costs do affect refining industry economics and
    fuel production capacity. We would point to the public rulemaking
    record illustrating recommendations industry has made on environmental
    regulations over the past eight years. The refining industry has
    consistently supported continued environmental progress, but cautioned
    regulators to balance environmental and energy goals by considering the
    supply implications of multiple new regulatory requirements, often
    overlapping and poorly coordinated. We have commented on many new
    stationary source and fuel proposals, urging adoption of reasonable and
    effective standards with appropriate lead times to facilitate
    investment and maintain supply. Many times, if not most, industry
    recommendations have been rejected, as regulators opt to promulgate
    more stringent standards without leaving a margin of safety for energy
    supply security.
        At the same time, when the domestic industry has made the
    significant capital expenditures required by the regulations, it is
    important that final regulations not be changed except in cases of
    absolute necessity. Stability and certainty in regulatory
    implementation is needed to encourage and recognize the investment of
    the regulated industry in the new regulations. A much better approach
    than granting waivers is to develop regulations that reflect from the
    outset the need for attention to fuel supply concerns before
    regulations are finalized, not during the implementation period after
    investments have already been made. Refiners are sometimes unfairly
    accused of seeking a ``rollback'' of environmental programs. This is
    not true. They favor implementation on schedule once the regulation is
    final and investments are made.
        This year, as gasoline markets began to reflect the implementation
    of Tier 2 gasoline sulfur reduction, policymakers seemed to consider
    easing the new gasoline sulfur specifications for some gasoline
    importers as a ``relief valve'' for the market, despite conflicting
    indications whether or not any real problems existed. This would have
    adversely affected the refining industry, which has already made
    substantial investments in gasoline sulfur reductions and is in the
    process of making equally large investments in diesel sulfur
    reductions. Even more importantly, this program change would have
    eliminated part of the environmental benefits of the Tier 2 program,
    for the benefit of foreign suppliers who did not invest, and to the
    detriment of U.S. refiners who did. Fortunately, EPA decided to take no
    action to waive gasoline sulfur requirements for importers.
        And of course, when any party suggests that regulatory relief is
    needed on a rule of this type, it is important that EPA consult with
    and work closely with the EIA, which has expertise in gasoline supply
    and demand analysis, along with other stakeholders who will be affected
    by such requirements.
        Waivers may merit consideration on rare occasions, and they are
    tools available to regulators. But there should be a high burden of
    proof for waiver proponents. Waivers, by their very nature, raise
    uncertainty and threaten unfair loss of investment in the affected
    market. However, where there is universal agreement that a particular
    rule or policy is no longer valid, or better options exist for reaching
    desired objectives, then certainly that policy should be reconsidered.
    An excellent example is the 2% oxygenate requirement for reformulated
    gasoline (RFG), which should be repealed. In the meantime, NPRA
    supports the waiver of the 2% requirement requested by California and
    New York.

       REFINERS WILL DO THEIR BEST TO MEET CONTINUING SUPPLY CHALLENGES;
             MERGERS, ACQUISITIONS AND SOME CLOSURES WILL CONTINUE

        Domestic refiners will rise to meet the supply challenges in the
    short and the long term with the help of policymakers and the public.
    They have demonstrated the ability to adapt to new challenges and
    maintain the supply of products needed by consumers across the nation.
    But certain economic realities cannot be ignored and they will impact
    the industry. Refiners will, in most cases, make the investments
    necessary to comply with the environmental programs outlined above. In
    some cases, however, where refiners are unable to justify the costs of
    investment at some facilities, facilities may close or be sold or the
    refiner may exit certain product markets. These are economic decisions
    based on facility profitability relative to the size of the required
    investment needed to stay in business either across the board or in one
    product line, such as U.S. highway diesel fuel. In the case of a
    refinery sale, a new owner may be able to invest and keep a facility
    operating that would otherwise have closed. In some cases, however, it
    may be difficult or impossible to find a buyer.
        EIA has addressed the subject of past and future refinery closures:
    ``Since 1987, about 1.6 million barrels per day of capacity has been
    closed. This represents almost 10% of today's capacity of 16.8 million
    barrels per calendar day . . . The United States still has 1.8 million
    barrels of capacity under 70 MB/CD (million barrels per calendar day)
    in place, and closures are expected to continue in future years. Our
    estimate is that closures will occur between now and 2007 at a rate of
    about 50-70 MB/CD per year.'' (EIA, J. Shore, ``Supply Impact of Losing
    MTBE & Using Ethanol,'' October 2002, p. 4.)

              REFINING INDUSTRY ECONOMICS ARE WIDELY MISUNDERSTOOD

        Refining industry profitability is also not well understood.
    According to data compiled by EIA (Performance Profiles of Major Energy
    Producers), the ten-year average return on investment in the industry
    is about 5.5%; this is about what investors could receive by investing
    in government bonds, with little or no risk. It is also less than half
    of the S& P Industrials figure of a 12.7% return. In 2002, the return
    was a negative 2.7% for refining, compared to a positive 6.6% for the S
    & P Industrials. This relatively low level of refiners' return, which
    incorporates the cost of capital expenditures required to meet
    environmental regulations, is another reason why domestic refinery
    capacity additions have been modest and helps explain why new
    refineries are less likely to be constructed here in the U.S.
        Refining industry profits as a percentage of operating capital are
    relatively modest. In dollars, they appear to be large due to the
    massive scale needed to compete in the world's largest industry. A new
    medium-scale refinery (100,000 to 200,000 barrels/day capacity) would
    cost $2 to $3 billion. And, over the last decade, companies spent about
    $5 billion per year on environmental compliance with refinery and fuels
    regulations. While they significantly improved air quality, these
    investments also help explain the low percentage return on refinery
    investment.
        An important reason the industry's profitability is not well
    understood is because the media typically report only half the story--
    the dollars in profits earned. Oil companies may earn a lot of money,
    but only after they spend huge sums to produce and market the products
    they sell, and only by selling in extremely high volumes. It is by
    looking at ``profit margins''--how much money is earned on each dollar
    of sales--that a more complete ``profits'' story is told. This year,
    for example, higher gasoline prices have contributed to company
    revenues, but average profit margins (measured as net income divided by
    sales) were below those of other industries in the first quarter, as
    reported last May in Oil Daily and Business Week. In short, industry
    revenues can be in the billions, but so, too, are the costs of
    operations.
        For the first quarter of 2004, the U.S. oil and gas industry, which
    includes producers, refiners and marketers, earned an average of 6.9
    cents on every dollar of sales. This was below the U.S. all-industry
    average, which was 7.5 cents. Independent refiners and marketers earned
    an average of just 1.8 cents on every dollar of sales, even though
    their profits increased 50% over the previous year. In short, it is
    important to keep the full story in mind when reading reports about oil
    industry profits.

    THERE ARE NO ``QUICK FIXES'' TO CURRENT MARKET CONDITIONS; POLICYMAKERS
             AND THE PUBLIC MUST NOT LOSE FAITH IN THE FREE MARKET

        Modern energy policy relies upon an important tool which encourages
    market participants to meet consumer demand in the most cost-efficient
    way: market pricing. The free market swiftly provides buyers and
    sellers with price and supply information to which they can quickly
    respond.
        Industry appreciates the patience and restraint that the public and
    policymakers have shown in responding to current market conditions and
    the higher cost of gasoline. Unfortunately, in the short term there are
    no ``silver bullets'' to alleviate the higher costs of gasoline this
    summer. Putting the current situation in a broader, more positive
    perspective, however, the U.S. has some of the cleanest and least
    costly fuels in the world.
        NPRA recommends that policymakers take particular care in weighing
    the impact of so-called ``boutique fuel'' gasolines. In many cases,
    these programs represent a local area's attempt to address its own air
    quality needs in a more cost-effective way than with RFG, which is
    burdened by an overly prescriptive recipe and an oxygenation mandate.
    Boutique fuels only result in supply problems when a refinery problem
    or pipeline outage occurs. (As in the Midwest in 2000 and Phoenix in
    2003.) In contrast, the current market situation results from high
    crude prices and strong demand. There is as much disagreement about the
    number of boutique fuels as there is lack of hard evidence about their
    impact. Better to study the situation, as H.R. 6 would require, than
    legislate in a knowledge vacuum, which might make matters worse.
    Refiners believe that the elimination of the 2% RFG oxygenation
    requirement and widespread availability of very low sulfur gasoline
    beginning in 2006 will eliminate the need for boutique fuels in many
    regions.
        Industry supports further study of the ``boutique fuels''
    phenomenon, but urges members of the Committee to resist imposition of
    any fuel specification changes on top of those already in progress.
    Further changes in fuel specifications in the 2004--2010 timeframe
    could add greater uncertainty to a situation which already provides
    significant challenges to U.S. refiners.

              REFINERS ARE COMMITTED TO SAFE AND SECURE FACILITIES

        NPRA and its members are absolutely committed to keeping all our
    facilities as secure as possible from threats of violence or terrorism.
    Contrary to what a few press articles would have us believe, industry
    is not standing idly by, waiting for the government to act before
    conducting comprehensive security vulnerability assessments and
    implementing strong facility security measures. Refiners and
    petrochemical manufacturers are heavily engaged--and were even before
    September 11--in maintaining and enhancing facility security.
        NPRA has held or has co-sponsored more than a dozen conferences and
    workshops dedicated to helping refiners and petrochemical manufacturers
    strengthen facility security. NPRA has worked with the American
    Petroleum Institute, the Argonne National Laboratory, and
    representatives of the DHS Information Analysis & Infrastructure
    Protection Directorate to develop a sophisticated and effective
    methodology for conducting facility security assessments. The
    methodology is the product of many minds, and it is being used
    successfully in large and medium-sized facilities. A new edition of the
    methodology will be coming out soon, this one incorporating security
    information dealing with truck and rail transportation to and from our
    facilities.
        We also work closely with federal, state, and local governments to
    address security issues. Some of these agencies include the CIA, the
    FBI, the Department of Transportation, the Department of Energy, the
    Department of Defense, the Chemical Safety and Hazard Investigation
    Board, and of course the Department of Homeland Security and its
    various components, including the U.S. Secret Service, the
    Transportation Security Agency, and the U.S. Coast Guard, as well as
    various state and local emergency response and law enforcement
    officers.
        The U.S. Coast Guard has been particularly helpful, as refiners and
    petrochemical manufacturers have conducted security vulnerability
    assessments and implemented facility security plans pursuant to the
    requirements of the Maritime Transportation Security Act. NPRA
    estimates that more than half of all its members' facilities are
    subject to the Coast Guard's security regulations. The Coast Guard has
    made hundreds of site visits to refineries and petrochemical plants,
    and industry personnel are working closely with the Coast Guard to
    assure these facilities are kept secure.
        NPRA and its members strongly believe that federal security efforts
    must be conducted by experienced organizations such as these, and not
    delegated to other branches of government that lack law enforcement and
    intelligence capabilities and security resources.
        The Environmental Protection Agency (EPA) regulates the safe use,
    storage, management and disposal of many potentially dangerous
    substances, and will continue to do so. But EPA does not have facility
    security expertise. Security is not its mission. This is a role
    Congress has delegated to the Department of Homeland Security. NPRA is
    opposed to policies that would disrupt current security initiatives and
    splinter security responsibility away from the Department of Homeland
    Security.
        In short, refiners and petrochemical manufacturers have spent many
    hours of effort and millions of dollars to enhance physical and cyber
    security, and they will continue to do so.

                                   CONCLUSION

        There is a very close connection between federal energy and
    environmental policies. Unfortunately, these policies are often debated
    and decided separately and thus in a vacuum. As a result, positive
    impacts for one policy area sometimes conflict with or even undermine
    goals and objectives in the other.
        Industry therefore requests that an updated energy policy be
    adopted incorporating the principle that, in the case of new
    environmental initiatives affecting fuels, environmental objectives
    must be balanced with energy supply requirements. We believe these
    regulations should contain an express statement of the impact on the
    domestic refining industry and U.S. fuel supply. As explained above,
    the refining industry is in the process of redesigning much of the
    current fuel slate to obtain desirable improvements in environmental
    performance. This task will continue because consumers desire higher-
    quality and cleaner-burning fuels. And our members want to satisfy
    their customers. We ask only that the programs be well-designed, well-
    coordinated, appropriately timed and cost-effective. The Committee can
    advance both the cause of cleaner fuels and preserve the domestic
    refining industry by adopting this principle as part of the nation's
    energy and environmental policies.
        A healthy and diverse U.S. refining industry serves the nation's
    interest in maintaining a secure supply of energy products.
    Rationalizing and balancing our nation's energy and environmental
    policies will protect this key American resource. Given the challenges
    of the current and future refining environment, the nation is fortunate
    to retain a refining industry with many diverse and specialized
    participants. Refining is a tough business, but the continuing
    diversity and commitment to performance within the industry demonstrate
    that it has the vitality needed to continue its important work,
    especially with the help of a supply-oriented national energy policy.

                                RECOMMENDATIONS

        We make the following recommendations to address concerns regarding
    fuel supplies, environmental regulations, and market issues.

     Enacting the Conference Report on HR 6, a balanced and fair energy
            bill that brings energy policy into the 21st century, is the
            most important step needed to encourage new energy supply and
            streamline regulations.
     Public policymakers should balance environmental policy objectives
            and energy supply concerns in formulating new regulations and
            legislation.
     EPA should grant the California and New York requests to waive the 2%
            oxygen requirement for federal RFG. This will give refiners
            increased flexibility to deal with changing market conditions.
            It will also allow them to blend gasoline to meet the standards
            for reformulated gasoline most efficiently and economically,
            without a mandate.
     Congress should support the New Source Review reforms as well as
            other policy changes that encourage capacity expansions at
            existing refineries.
     Congress should enact legislation that streamlines the permitting
            process for refinery expansion projects, new refineries, and
            other key refining projects. Congress should consider declaring
            expansion of U.S. refining capacity a national priority, and
            provide guidelines for consideration of refining permits.
     Congress should be cautious about making any policy changes affecting
            ``boutique fuels.'' More information is needed about boutique
            fuels, as well as future developments that may reduce the
            number of boutique fuels without legislative action.
     Policymakers must resist turning the clock backwards to the failed
            policies of the past. Experience with price constraints and
            allocation controls in the 1970s and 1980s demonstrates the
            failure of price regulation, which adversely impacted both fuel
            supply and consumer cost.
        The industry looks forward to continuing to work with this
    Subcommittee, and thanks the Chairman for holding this important
    hearing. I would be glad to answer any questions raised by our
    testimony today.

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        Mr. Hall. Thank you, Mr. Slaughter.
        The Chair recognizes Mr. Blakeman Early, Environmental
    Consultant, American Lung Association. Mr. Early, we recognize
    you for 5 minutes, sir.

                     STATEMENT OF A. BLAKEMAN EARLY

        Mr. Early. Thank you, Mr. Chairman and members of the
    committee. I am Blakeman Early, and I am here on behalf of the
    Lung Association.
        The Clean Air programs that we believe most affect the
    refining industry are the Reformulated Gasoline Program and the
    low-sulfur requirements for gasoline, on-road diesel, and off-
    road diesel fuel. These clean fuels are a cornerstone of the
    Clean Air Act. I will confine my remarks to these programs.
        RFG has been shown by EPA in California to be a cost-
    effective program to reduce vehicle emissions that contribute
    to ozone, and reduce toxic air pollution from vehicles by 30
    percent. Low-sulfur gasoline, on-road diesel, and non-road
    diesel requirements issued by both the Clinton and Bush
    Administrations are key to enabling a new generation of
    emission controls everything from SUVs to diesel trucks to
    earth movers that will reduce smog, fine particulate air
    pollution and toxic air pollution, and save tens of thousands
    of lives, heart attacks, respiratory-related hospitalizations,
    and reduce thousands of asthma attacks among children each and
    every year.
        The benefits from these low-sulfur fuel programs are
    enormous, calculated to approximate $24, $51, and $53 billion
    each year for those three respective programs when they are
    fully implemented. Any attempt to modify these rules at this
    juncture without thoroughly evaluating the risks of disrupting
    these programs in ways that could reduce or delay the large
    public health benefits we need them to be deliver must be
    scrutinized very carefully. Those who propose these changes
    bare a very heavy burden of showing the need and demonstrating
    the benefit. This is because air pollution still threatens
    millions of Americans. The American Lung Association found 441
    counties, home to 136 million people, have monitored unhealthy
    levels of either ozone or particulate air pollution.
        We believe that should Congress choose to change the law or
    gasoline policy, it should do so in ways that make it easier
    for areas with dirty air to adopt clean fuels programs, and not
    lock in the use of dirtier conventional fuels.
        In mid June, many members of this committee voted for H.R.
    4545, the Gasoline Price Reduction Act of 2004. This bill would
    violate the principal I just espoused. The bill is unneeded,
    overly broad, and can be used in ways that would reduce public
    health protection already adopted in States' implementation
    plans to reduce air pollution.
        The bill also would limit future adoption of these needed
    fuel requirements for all fuels by States based on arbitrary
    limits that would not alleviate gasoline price or supply
    concerns.
        There is no evidence that current clean fuel programs
    significantly influence current gasoline price increases.
    Prices for both clean fuels and conventional gasoline have
    risen at the same rate broadly across the entire Nation, and
    prices for clean fuels generally have not risen faster for
    clean fuels than for conventional gasoline. In some cases,
    conventional gasoline is the same or more expensive than RFG,
    although this has varied in recent weeks. I have two charts in
    my testimony that illustrate my point.
        The one clean fuel requirement that we believe does
    contribute to price volatility is the Federal oxygen
    requirement. The one thing the Bush Administration should do is
    grant California's request for an oxygen waiver. Granting the
    waive would improve air quality and reduce gasoline prices in
    California, and perhaps in other parts of the country. EPA has
    been avoiding a decision on this urgent matter and treating it
    as a routine matter.
        I attached to my testimony a letter signed by nine health
    and environmental organizations urging Administrator Leavitt to
    grant the waiver immediately. This is a priority matter that
    could make a real difference this summer, Mr. Chairman. And I
    will take any questions you may have for me. Thank you.
        [The prepared statement of A. Blakeman Early follows:]

    Prepared Statement of A. Blakeman Early on behalf of the American Lung
                                  Association

        Mr. Chairman and members of the committee, my name is A. Blakeman
    Early. I am pleased to appear today on behalf of the American Lung
    Association. Celebrating its 100th anniversary this year, the American
    Lung Association has been working to promote lung health through the
    reduction of air pollution for over thirty years. I am here today to
    discuss elements of the Clean Air Act that impact the oil refining
    industry and gasoline prices.

    Clean Fuels Are a Cornerstone of the Clean Air Act
        The Clean Air Act programs that we believe most affect the refining
    industry are the Reformulated Gasoline Program (RFG) and the low-sulfur
    requirements for gasoline, on-road diesel, and off-road diesel fuel. We
    recognize that there are important stationary source requirements of
    the Clean Air Act that impact the refining industry. However, because
    of their importance, I will limit my comments to the most significant
    fuel requirements of the law.

    Reformulated Gasoline
        As has been demonstrated in California and across the nation,
    reformulated gasoline can be an effective tool in reducing both
    evaporative and tailpipe emissions from cars and trucks that contribute
    to smog. Based on separate cost effectiveness analyses by both EPA and
    California, when compared to all available emissions control options,
    reformulated gasoline (RFG) is a cost-effective approach to reducing
    the pollutants that contribute to smog.1 Compared to
    conventional gasoline, RFG has also been shown to reduce toxic air
    emissions from vehicles by approximately 30 percent.2 A
    study done by the Northeast States for Coordinated Air Use Management,
    an organization of state air quality regulators, estimated that ambient
    reduction of toxic air pollutants achieved by RFG translates into a
    reduction in the relative cancer risk associated with conventional
    gasoline by a range of 18 to 23 percent in many areas of the country
    where RFG is used.3
    ---------------------------------------------------------------------------
        \1\ U.S. Environmental Protection Agency, Regulatory Impact
    Analysis, 59 FR 7716, docket No. A-92-12, 1993.
        \2\ Report of the Blue Ribbon Panel on Oxygenates, September 1999,
    pp.28-29.
        \3\ Relative Cancer Risk of Reformulated Gasoline and Conventional
    Gasoline Sold in the Northeast, August 1998, p. ES-6, found at www.
    Nescaum.org.
    ---------------------------------------------------------------------------
        The benefits from RFG accrue from evaporative and tailpipe
    emissions reductions from vehicles on the road today, as well as from
    non-road gasoline powered engines, such as lawn mowers. They begin as
    soon as the fuel is used in an area. As with most Clean Air Act
    programs, the RFG program has cost less than estimated and the
    emissions benefits have been greater than expected or required by law.
    It is no wonder that RFG or other clean gasoline programs are in use in
    15 states, according to EPA.

    Low Sulfur Conventional Gasoline
        This year begins the phase in of sulfur reduction requirements for
    all gasoline, which will be fully implemented by the end of 2006. These
    requirements derive from the Tier 2/Gasoline Sulfur rule issued during
    the Clinton Administration. This program is even more significant than
    the RFG program because the lower sulfur levels required in
    conventional gasoline will reduce tailpipe emissions from vehicles and
    other engines used today not just in RFG areas, but virtually across
    the nation. More importantly, the limit on sulfur in gasoline enables
    the use of very sophisticated technology on a new generation of
    gasoline- powered vehicles (including SUVs) that will generate very low
    rates of tailpipe emissions. These emissions reductions will grow as
    the new cleaner vehicles replace older dirtier ones. This program is so
    important to offset the growth in vehicle emission attributable to the
    fact that each year more people are driving more vehicles more miles
    than ever before. The Tier 2/Gasoline Sulfur requirements will replace
    and unify varying sulfur limits found in so-called ``boutique'' fuels
    standards as well as RFG. In other words, all gasoline sold in the
    nation will meet the same sulfur limits, except in California.
        The estimated benefits from the Tier2/Gasoline Sulfur rule will be
    enormous. EPA estimates that when fully implemented, the program will
    reduce premature mortality, hospital admissions from respiratory causes
    and a range of other health benefits that have a monetized benefit of
    over $24 billion each year.4 The actual benefits will likely
    be higher if history is any guide in these matters.
    ---------------------------------------------------------------------------
        \4\ Tier 2/Sulfur Regulatory Impact Analysis, December 1999, p.
    VII-54.
    ---------------------------------------------------------------------------
        At this point I am going to say something unexpected. It is
    important to note that with respect to the RFG program and the Tier 2
    sulfur reduction program the refining industry is getting the job done
    and at a cost below what it and others predicted. Moreover, refiners
    are reducing toxic emissions from RFG by a significantly larger
    percentage than the minimum required by the Clean Air Act Some
    refiners, such as BP have met low sulfur goals ahead of legal
    requirements and are using their success as a marketing tool and even
    have received public recognition from American Lung Association state
    affiliates. We at the American Lung Association want to give credit
    where credit is due.

    Low Sulfur On-Road Diesel Fuel
        While the Tier 2 rule was issued by the Clinton Administration, the
    value of clean fuels has not been lost on the Bush Administration. The
    Heavy Duty Diesel Engine/Diesel Fuel rule was first issued in the
    Clinton Administration and was reaffirmed by the Bush Administration in
    January 2000. Like the Tier 2 rule, this rule will provide immediate
    benefits from reductions of both NOx and particulate emissions from
    diesel fueled vehicles on the road today but also enable the
    application of new technology to a new generation of heavy duty diesel
    engines used in trucks and buses in the future that will reduce
    particle and NOx emissions from the vehicles by 90%. The sulfur
    reduction requirements for on-road diesel fuel are phased in beginning
    in 2007.
        Diesel emissions are an important contributor of NOx, a precursor
    of smog. More importantly, heavy-duty diesel emissions generate a large
    amount of fine particle air pollution that is associated with premature
    mortality and cancer. The EPA estimates that when fully implemented,
    the HD Diesel Engine/Diesel Fuel rule will provide health benefits that
    approximately double the Tier 2 rule at a monetized calculation of
    nearly $51 billion each year.5
    ---------------------------------------------------------------------------
        \5\ HD Engine/Diesel Fuel Regulatory Impact Analysis, January 18,
    2001, p. VII-64.
    ---------------------------------------------------------------------------
        Finally, in further recognition of the importance diesel emissions
    play as a contributor to both smog and fine particle pollution, the
    Bush Administration just issued in May a new Off-Road Diesel Engine/
    Diesel Fuel rule Through phased reductions of sulfur in off-road diesel
    fuel this rule will achieve immediate emissions reductions from a
    diverse group of diesel engines used in construction, electricity
    generation and even trains and marine vessels. The clean fuel
    requirements of this rule, too, will enable a new generation of much
    cleaner off-road diesel engines which will result in lower diesel
    emissions far into the future as older engines are replaced.
        My understanding is that the estimate of health benefits from this
    rule will be even greater than the HD Engine/Diesel Fuel rule in large
    part because this category of engines and their fuel have been under
    regulated in comparison to other engine sectors. EPA projects that,
    when fully implemented, health benefits to include: 12,000 fewer
    premature deaths, 15,000 fewer heart attacks, 6,000 fewer emergency
    room visits by children with asthma, and 8,900 fewer respiratory-
    related hospital admissions each year.6
    ---------------------------------------------------------------------------
        \6\ EPA Regulatory Announcement: Public Health and Environmental
    Benefits of EPA's Proposed Program for Low-Emission Nonroad Diesel
    Engines and Fuel. April 2003.
    ---------------------------------------------------------------------------
    We Oppose Changes to Clean Fuels Programs That Weaken or Delay
            Emissions Reductions
        Each of the regulations implementing the clean fuels programs and
    requirements were the product of a broad, lengthy and public process
    that ultimately reached a delicate political and substantive
    compromise. No party got everything it wanted. Each rule provides large
    and critical emissions reductions needed to protect public health. Any
    attempt to modify these rules at this juncture without thorough
    evaluation risks disrupting these programs in ways to could reduce or
    delay the large public health benefits we need them to deliver. Such
    changes also risk penalizing those refiners who have made the
    commitment to meet the requirements of these programs, some times
    earlier than required. Those who propose changes bear a heavy burden of
    showing the need and demonstrating the benefit.

    Air Pollution Still Threatens Millions of Americans
        Although we have made important progress in reducing air pollution,
    the battle is far from being won. This is true in part due to improved
    research in recent years which indicates that exposure to lower levels
    of smog over longer periods can have adverse health effects. The
    adverse impact of smog is being magnified also by the increase in the
    number of people with asthma. Smog is an important trigger of asthma
    attacks. New research has also revealed the lethality of so-called fine
    particle air pollution not only among those previously known as
    vulnerable such as people with asthma or chronic lung disease, but also
    among those with cardiovascular disease. This research is the
    foundation of the establishment of the eight-hour NAAQS for ozone and
    the NAAQS for PM 2.5 promulgated in 1997. Additional research since
    then has reinforced the need for these standards.7
    ---------------------------------------------------------------------------
        \7\ See Annotated Bibliography of Ozone Health Studies, January 27,
    2003 and Fact Sheet on Fine Particles, May 2003 at
    www.cleanairstandards.org a website of the American Lung Association
    ---------------------------------------------------------------------------
        The senate received testimony from Dr. George Thurston, a leading
    air pollution researcher, just a few weeks ago demonstrating that the
    progress in reducing eight-hour levels of ozone has stalled in recent
    years. A graph in his testimony, based on EPA monitoring data shows the
    decline in eight-hour ozone levels to be essentially flat between 1996
    and 2002.8
    ---------------------------------------------------------------------------
        \8\ Statement of George D. Thurston, Sc.D., before the Senate
    Environment and Public Works Committee, April 1, 2004, p.6.
    ---------------------------------------------------------------------------
        At the end of April, the American Lung Association released its
    State of the Air 2004 report identifying all the counties nation-wide
    with air pollution monitors that monitored unhealthy levels of smog and
    fine particles over the 2000-2002-time period. The report found that
    counties that are home to nearly half the U.S. population, 136 million
    people, experienced multiple days of unhealthy ozone each year. The
    report further found that over 81 million Americans live in areas where
    they are exposed to unhealthful short-term levels of fine particle air
    pollution. In all, the report found that 441 counties, home to 55% of
    the U.S. population have monitored unhealthy levels of either ozone or
    particle pollution. Among those vulnerable to the effects of air
    pollution living in these counties include 29 million children, 10
    million adults and children with asthma and nearly 17 million people
    with cardiovascular disease.9 As impressive as these numbers
    may seem, it is undoubtedly an under estimate of the nature of the air
    pollution problem in this country because far from every county has a
    monitor for either smog or particle pollution.
    ---------------------------------------------------------------------------
        \9\ State of the Air: 2004, pp. 5-11 at www.lungusa.org
    ---------------------------------------------------------------------------
    We Need Greater Use of Clean Fuels in Areas with Unhealthy Levels of
            Smog and Particulate Air Pollution
        As you know, on April 15 EPA designated all or part of 474 counties
    in non-attainment with the eight-hour National Ambient Air Quality
    Standard (NAAQS) for Ozone. Last week EPA proposed to designate
    approximately 233 counties in non-attainment for the fine particle or
    PM 2.5 NAAQS to take effect in December. These areas will be required
    to evaluate and select emissions reduction strategies that, in
    combination with the federal programs aimed at air pollution
    transported over long distances, will enable them to achieve the eight-
    hour standard and fine particle standards. The American Lung
    Association believes that many new non-attainment areas may want to
    adopt a clean fuels program using either RFG or a low volatility
    alternative or obtaining low sulfur diesel sooner than required by the
    regulations previously described. We believe that should congress
    choose to change the law or otherwise influence gasoline policy, it
    should do so in a way that makes it easier for areas that exceed air
    pollution standards to adopt clean fuels programs and not ``lock in''
    the use of dirtier conventional fuels. We need clean fuels programs to
    be broadly adopted to obtain clean air and protect the public health as
    soon as possible.
        Legislation that violated this principle was recently voted on in
    the House and garnered the support of many members of this committee.
    H.R. 4545, The Gasoline Price Reduction Act of 2004, was introduced by
    Mr. Blunt and, remarkably, was not the subject of a hearing or mark-up
    by this committee. The bill would have given EPA broad authority to EPA
    to waive state fuel or fuel additive SIP measures adopted under section
    211(c)(4) of the Clean Air Act based on a ``significant fuel
    disruption.'' It would also, among other provisions, limit the adoption
    of fuel or fuel additive SIP requirements by any area in the future if
    they exceeded a cap based on such requirements in effect on June 1,
    2004. The American Lung Association opposed several elements of this
    legislation.
        With regard to the waiver provision in Section 2 of the bill, it is
    not clear that current authority, which allows for EPA to exercise
    enforcement discretion, is insufficient in times of true disruption
    problems. As members of the committee may know, such discretion already
    has been exercised with respect to RFG in Chicago/Milwaukee, St. Louis,
    and Phoenix. The bill does not define ``significant supply
    disruption,'' limit the time period for the waiver, or require that
    offsets of lost emissions reductions be obtained in order to avoid air
    quality standards exceedences or to prevent disruption of timely
    attainment of air quality standards. In sum, Section 2 of the bill is
    unneeded, overly broad and could be used in ways that would reduce
    public health protections already adopted into law in state SIPS.
        Section 3 of the Blunt bill would operate as a limitation to the
    future adoption of fuel or fuel additive requirement or limitation in a
    state SIP based on the arbitrary number of such requirements in
    existence on June 1, 2004. This limitation would apply to all fuel and
    fuel additives requirements regardless of their need and even if such
    requirement placed no burden on gasoline price or supply. For instance,
    diesel fuel specifications limiting sulfur in diesel fuel used by ocean
    vessels or airplanes would be barred even though such requirements may
    have no direct impact on gasoline price or supply. Of importance to
    some members of this committee, a state could not adopt bio-diesel
    requirements into its SIP as part of an ozone or fine particle
    reduction strategy if it exceeded the artificial cap of Section 3.
    Lastly, this provision would provide a litigation hook for any interest
    to challenge an adopted fuel SIP requirement even if such challenge
    were not in the best interest of public health, lower gasoline prices,
    or improved gasoline supply. I have heard many members of this
    committee express the need to reduce the amount of litigation brought
    in this country. Section 3 might well result in more lawsuits, not
    fewer.
        At a minimum, H.R. 4545 needs a thorough review and mark-up by this
    committee before further consideration by the House. The American Lung
    Association would hope to convince you that this legislation is not
    needed and counter-productive to the effort to find ways to improve air
    quality using fuel strategies while not jeopardizing the affordability
    of our fuels. I have attached to my testimony a letter in opposition to
    H.R. 4545 signed by twelve environmental, health and air pollution
    control organizations.

    There is No Evidence That Current Clean Fuels Programs Significantly
            Influence Current Gasoline Price Increases
        As is customary when gasoline prices spike, some have recently
    suggested that the clean fuels programs, often referred to as
    ``boutique fuels'' are responsible. While it appears that clean
    gasoline programs in both California and the Chicago/Milwaukee area
    have contributed to temporary price spikes in the past, we believe
    there has been little evidence presented publicly demonstrating that
    clean fuels programs across the country are contributing in any
    significant way to today's high gasoline prices. Indeed, the evidence
    would suggest that systemic influences in gasoline production and
    marketing are the reason gasoline prices are as high as they are today.
    We believe this to be the case because: 1) gasoline prices have
    increased nation-wide, 2) conventional and clean gasoline prices are
    rising at the same rate, 3) in some areas, conventional gasoline is
    priced at or near the price of clean gasolines, 4) refiners are posting
    higher profits than they did a year ago when prices were lower.
        Both conventional and clean fuels have risen in price $.30 cents a
    gallon or more from a year ago. This increase has occurred in virtually
    all parts of the country regardless of where their gasoline comes from
    or who makes it. More significantly, the increases in price for
    conventional gasoline and clean gasolines have pretty much been the
    same. Attached to the end of my testimony I have prepared two
    unscientific charts that illustrates my point. I believe a more
    comprehensive examination of the data will support my conclusions. I
    encourage the committee to ask DOE or EPA to conduct such an
    examination.
        If the cost of producing clean gasoline were a major factor, the
    prices of these fuels would be rising at a faster rate. As my Chart A
    shows, this does not appear to be happening. What is noteworthy is that
    in the West, the ``rack'' or wholesale cost of conventional gasoline in
    the states that border California, which has the most stringent fuel
    requirements in the country, has risen more than in California. In Las
    Vegas conventional gasoline is actually more expensive than the average
    rack price in California and Reno is almost the same. Portland also has
    the same expensive conventional gasoline. In New York the RFG sold in
    the New York City/Connecticut area will for the first time use the same
    low volatility blend-stock used in the Chicago/Milwaukee market because
    of new state MTBE bans. Yet the price of conventional gasoline in
    Albany has risen at the same rate and maintains the same price spread
    as a year ago. Note in Chart A that Atlanta, which has required the use
    of a low volatility; low sulfur ``boutique'' for several years has
    experienced a price increase no greater than Macon, which uses
    conventional gasoline. Even when Atlanta introduced RFG with ethanol,
    its price increase is only three cents greater (See Chart B). Atlanta's
    fuel prices have consistently been below the national average price for
    conventional gasoline for reasons that remain a mystery. Since I
    collected the prices in Chart A, there has been much shifting in
    gasoline prices (See Char B) but the pattern has remained basically the
    same with some exception. In some areas the spread between RFG and
    conventional fuels is greater, notably the Portland and Las Vegas.
        The point is that the many other factors that impact gasoline
    price, lead by unsustainable growth in demand and the price of crude
    oil which is currently at or near $40 per barrel have historically
    driven price and do so today. Clean fuel requirements have an
    insignificant impact in comparison.

    The Bush Administration Should Grant the California Oxygen Waiver
            Request
        The one fuel requirement which operates as an exception to my
    testimony provided above is the federal oxygen requirement applicable
    to RFG in California As you know, California has been seeking a waver
    of the 2% oxygen requirement applicable to federal RFG sold in
    California since 1999. The state has provided impressive data showing
    that because California has banned MTBE and must use ethanol in every
    gallon of RFG sold in the state, emissions of soot and smog forming
    nitrogen oxides are higher compared to the use of California's Cleaner
    Burning Gasoline (CBG) without minimum oxygen levels met with ethanol.
    By all accounts, granting California's waiver request would increase
    the flexibility California refiners have to produce CBG and could lower
    gasoline prices modestly. The reduced need for ethanol in California,
    the largest in the nation, might even lower the cost of gasoline
    containing ethanol sold elsewhere across the country, such as in New
    York and Connecticut that have also banned MTBE. Yet EPA is not even
    giving California's request priority consideration even though it has
    been under court order since last October. A letter urging expedited
    approval of California's waiver request signed by nine health
    environmental organizations was sent to Administrator Leavitt last
    week. I have attached the letter to my testimony.

    If President Bush would order Administrator Leavitt to grant
            California's oxygen waiver request tomorrow, it would result in
            improved air quality an immediate reduction in gasoline prices
            in California and perhaps other parts on the nation.
        Finally, I must note that across the board, refiners are making
    more money this year than a year ago. The popular media has been filled
    with stories over the record high profits refiners earned in the first
    quarter of 2004. The cost of gasoline is high because demand continues
    to grow at an unsupportable pace. Refiners could make money by
    producing more gasoline, but selling it at a lower price. It is pretty
    obvious that they are not choosing this strategy. It is apparently
    easier and more profitable to maintain a larger gap between demand and
    supply and earn higher profits on a lower level of production.

                                     CHART A
                    RETAIL PRICE RISE COMPARISON OF CG & RFG
                               (Cents per gallon)
    ------------------------------------------------------------------------
                                                 5/6/03    5/6/04    Change
    ------------------------------------------------------------------------
    Chicago (RFG).............................    158.10    201.30    +43.20
    Champaign (CG)............................    141.70    186.00    +44.30
    St. Louis (RFG)...........................    137.80    183.60    +45.80
    Milwaukee (RFG)...........................    156.40    196.40    +40.00
    Madison (CG)..............................    150.20    192.00    +41.80
    Allentown (CG)............................    147.80    179.30    +31.50
    Philadelphia (RFG)........................    160.30    182.60    +22.30
    Atlanta (GG-low S, Low RVP)...............    133.10    173.70    +40.60
    Macon (CG)................................    129.80    169.50    +39.70
    Denver/Boulder (CG-low RVP)...............    144.70    182.30    +37.60
    Colorado Springs (CG).....................    145.60    185.10    +39.50
    Albany (CG)...............................    162.60    186.10    +23.50
    New York (RFG)............................    174.80    200.10    +25.30
    ------------------------------------------------------------------------

                              GASOLINE RACK PRICES
                               (Cents per gallon)
    ------------------------------------------------------------------------
                                                 5/1/03    4/29/04   Change
    ------------------------------------------------------------------------
    Portland..................................     97.22    152.05    +54.83
    Reno......................................     95.95    148.25    +52.30
    Las Vegas.................................     98.83    153.03    +54.20
    California Average........................    100.73    151.27    +50.54
    ------------------------------------------------------------------------

                                     CHART B
                    RETAIL PRICE RISE COMPARISON OF CG & RFG
                               (Cents per gallon)
    ------------------------------------------------------------------------
                                                 7/12/03   7/12/04   Change
    ------------------------------------------------------------------------
    Chicago (RFG).............................    162.00    199.20    +37.20
    Champaign (CG)............................    149.30    187.30    +38.00
    St. Louis (RFG)...........................    148.40    185.90    +37.50
    Milwaukee (RFG)...........................    156.10    195.00    +38.90
    Madison (CG)..............................    154.40    192.50    +38.10
    Allentown (CG)............................    143.60    183.70    +40.10
    Philadelphia (RFG)........................    151.50    196.30    +44.80
    Atlanta (RFG).............................    136.60    178.60    +42.00
    Macon (CG)................................    134.40    172.90    +38.50
    Denver/Boulder (CG-low RVP)...............    143.30    184.50    +41.20
    Colorado Springs (CG).....................    141.40    185.10    +43.70
    Albany (CG)...............................    149.20    196.40    +47.20
    New York (RFG)............................    165.70    221.70    +56.00
    ------------------------------------------------------------------------

                              GASOLINE RACK PRICES
                               (Cents per gallon)
    ------------------------------------------------------------------------
                                                 7/10/03   7/8/04    Change
    ------------------------------------------------------------------------
    Portland..................................     99.39    131.24    +31.85
    Reno......................................    104.35    145.49    +41.14
    Las Vegas.................................    100.65    144.73    +44.08
    California Average........................    108.46    153.55    +45.09
    ------------------------------------------------------------------------

        Mr. Hall. Thank you, Mr. Early.
        I recognize Mr. Red Cavaney, President, American Petroleum
    Institute.

                        STATEMENT OF RED CAVANEY

        Mr. Cavaney. Thank you, Mr. Chairman, for this opportunity
    to present the views of API's member companies on U.S. refining
    capacity and boutique fuels.
        Recent gasoline prices, while primarily caused by increased
    crude oil prices, have underscored the fact that U.S. demand
    for petroleum products has been growing faster than, and now
    exceeds, domestic refining capacity. While refiners have
    increased the efficiency, utilization, and capacity of existing
    refineries, these efforts have not enabled the refining
    industry to keep up with growing demand.
        Refiners have been operating at an average utilization rate
    of almost 96 percent over the past few months. To put this in
    perspective, the average annual utilization rate for all other
    manufacturing industries is 82 percent. At times during the
    summer drive season, refiners operate at rates close to 98
    percent. With virtually no excess capacity available, such high
    rates cannot be sustained for long periods of time.
        There are a number of reasons why no new refineries or
    major expansion projects have been undertaken in recent years.
    Economic factors have discouraged the investment needed to
    expand capacity. The average annual rate of return on capital
    investment for petroleum refining and marketing was 5.5 percent
    over the decade ending in 2002. This is significantly below the
    12.7 percent average annual return for the Standard & Poors
    Industrial. Similar results were also experienced in the decade
    immediately preceding the one I have just cited.
        Just to comply with environmental requirements, refiners
    must make massive investments while coping with a lengthy
    permit review process, regulatory uncertainty, stringent max
    deadlines, and continued NIMBY, the ``Not In My Back Yard,''
    public attitude.
        The refining situation needs to be addressed now. Congress
    can take an important step by passing the comprehensive Energy
    Bill, H.R. 6, which would encourage new energy supply and lead
    to greater production and distribution flexibility.
        Congress should also take some additional steps outlined in
    my written statement. These include aligning with other
    industries the depreciation life for refinery assets to 5
    years, codifying the President's Executive Order on assessing
    the energy impact of new regulations, taking steps to speed up
    the permit review process, codifying EPA's New Source Review
    reform rule, and minimizing the use of enforcement discretion
    in fuels regulation.
        Turning now to boutique fuels, while the patchwork of these
    localized fuels is not principally responsible for the recent
    higher gasoline prices, their proliferation in recent years has
    presented significant challenges to U.S. refiners and resulted
    in an inflexible fuel system. A classic example of the
    disadvantages of boutique fuels is the New York-New Jersey
    where gasoline intended for use in Bayonne, New Jersey cannot
    be used to address any supply shortage on the other side of the
    river in New York City.
        Importantly, we urge policymakers to take particular care
    in addressing boutique fuels, as there are many factors that
    affect this complex issue, and the law of unintended
    consequences can prove unforgiving.
        API and its member companies believe that the best way to
    address boutique fuel is to pass the comprehensive national
    energy legislation, H.R. 6. The Energy Bill would repeal the
    oxygen content requirement for reformulated gasoline in the
    Clean Air Act, which is a major driver of boutique fuel. It
    would also require a national phase-down of MTBE, and have EPA
    consult with DOE on the supply and distribution impacts of new
    State requests for specialized fuel.
        Finally, H.R. 6 requires EPA and DOE to conduct a
    comprehensive study of the impacts of boutique fuels, and make
    recommendations to Congress for addressing them within 18
    months of bill enactment.
        Given these significant changes and the benefits of the
    study recommendations, we urge Members of Congress to resist
    imposition of any additional fuel specification changes outside
    the context of the national energy legislation.
        API, NPRA, fuels marketers, and numerous agriculture and
    ethanol interests support the fuels provisions in H.R. 6. They
    offer carefully considered solutions to the fuels problems that
    have challenged both fuel providers and burdened energy
    consumers.
        Thank you for this opportunity to appear before this panel.
        [The prepared statement of Red Cavaney follows:]

        Prepared Statement of Red Cavaney, President and CEO, American
                              Petroleum Institute

        I am Red Cavaney, president and CEO of the American Petroleum
    Institute. API welcomes this opportunity to present the views of its
    member companies on U.S. refining capacity and boutique fuels. API is a
    national trade association representing more than 400 companies engaged
    in all sectors of the U.S. oil and natural gas industry.
        We are particularly gratified that this subcommittee is taking an
    interest in refining capacity. To summarize my message today: recent
    gasoline price increases, while primarily caused by increased crude oil
    prices, have underscored the fact that U.S. demand for petroleum
    products has been growing faster than--and now exceeds--domestic
    refining capacity. While refiners have increased the efficiency,
    utilization and capacity of existing refineries, these efforts have not
    enabled the refining industry to keep up with growing demand.
        Government policies are needed to create a climate conducive to
    investments to expand refining capacity. The refining situation needs
    to be addressed now. Congress can take an important step by passing the
    comprehensive energy bill, H.R. 6., which would encourage new energy
    supply and streamline regulations, leading to greater production and
    distribution flexibility.
        The Subcommittee is also considering boutique fuels, and I will
    address that subject following my discussion of refining capacity.
    Challenges for U.S. refiners
        While U.S. refiners are producing record amounts of gasoline,
    strong demand and a reduction in gasoline imports, due--at least in
    part--to new low-sulfur gasoline requirements, have tightened supply,
    putting upward pressure on prices. Press reports indicate that
    Venezuela may be unable to meet its target level for RBOB exports to
    the U.S., which could further tighten domestic supplies. (RBOB is the
    petroleum blendstock that is blended with ethanol to make reformulated
    gasoline.)
        Even with refineries running flat out, strong demand has kept
    inventories below average. Refiners have been operating at an average
    utilization rate of almost 96 percent over the past few months. To put
    this in perspective, the average utilization rate for other
    manufacturers is 82 percent. At times during the summer, refiners
    operate at rates close to 98 percent. However, with virtually no excess
    capacity available, such high rates cannot be sustained for long
    periods, especially given the inevitable need for shutdowns to perform
    crucial maintenance or to comply with new regulatory requirements.
        Regulations affecting the petroleum industry have made it harder
    for refiners to expand capacity and for distributors to move supplies
    around, especially when localized refinery and distribution problems
    occur. Both have contributed to tighter markets and, thus, higher
    gasoline prices. Four years ago, the National Petroleum Council (NPC),
    an industry advisory group to the U.S. Department of Energy, noted in a
    landmark report on the refining industry that the industry would be
    ``significantly challenged to meet the increasing domestic light
    petroleum product demand with the substantial changes in fuel quality
    specifications recently promulgated and currently being considered.''
    Some of these changes are now being implemented, including gasoline
    sulfur reductions and the removal of MTBE from significant parts of the
    gasoline pool.
        In its report, the NPC noted the limited return on investment in
    the industry and the capital requirements of complying with
    environmental regulations and urged policymakers to pay special
    attention to the timing and sequencing of any changes in product
    specifications. Failing such action, the report cautioned that adverse
    fuel supply ramifications could result. Therefore, had the NPC
    recommendations been acted upon when first put forth in 2000, today's
    shortfall in refining capacity may well have been minimized.
        Since the NPC issued its report, refiners have faced many new
    challenges in meeting gasoline demand. On January 1, 2004, a new
    federal regulation required the amount of sulfur in gasoline to be
    reduced from more than 300 parts per million (ppm) to a corporate
    average of 120 ppm--and then to 30 ppm in 2006--giving refiners an
    additional challenge in both the manufacture and distribution of fuel
    nationwide. Equally significant, California, New York and Connecticut
    bans on the use of MTBE also went into effect January 1. This is a
    major change affecting one-sixth of the nation's gasoline market.
        Where MTBE was used as the required oxygenate in reformulated
    gasoline (RFG), it accounted for as much as 11 percent of RFG supply at
    its peak, and the substitution of ethanol for MTBE does not replace all
    of the volume lost by removing MTBE. Ethanol's properties generally
    cause it to replace only about 50 percent of the volume lost when MTBE
    is removed. The missing volume must be supplied by additional gasoline
    or gasoline blendstocks. The resulting volume loss of moving from MTBE-
    blended gasoline to ethanol-blended gasoline is primarily due to
    changes that must be made to gasoline blendstocks (RBOB) to accommodate
    increased volatility, or RVP, with the use of ethanol. Light-end
    components of gasoline blendstocks must be removed, accounting for 5-6
    percent volume loss. In addition, ethanol may only be blended to as
    much as 10 percent by volume in gasoline, while MTBE is typically
    blended at 11 percent by volume in RFG.
    Refining capacity has increased but more needs to be done
        No new major refineries have been built in the U.S. since 1976.
    However, upgrading existing facilities has often allowed refiners to
    expand capacity. Thus, refining capacity has increased at about a 1.5
    percent annual rate over the last decade to about 16.7 million barrels
    per day, even as the number of refineries has decreased to fewer than
    150. Similarly, hydrocracker and coker capacity (which allow refiners
    to produce more light products from an increasingly heavier, more sour,
    crude slate) has increased by 30 percent and 60 percent, respectively,
    in the last decade. But progress in increasing refining capacity
    stalled, as new fuels regulations began to have an impact and EPA's
    reinterpretation of New Source Review and other regulations, begun in
    the 1990s, created increased uncertainty and jeopardized past
    investments for some companies.
        This year, short-term changes in crude slates have been made with
    refiners purchasing sweeter crudes, resulting in higher gasoline
    yields. However, such strategies are unlikely to be sustained in the
    face of the long-term production trend towards more sour crudes.
    Imports meet 10 percent of U.S. gasoline supply
        The U.S. currently must import nearly 10 percent of its gasoline
    supply to meet demand. This percentage will likely increase as demand
    for petroleum products outpaces domestic refinery production over the
    next decade, as projected by the Energy Information Administration.
    Reliance on gasoline imports has provided refiners with needed
    flexibility in meeting consumer demand and minimizing tight supplies.
        Historically, there has been spare refining capacity worldwide,
    which has allowed the U.S. to rely on product imports since World War
    II. However, many believe that excess worldwide refining capacity will
    have largely been consumed by as early as year-end as a result of
    growing foreign economies. Perhaps more importantly, the historical
    volatility in California prices shows that a combination of very high
    refinery utilization rates and extended transportation routes (imports)
    leads to volatile supply situations when the inevitable operational
    interruptions occur.

    Barriers to expanded refining capacity
        We don't know what prices will do in the future. We do know,
    however, that we will continue working hard to increase supplies of
    crude oil and gasoline to meet the nation's energy needs. Companies
    value their reputations as reliable providers of petroleum products.
    However, despite increasing capacity at the remaining refineries over
    the last 10 years, today, our nation has fewer than half the refineries
    and 90 percent of the capacity of the early 1980s. As for building new
    refineries, investors will need to believe the return on investment
    will be adequate into the future and that refiners will be able to
    obtain the necessary permits. For years, getting permission to build a
    new refinery or expand existing refineries in the United States has
    been an extremely difficult, inefficient and inordinately time-
    consuming process.
        While there is increased recognition that refining capacity
    expansion can help meet the growing consumer demand for petroleum
    products, there are a number of constraints to expansion:
        Economics. Economic factors have discouraged the investments needed
    to expand capacity. Fuels specifications have become so stringent in
    the U.S. and Europe that refineries must undertake expensive
    configuration upgrades to make the products that are required in those
    markets. Making large capital investments at refineries runs into
    hundreds of millions of dollars in the case of existing refineries--and
    from two to three billion dollars for a new refinery. The average
    annual return on capital investment for petroleum refining and
    marketing was about 5.5 percent over the decade ending in 2002, which
    is significantly below the 12.7 percent average return for the S&P
    Industrials. Such unattractive returns have had a chilling effect on
    investment in refining infrastructure.
        Environmental expenditures. Refiners must make massive
    environmental expenditures to comply with stringent, complex and often
    unclear clean air and clean water requirements. These expenditures,
    particularly those aimed at reducing stationary source emissions, while
    important, generally yield refiners small and sometimes negligible
    economic returns on investment. These regulatory investments also
    compete with those funds that might otherwise be committed to
    discretionary expansion projects. The pacing and timely clarification
    of regulatory requirements can help maximize opportunities for both
    emissions reductions and some incremental gains in capacity.
        The U.S. oil and natural gas industry as a whole spent $9.1 billion
    to protect the nation's environment in 2002. From 1993 to 2002, API
    estimates the industry spent almost $89 billion to protect the
    environment. This amounts to $308 for every man, woman, and child in
    the United States. More than half of the $89 billion was spent in the
    refining sector of the industry. The $9.1 billion in environmental
    expenditures in 2002 was equal to about 47 percent of the net income of
    the top 200 oil and natural gas companies, as reported in Oil & Gas
    Journal. Moreover, the industry's investments currently underway in
    additional clean fuels requirements in this decade will be
    considerable: $8 billion for gasoline sulfur reductions; another $8
    billion for highway diesel sulfur reductions; and more than $1 billion
    for non-road diesel.
        Regulatory requirements. Once a decision has been made to expand an
    existing refinery or to build a new one, the process for licensing,
    obtaining construction and operating permits and many other required
    steps can take up to four years, sometimes longer. The permitting
    process can be lengthy, with no guarantee that permits will ultimately
    be issued. Public involvement as part of most permit review
    requirements is typically not subject to time limits or deadlines and
    can result in an open-ended process, increasing uncertainty and
    ultimate project cost.
        Regulatory uncertainty. Refiners who must make major, long-term
    investments to build new refineries or expand existing ones must have
    confidence that the rules will not be changed in mid-course.
    Uncertainty about laws and regulations creates a major disincentive to
    investment. Moreover, the extremely complex and often unclear New
    Source Review regulations (only recently and partially reformed by EPA)
    discouraged refineries from undertaking expansion projects and
    improving process efficiency by contributing to overall uncertainty
    about regulatory requirements. In addition, litigation challenging
    EPA's recent NSR reforms has stymied efforts to integrate those reforms
    into state air programs. Not surprisingly, little capacity expansion
    has occurred in the past several years or is planned for the immediate
    future.
        Public attitudes. Another obstacle to new refineries is NIMBY
    (``not-in-my-backyard'') sentiment. Given the likely public opposition
    to siting a new refinery in many communities in the U.S., most
    companies are unlikely to undertake the significant investments needed
    to even begin the process when the likelihood of success is so
    uncertain.
        National Ambient Air Quality impacts. Building new refineries or
    expanding existing ones has been difficult under the constraints of the
    1-hour ozone National Ambient Air Quality Standard (NAAQS) and the New
    Source Review permit program requirements. The new 8-hour ozone NAAQS
    is much more stringent and creates many more non-attainment areas that
    are subject to more stringent requirements than attainment areas,
    including barriers to permitting of new stationary sources. The
    expected implementation of the PM2.5 air quality standards
    in 2005 will add still more non-attainment areas in which it will be
    difficult or impossible to obtain construction and operating permits
    for expansions or new refineries. Moreover, a number of refining and
    petrochemical manufacturing areas of the country face deadlines under
    the new 8-hour ozone NAAQS implementation rule that do not provide
    adequate time for some manufacturers to install the very stringent
    emission control technologies likely to be required to attain the
    standard. Yet, manufacturers in other areas may be forced to reduce
    their emissions simply because the deadlines do not recognize the
    projected air quality benefits of newly required national fuel and
    vehicle changes and interstate emissions transport controls.

    Increased refining capacity means more jobs
        New refining capacity would not only help meet U.S. gasoline
    demand, it would also produce jobs. As of April of this year, total
    refinery employment was 70,100, or an average of 480 jobs per refinery.
    However, based on U.S. Department of Commerce data, every $1 billion of
    increased production of refined products yields an estimated 400 new
    jobs at a refinery, plus 4,700 ``indirect'' jobs involved in producing
    and supplying materials used in the refinery. An additional 5,500
    ``induced'' jobs are produced through the general impact on the
    economy. These estimates likely understate the jobs impact because they
    do not reflect the effects of investment on economic growth. In
    addition to producing jobs, increased refining capacity would enable
    refiners to more successfully meet consumer demand and reduce supply
    volatility and price volatility, thereby strengthening the overall U.S.
    economy and contributing to further economic growth.

    Recommended actions
        API and its members believe that the following actions would help
    create a more favorable and predictable investment climate that could
    encourage building additional refining capacity:

     National Petroleum Council recommendations should be acted upon.
            Congress should enact legislation directing the Secretary of
            Energy to implement the findings and recommendations in the
            June 2000 National Petroleum Council (NPC) report, U.S.
            Petroleum Refining--Assuring the Adequacy and Affordability of
            Cleaner Fuels. Had these recommendations been acted upon when
            first proposed in 2000, today's shortfall in refining
            capacity--a situation that, in the absence of action, was
            predicted by the NPC report--might have been minimized.
            Secretary Abraham recently asked for the report to be updated
            and expanded, and the industry is working through the NPC to
            develop a new set of recommendations.
     Refinery assets should be five-year property. When the industry
            testified before the House Ways and Means Subcommittee on
            Select Revenue Measures in June 2001, it noted that one way of
            helping to create a climate more conducive to new refining
            capacity investments was to eliminate the outdated tax
            treatment of those investments. We reiterate that view today.
            Most manufacturing assets are depreciated over five or seven
            years. Chemical manufacturing assets, which are very similar in
            nature to petroleum refinery assets, are, in fact, depreciated
            over five years. Despite substantial changes in the refining
            business and considerable investment made during the last
            decade and a half, refinery assets are still subject to a 10-
            year depreciation schedule. The longer recovery period for
            refinery capital assets results in a depreciation deduction
            present value that is 17 to 25 percent less than that for other
            manufacturing assets, thereby reducing the incentive to invest
            in refinery capacity expansion projects. Shortening the
            depreciation life for refinery assets to five years will reduce
            the cost of capital, make those investments more competitive
            with alternative capital investments, and remove the current
            bias in the tax code against needed refinery capacity
            expansion.
     Executive order on energy impact should be codified. Executive Order
            13211, signed by the President in 2001, requires that agencies
            prepare a ``Statement of Energy Effects,'' including impacts on
            energy supply, distribution and use, when undertaking certain
            regulatory actions. The order has rarely, if ever, been fully
            implemented. This has been most apparent as EPA has promulgated
            numerous major fuel and facility regulations affecting the U.S.
            refining industry, with only superficial analysis for Executive
            Order 13211. The industry will be faced by over a dozen new
            environmental programs by 2010--programs that should have
            received a more robust review under Executive Order 13211. In
            order for policymakers and the public to better understand
            potential energy supply impacts of new environmental policies
            and regulations, Executive Order 13211 should be codified in
            legislation passed by Congress.
     ``Reasonable Permit Review Act'' should be passed. One of the major
            disincentives to expanding refining capacity is the numerous
            permitting requirements and the time it takes to get permits
            reviewed and issued. Congress should enact a ``Reasonable
            Permit Review Act'' designed to coordinate and eliminate
            overlap among the numerous permitting processes. The
            legislation could direct federal agencies involved in permit
            review to enter into a memorandum of understanding that would
            clearly define the steps to be taken when federal permit review
            and approvals are required.
     Avoid excessive use of enforcement discretion. EPA and other federal,
            state and local agencies regulating fuels should minimize
            creating situations that are likely to result in the use of
            enforcement discretion for existing regulatory requirements.
            Although occasionally necessary as a last resort to prevent
            unintended or untenable consequences, the uncertainty can
            exacerbate the supply situation. Agencies should adopt policies
            that clearly outline the processes and requirements suppliers
            would need to follow during periods of supply disruption,
            removing the need for, and uncertainty associated with, use of
            enforcement discretion.
     Codify EPA New Source Review (NSR) reforms. Congress should codify
            into federal law EPA's NSR reform rules that are expected to
            remove obstacles to greater efficiency, encourage industry to
            modernize refineries, and simultaneously provide a clear and
            reasonable requirement for the installation of new pollution
            controls to reduce emissions. The NSR regulations had become a
            cumbersome, confusing, ineffective and sometimes
            counterproductive tool for regulating air emissions under the
            Clean Air Act. Those regulations have discouraged refineries
            from expanding capacity and improving efficiency. The reformed
            rules will provide greater clarity, resulting in more efficient
            regulation and a reduction in the uncertainty factor.
     Provide State Environmental Permitting Assistance (SEPA). Congress
            should enact legislation directing EPA and other agencies to
            lend appropriate technical, legal and other assistance to
            states whose resources are inadequate to meet permit review
            demands. This concept could be implemented by earmarking
            federal resources for state refinery permit reviews. In order
            to take advantage of this federal assistance, states would be
            required to establish a refining infrastructure coordination
            office to facilitate federal-state cooperation in permit
            reviews.
        No single government action will ensure that additional refining
    capacity will be built, but positive government policies can help bring
    about a climate more conducive to increased investment. Decisions to
    add new capacity are primarily business decisions. Investments will be
    more likely in a climate of regulatory certainty, with well-defined
    permitting requirements and timelines and assurance that the government
    won't keep changing the rules. Industry is not suggesting a rollback of
    environmental safeguards; what is needed is more efficient, less time-
    consuming regulatory procedures that safeguard the environment without
    resulting in needless and excessive delays in obtaining permits and
    meeting other requirements.

    Boutique Fuels
        While the patchwork of localized ``boutique fuels'' is not
    principally responsible for the recent higher gasoline prices, the
    proliferation of these fuels in recent years has presented significant
    challenges to U.S. refiners and resulted in an inflexible fuels system.
    A classic example of the disadvantages of boutique fuels is in the New
    York/New Jersey area where gasoline intended for use in Bayonne, New
    Jersey, cannot be used on the other side of the river in New York City
    to address any supply shortage. Refiners and suppliers have made the
    refinery and distribution system investments to handle both of these
    gasolines with minimal problems to date. However, if a serious
    infrastructure problem occurs in the refineries, the pipelines, or the
    terminals that supply these areas with gasoline, the boutique fuels
    involved could lead to serious supply disruptions. We urge policymakers
    to take particular care in addressing boutique fuels, as there are many
    factors that affect this complex issue.
        Priority should be assigned to the repeal of the federal RFG oxygen
    requirement--and, of equal importance, to avoiding simplistic, counter-
    productive solutions that fail to recognize how the U.S. fuels system
    operates. Consideration should be given to both the refining
    distribution system and the availability of similar fuels in each area.
    For example, some advocate a national 7.8 pound RVP requirement, but
    ignore the fact that, while 7.8 pound RVP fuel is the standard fuel in
    southern nonattainment areas, its use in other areas of the country is
    limited. Thus, a bill that would allow 7.8 RVP fuel in any state that
    desired it would lead to a boutique fuel if, for example, this fuel was
    adopted in New Hampshire.
        API and its members believe that the best way to address boutique
    fuels is to pass the comprehensive national energy legislation, H.R. 6.
    The energy bill would repeal the oxygen content requirement for
    reformulated gasoline in the Clean Air Act, a major driver of boutique
    fuels, and require a national phasedown of MTBE. It also requires that
    EPA consult with DOE on the supply and distribution impacts of new
    state requests for specialized fuels. Finally, H.R. 6 requires EPA and
    DOE to conduct a comprehensive study of the impacts of boutique fuels
    and make recommendations to Congress for addressing them, within 18
    months of enactment. Given these significant changes and the benefit of
    the study recommendations, we urge members of Congress to resist
    imposition of any additional fuel specification changes outside the
    context of the national energy legislation.
        API, the National Petrochemical & Refiners Association, fuels
    marketers, and numerous farm and ethanol interests support the fuels
    provisions of H.R. 6. They offer carefully considered solutions to the
    fuels problems that have challenged fuel providers and burdened energy
    consumers.

        Mr. Hall. Thank you very much, sir. Thanks for your support
    of H.R. 6.
        Mr. Schaeffer, we recognize you at this time, Director of
    Environmental Integrity Project. Let me say this, before you
    begin, don't be dismayed by the lack of attendance. These men
    and women have other committees they have to attend, and
    actually you are called here to give us your testimony, it is
    taken down, each one gets copies of it. As a matter of fact,
    whether there is 1 or 5 or 30 of the members here, it goes to
    everyone, and it is all considered when we get together to
    write the law. We ask you, as men and women who know more about
    your own business than we know, and we base these laws on your
    testimony here. So, it is not wasted on just a couple of guys
    from Texas up here that have unusual interest in energy. And
    you have the presence of several committee people here that
    really do most of the work and a lot of the thinking for us.
    Proceed.

                       STATEMENT OF ERIC SCHAEFFER

        Mr. Schaeffer. Thank you, sir. Thank you, Mr. Chairman.
    Speaking of testimony, I made some minor changes last night
    that are incorporated in the copy you have.
        Mr. Hall. The entire statement of all of you will be placed
    in the record. Your entire statement will go to the record
    without objection.
        Mr. Schaeffer. Thank you, sir. I would like to question the
    basic premise that environmental permitting acts as a
    significant drag on expansion of refinery capacity, and would
    like to offer maybe a little more optimistic perspective and
    give the industry some credit.
        U.S. refining capacity has expanded at a pretty brisk pace
    in the 1990's. This happened after the 1990 Clean Air Act when
    lots of new requirements came into play. We are at record
    levels of production in motor gasoline. We have had substantial
    increases there. According to the Energy Information
    Administration, we have added the equivalent of one medium-size
    refinery a year through expansion of existing plants. I think
    the industry's decision to build out its capacity at existing
    sites is more likely a business decision than one driven
    primarily by permitting.
        I would point out that the average refinery has doubled in
    size since the 1980's, that is why we have more capacity. I am
    struggling to understand how New Source Review, which has
    become kind of an urban legend now for the industry, has acted
    to limit capacity growth if refineries are twice as big as they
    used to be. We have been living with these requirements for a
    long time.
        I would like to express some concern while I have the
    chance, or at least raise some questions about the Refinery
    Revitalization Act. If there are no objections, I would like to
    submit statements of opposition from all the environmental
    groups as well as the National Conference of State Legislatures
    and associations representing State permitting officials.
        Mr. Hall. You have something you want to submit for the
    record?
        Mr. Schaeffer. I do, all the written statements.
        Mr. Hall. Without objection.
        Mr. Schaeffer. Thank you, Mr. Chairman. I would like to
    make four points very briefly. As I understand the legislation,
    if you are in an economically distressed area, which seems
    somewhat vaguely defined, a refinery at that location that
    wanted to restart or build, would get a fast-track permitting
    process from its friends at the Department of Energy.
        If the idea is to increase total capacity in the country, I
    question whether an approach that essentially creates
    geographic disparity, in effect, invites refiners to move from
    an area where permitting is stringent to an area where it is
    faster and cheaper is going to do much to increase overall
    supply, but whether, instead, it will exaggerate regional
    shortages that do seem to be a problem, at least when it comes
    to production of clean fuels, in certain markets. In other
    words, is it a good idea to encourage refiners, based on
    differential permitting, to move away from Pennsylvania or
    California to other areas where there may already be a surplus
    of capacity, just because permitting is cheaper and easier and
    they can deal with the Department of Energy instead of EPA?
        Second point I want to make is, no matter what the Congress
    does, it is very, very difficult to force a refinery on a
    community that just doesn't want it. And as I read the
    provisions of this bill, it would allow the Department of
    Energy to do that, and DOE would be empowered to override the
    objections of State permitting authorities who traditionally
    get to decide whether a permit is issued or denied. That seems
    to me a recipe for more conflict and more litigation.
        If I could point to one example, the Synco Refinery's
    proposed restart in California. The permit in that case was
    granted. It was granted by EPA and by the State. The community
    did not want that refinery. They didn't trust the owner. They
    didn't think it was meeting its environmental obligations. They
    went to Federal Court. They won. The refinery didn't go
    forward. The problem didn't lie in the permit, it lay in the
    opposition of the community and in their perception that this
    was not a refinery that was going to comply with the law.
        A third point I want to make is, managing refineries is an
    awesome and very difficult responsibility. I have a lot of
    respect for the men and women of the industry who do that well,
    it is a very, very hard job. I would worry that fast-track
    permitting would encourage the entry into the market of
    companies that are under-financed and, frankly, incompetent and
    unprepared to take on those responsibilities. And I would offer
    the case study of the Orion Refinery. I think it offers a
    cautionary tale.
        Orion came to us wanting to restart a 185,000 barrel a day
    plant in Louisiana in the year 2002, came to EPA when I was
    still working there. We expressed some concern about the
    capacity of that company to undertake that reopening and
    operate the refinery safely. Nonetheless, they granted the
    permit and EPA didn't object.
        What happened? As soon as they opened, they were plagued by
    a series of accidents. This has to have been one of the most
    accident-prone refineries I have ever seen. They flared night
    and day. They dumped thousands of tons of pollutants on
    neighboring residents. They were sued by neighboring residents.
    They were sued by the State. This all ended with a big fire at
    the coking plant at the refinery, which ultimately shut the
    plant down. They are now in bankruptcy. We don't have any
    supply, but we have a lingering memory in that neighborhood of
    citizens having been showered with coke dust.
        So, when we want to talk about the NIMBY issue and why
    communities are so anxious about having refineries come to
    their neighborhood, I would just suggest that having your coker
    explode and deposit chunks of hot metal in a schoolyard--this
    happened at another plant in Louisiana--is not the way to win
    the hearts and minds of your neighbors, and kind of warm them
    to the idea of refinery expansion. That problem needs to be
    dealt with, which leads to my last point.
        The industry, I think it is fair to say, has a checkered
    history of complying with the Clean Air Act. Some companies
    have done a good job----
        Mr. Hall. Would you try to wind down, Mr. Schaeffer.
        Mr. Schaeffer. Thank you. We get so few opportunities to
    raise these issues.
        Mr. Hall. Well, your entire statement is going to be there,
    but go ahead, we will let you finish.
        Mr. Schaeffer. I can be very brief. Attached to my
    statement, you will see a list of companies that EPA has
    identified with notices of violations, some going back to 1998.
    These are refineries with violations that have been hanging for
    a long time. The Administration, EPA, the Department of
    Justice, they are not moving on any of these cases.
        I guess I would close by asking, what good is an
    environmental permit, no matter who issues it and no matter how
    it is granted, if its terms and conditions are never going to
    be enforced? Thank you, Mr. Chairman.
        [The prepared statement of Eric Schaeffer follows:]

    Prepared Statement of Eric Schaeffer, Director, Environmental Integrity
                                    Project

        Thank you, Mr. Chairman and Members of the Subcommittee, for the
    opportunity to testify today. My name is Eric Schaeffer, and I am
    currently director of the Environmental Integrity Project, a nonprofit
    organization that advocates for effective enforcement of environmental
    laws. Previously, I served as director of the USEPA's Office of
    Regulatory Enforcement, where I had a role in negotiating a series of
    Clean Air Act settlements with refinery companies.
        I want to question the notion that environmental laws, rather than
    market forces, have limited the ability of U.S. oil companies to expand
    refinery capacity in the United States. I also want to raise specific
    concerns about H.R. 4517, the United States Refinery Revitalization Act
    of 2004, which was recently approved by the House of Representatives
    without any hearings and with little debate. My testimony will make the
    following points:

     U.S. refining capacity has expanded recently in response to market
            signals, and is at an all-time high. While additional capacity
            may be helpful, there is little evidence that permitting
            requirements are a significant barrier to new investment.
     Environmental permitting requirements are admittedly challenging. But
            H.R. 4517 would set up a two-tiered permitting system based on
            geographic differences in employment statistics that may change
            rapidly, will make the system more complex, and may do more to
            shift refining capacity than increase it.
     States are primarily responsible for permitting U.S. refiners, with
            oversight from EPA and with the opportunity for meaningful
            comment from the public. H.R. 4517 apparently allows the
            Department of Energy to grant permits that states want to deny,
            and will increase local hostility to expansion projects by
            effectively shutting communities out of decision-making.
     The Department of Energy is not a regulatory agency, and is not
            qualified to interpret federal environmental laws.
     The fast-track permitting authorized by H.R. 4517 encourages the
            entry of under-capitalized and poorly managed companies into
            the marketplace, which may lead to environmental disasters and
            interruption of gasoline supplies.
     The Bush Administration has deliberately refused to enforce the Clean
            Air Act and other environmental laws against U.S. refineries.
            If the government is unwilling to enforce permit limits, then
            the permitting process is ultimately meaningless, no matter who
            is in charge.

                     U.S. REFINING CAPACITY--NOT IN CRISIS

        According to the Energy Information Administration, refining
    capacity has increased steadily over the past decade to levels not seen
    since the early 1980's. Meanwhile, improvements in downstream
    processing have raised the output of gasoline to record levels. As the
    attached data from the Department of Energy (Table A) shows, gasoline
    output at U.S. refineries grew faster in the nineties than in the
    preceding two decades. That this faster rate of growth occurred after
    the Clean Air Act of 1990, which imposed significant new emission
    control and clean fuels requirements for refiners, suggests that
    environmental factors are not a significant drag on the expansion of
    capacity.
        The refinery industry has played an active role in writing the
    rules that govern its operations, which have frequently been relaxed to
    accommodate its concerns. Clean fuels requirements have been extended
    for refineries pleading economic hardship, and New Source Review
    requirements that apply to existing facilities have been substantially
    weakened. Refineries expanded capacity at existing plants at a healthy
    pace in the late nineties, contradicting the notion that NSR limited
    growth. But even if you believe that the old NSR rules did constrain
    capacity (and I do not), the Bush Administration has rewritten them to
    the refinery industry's liking.
        We hear frequently that refineries are operating at near maximum
    capacity. But that is historically true, and data from the Energy
    Information Administration again shows refiners have historically
    operated close to capacity limits. Environmental requirements
    undeniably impose costs on refiners, but may also give them a
    competitive advantage over foreign refiners unable to meet U.S.
    requirements for clean fuels.
        I do not mean to suggest that permitting requirements play no role
    in decisions to expand or build refineries, but that traditional market
    forces--such as the high prices motorists now pay at the pump--may
    provide far more powerful incentives to invest in increased supply.

                SHUFFLING THE DECK INSTEAD OF INCREASING SUPPLY

        H.R. 4517 would designate ``refinery revitalization zones'' in
    areas that have experienced ``mass layoffs'' or have idle refineries,
    and which have unemployment rates 20 percent above the national
    average. The Department of Energy would step in to manage environmental
    permitting for refineries in these revitalization zones, with permits
    to be granted within six months. This approach creates a two-tier
    scheme, reserving traditional permitting for some areas while
    establishing an industry-friendly ``fast-track'' for others. Those who
    favor this approach should answer three questions:

     Would this approach actually increase total refinery capacity, or
            merely encourage shifting expansion projects from one
            geographic area to another, based on small differences in local
            employment rates?
     How would this approach assure that refinery capacity is added where
            it is needed most to alleviate local shortages in gasoline and
            clean fuels?
     Refineries have expanded capacity by more than ten percent over the
            past decade. Has this added capacity increased employment, or
            have payrolls in fact been substantially cut to improve
            refinery profit margins?

             H.R. 4517 LIMITS POWER OF STATES AND LOCAL COMMUNITIES

        Since their inception, federal environmental laws have recognized
    that states have the primary authority for issuing permits, subject to
    minimum national standards and EPA oversight. Equally important, the
    public has a right to review and comment on major permits, and to have
    their objections fairly considered by permitting authorities. While
    vaguely worded, H.R. 4517 seems to authorize the Department of Energy
    to permit a new refinery over the objection of the state and the local
    community. It's little wonder that the National Conference of State
    Legislatures, the Environmental Council of States (representing state
    environmental commissioners) as well as STAPA/ALAPCO (representing
    state air permitting programs) are strongly opposed to H.R. 4517.
    National and local environmental organizations have unanimously opposed
    this legislation as well.
        Is the Department of Energy going to start running the public
    hearings that the Clean Air Act requires for any major expansion
    projects? Regardless, citizens who challenge the Department of Energy's
    decisions in court would have to fly to Washington DC and appear before
    the DC Circuit Court of Appeals. Riding roughshod over the right of
    local communities to object to the siting of facilities that may affect
    their health and property values seems sure to provoke an angry
    backlash that may work against the goals of this legislation in the
    long run.

        THE DEPARTMENT OF ENERGY IS NOT QUALIFIED TO RUN ENVIRONMENTAL
                              PERMITTING PROGRAMS

        As the attached June 14 letter from the Environmental Council of
    States points out, the Department of Energy is ``an agency with
    expertise on energy production, not environmental regulations.'' There
    is no evidence to suggest that DoE is up to handling the new powers it
    would receive under H.R. 4517. In fact, the Department already has its
    hands full managing multibillion dollar environmental cleanups at
    Hanford, Rocky Flats, Portsmouth and other facilities it owns or
    manages. I would respectfully suggest that Congress not grant the
    Department of Energy new power to interpret laws it is still struggling
    to comply with.

     FAST-TRACK PERMITTING MAY SET POORLY MANAGED COMPANIES UP FOR FAILURE

        Managing a refinery safely and in compliance with environmental
    laws is a challenging endeavor. Rushing permits for companies ill-
    prepared to meet these challenges is a recipe for environmental
    disaster. The case of the now-closed Orion refinery offers a cautionary
    tale. Orion's investors approached EPA in 2000 to ask for help
    expediting a permit for a refinery with a troubled past that it
    proposed to reopen in Norco, Louisiana. At the time, EPA staff
    expressed concern over the company's ability to safely manage the
    plant, but the permit was nonetheless granted. Our worst fears were
    realized, as the star-crossed Orion refinery stumbled through one
    mishap after another, and a series of malfunctions shed thousands of
    tons of illegal pollutants on nearby neighborhoods. Ultimately, the
    refinery was forced into bankruptcy after a fire at its coker shut down
    operations. Gasoline supplies were temporarily curtailed (the refinery
    has since been purchased by Valero) and residents were left with the
    bitter experience of living with a shoddy operation.
        Some refineries are simply accident prone, and release emissions
    far in excess of permitted levels because they are apparently unable to
    maintain their equipment in working order. One of the most notorious
    examples, the Atofina refinery in Port Arthur Texas, annually releases
    several thousand tons of sulfur dioxide as a result of malfunctions, or
    about ten times the amount that it reports annually from routine
    operations. These types of incidents--and the government's failure to
    put a stop to them--do not inspire confidence in the company's ability
    to manage a significant expansion of capacity.

                     REFINERY ENFORCEMENT HAS BEEN DERAILED

        While the industry urges fast-track permitting, the Bush
    Administration has effectively derailed enforcement against refineries
    for violating laws already on the books. Table B lists outstanding
    notices of violation against U.S. refineries, some dating back six
    years, for failing to comply with the Clean Air Act. The U.S.
    Department of Justice has not filed complaints against any of these
    facilities, creating the unfortunate impression that these companies
    enjoy some kind of political protection. Worse still, the failure to
    enforce the law has undercut those responsible refiners who are
    spending hundreds of millions of dollars to clean up their plants under
    the terms of settlements reached with the federal government and state
    partners.
        The refinery lobby has complained for years that a ``not-in-my-
    backyard'' syndrome has made it impossible for companies to build new
    refineries in the United States. There may be some truth to what the
    industry says, but that claim is difficult to evaluate given the
    failure of refiners to submit any serious applications for new
    refineries over the past twenty years. But in the final analysis, the
    industry needs to recognize that the failure of some of its members to
    respect environmental law has contributed to an atmosphere of cynicism
    and distrust. Recently, some companies--BP, Marathon-Ashland and Koch,
    for example--have shown signs on at least some issues of breaking free
    of the old paradigm, by taking responsible actions that could help to
    restore trust between refineries and their neighbors. Turning
    environmental permitting over to the Department of Energy, and allowing
    it to license refineries that neither states nor communities want,
    would only threaten the fragile progress we have made so far.

                                     TABLE B
         Petroleum Refineries with Outstanding NSR Notices of Violation
    ------------------------------------------------------------------------
                 Company                   Facility         Date NOV Issued
    ------------------------------------------------------------------------
    ExxonMobile.....................  Paulsboro, NJ.....  1/29/2001
    Phillips Puerto Rico Core.......  Guyama, PR........  1/22/1999
    Sunoco, Inc.....................  Marcus Hook, PA...  12/20/2001
    United Refining.................  Warren, PA........  6/24/98, 10/19/00
    Citgo Petroleum Corp............  Lemont, IL........  3/17/98, 6/28/99,
                                                           3/22/02
    Sun Refining & Marketing........  Oregon, OH........  12/19/2001
    Mobile Oil......................  Joliet, IL........  8/30/2000
    ExxonMobile Oil.................  Joliet, IL........  8/20/2000
    Citgo Petroleum Corp............  Lake Charles, LA    1/19/2001
                                       and Corpus
                                       Christi, LA.
    ExxonMobile Oil.................  Beaumont, TX......  12/20/2001
    ExxonMobile Oil.................  Baytown, TX and     8/20/2002
                                       Beaumont, TX.
    Lyondell-Citgo..................  Houston, TX.......  1/18/2001
    Phillips Petroleum..............  Borger, OK........  2/27/1998
    Phillips Petroleum..............  Woods Cross, TX...  2/25/1999
    ------------------------------------------------------------------------

        Mr. Hall. Thank you, Mr. Schaeffer.
        I am pleased to recognize Bill Douglass, of my district, a
    leader in Northeast Texas and head of the Douglass Distributing
    Company, many convenience stores across my area in Northeast
    Texas, 150 retail locations through Dallas and Fort Worth. Mr.
    Douglass, we are happy to have you. Proceed.

                       STATEMENT OF BILL DOUGLASS

        Mr. Douglass. Thank you, Mr. Chairman and members of the
    subcommittee, and thank you for inviting me to testify today.
    As you said, we are headquartered in Sherman, Texas, in the
    Fourth Congressional District, and we operate convenience
    stores and supply gasoline and diesel to 150 locations
    throughout the Greater Dallas-Fort Worth market. I appear
    before the subcommittee today representing the National
    Association of Convenience Stores, which we call NACS, and the
    Society of Independent Gasoline Marketers of America, which we
    call SIGMA. You may question why am I testifying today, and
    what message do independent motor fuel marketers have to offer
    with respect to domestic refining capacity.
        Collectively, NACS and SIGMA members sell approximately 80
    percent of all the gasoline and diesel sold in the United
    States today. And I feel strongly, as do my colleagues within
    NACS and SIGMA, that this Nation needs additional refining
    capacity. Independent marketers are, in essence, proxies for
    consumers, your constituents and our customers. We rely on
    plentiful sources of gasoline and diesel fuel supplies from
    diverse sources. When supplies are low or sources of supply are
    reduced, competition is reduced, and the check that the
    independent marketers represent on higher motor fuel prices
    becomes less relevant.
        Our message to this subcommittee is simple--our Nation's
    domestic refining industry is shrinking at a time when consumer
    demand continues to rise. Unless we collectively change course,
    domestic refining capacity will be unable to keep up with the
    pace of the demand. Gasoline and diesel fuel price spikes will
    become the norm rather than the exception, and our Nation will
    become more reliant on imports of gasoline and diesel fuel.
    This subcommittee and this Congress must investigate ways to
    encourage rather than discourage the expansion of our Nation's
    domestic capacity to make gasoline and diesel fuel.
        NACS and SIGMA may differ with our friends in the refining
    industry on this issue. Their position is understandable. If
    you were to ask me if I wanted additional retailers--that is,
    new competitors--opening gasoline facilities in the Dallas-Fort
    Worth market, I would respond emphatically, ``no.'' Likewise,
    it would be understandable if our Nation's domestic refiners
    were to oppose the addition of new capacity, however, it is
    your role as elected representatives of our Nation's citizens
    to determine what public policies are in the best interest of
    the Nation as a whole, and not a small segment of it.
        NACS and SIGMA recommend that this subcommittee consider
    three different, yet related, areas for public policy for
    changing the path on which we currently travel. First,
    implement regulatory reform. NACS and SIGMA urge Congress and
    the EPA to move forward with New Source Review reform that will
    continue to protect the environment while enabling facilities
    to expand capacity and satisfy consumer demand. In addition,
    Congress should streamline the process for obtaining Federal
    and State permits without sacrificing environmental protection,
    and to encourage the expansion again of refining capacity.
    Chairman Barton's legislation, H.R. 4517, takes an important
    step in this direction.
        Second, incentivize expansion of refining capacity. NACS
    and SIGMA believe Congress should adopt changes to the Federal
    Tax Code to incentivize domestic refiners to expand capacity.
    Such changes might include faster depreciation periods, the
    ability to expense environmental upgrades when capacity is also
    expanded, or an investment tax credit aimed at encouraging the
    construction of new clean-fuels refineries.
        The third, address boutique fuels. Additional refining
    capacity will go a long way to restoring the balance between
    supply and demand, but it alone is not sufficient to restore
    fungibility to the system. The balkinization of the Nation into
    islands of boutique fuels leads to regional supply shortages
    and price spikes by reducing the market's ability to adjust to
    supply conditions. NACS and SIGMA suggest that Congress can
    address these problems by, first, repealing the oxygen
    requirement of the Clean Air Act as provided for in H.R. 6;
    next, placing a moratorium on new fuel formulations as provided
    for in H.R. 4545, and identifying ways to reduce the number of
    fuels in the market without sacrificing supply.
        NACS and SIGMA believe that the above provisions would
    result in more domestically produced gasoline and diesel fuel,
    additional capacity to respond to supply emergencies, greater
    flexibility in the distribution system, and a more stable motor
    fuels marketplace, all while continuing to improve air quality.
        The availability of gasoline and diesel fuel to all markets
    is essential. By expanding capacity and rationalizing the fuel
    specifications between markets, Congress can improve the
    operations of the market for the benefit of the consumer.
        Thank you for this opportunity to speak with you, and I
    look forward to answering any questions you may have.
        [The prepared statement of Bill Douglass follows:]

    Prepared Statement of Bill Douglass, Chief Executive Officer, Douglass
        Distributing Company, Representing The National Association of
    Convenience Stores and The Society of Independent Gasoline Marketers of
                                    America

                                I. INTRODUCTION

        Good morning, Mr. Chairman and members of the Subcommittee. My name
    is Bill Douglass. I am Chief Executive Officer of Douglass Distributing
    Company, headquartered in Sherman, Texas. My company operates 13
    convenience stores and supplies gasoline and diesel fuel to 150 retail
    locations throughout the Dallas-Fort Worth area.
        I appear before the Subcommittee today representing the National
    Association of Convenience Stores (``NACS'') and the Society of
    Independent Gasoline Marketers of America (``SIGMA'')

        II. THE ASSOCIATIONS

        NACS is an international trade association comprised of more than
    1,700 retail member companies operating more than 100,000 stores. The
    convenience store industry as a whole sold 142.1 billion gallons of
    motor fuel in 2003 and employs 1.4 million workers across the nation.
        SIGMA is an association of more than 250 independent motor fuel
    marketers operating in all 50 states. Last year, SIGMA members sold
    more than 48 billion gallons of motor fuel, representing more than 30
    percent of all motor fuels sold in the United States in 2003. SIGMA
    members supply more than 28,000 retail outlets across the nation and
    employ more than 270,000 workers nationwide.

        III. MARKETERS URGE POLICIES TO INCREASE DOMESTIC REFINING CAPACITY

        Today's hearing is exceptionally important, Mr. Chairman, and I am
    very pleased you have invited me to testify. I feel strongly, as do my
    colleagues within NACS and SIGMA, that this nation needs additional
    domestic refining capacity. This Subcommittee, and this Congress, must
    investigate ways to encourage, rather than discourage, the expansion of
    our nation's domestic capacity to make gasoline and diesel fuel.
        Collectively, NACS and SIGMA members sell approximately 80 percent
    of the gasoline and diesel fuel in the United States each year.
    However, like the vast majority of NACS members, and all SIGMA members,
    my company does not refine gasoline or diesel fuel. Consequently, you
    may question why I am testifying before you today and what message
    independent motor fuel marketers have to offer with respect to domestic
    refining capacity that is relevant to today's hearing.
        Our message to this Subcommittee today is simple. Our nation's
    domestic gasoline and diesel refining industry is shrinking at a time
    when consumer demand continues to rise. Unless we collectively change
    course, domestic refining capacity will be unable to keep pace with
    demand, gasoline and diesel fuel price spikes such as the one we have
    experienced this year will become the norm rather than the exception,
    and our nation will become more reliant on imports of gasoline and
    diesel fuel to meet increased consumer demand in the coming years.
        Independent marketers are, in essence, proxies for consumers--your
    constituents and our customers. We buy gasoline and diesel fuel
    directly from integrated and independent refiners and then compete with
    them directly in the marketplace for retail market share. Independent
    marketers have long been recognized as the most cost competitive
    segment of the nation's motor fuels distribution industry. We rely on
    plentiful sources of gasoline and diesel fuel supplies from diverse
    sources in order to occupy this competitive niche in the marketplace.
    When supplies are low, or sources of supply are reduced, competition is
    reduced and the check that independent marketers represent on higher
    motor fuel prices becomes less relevant.
        The gasoline and diesel fuel wholesale and retail price volatility
    experienced by marketers and consumers over the past several years,
    including the price spike we experienced this Spring and early Summer,
    is the direct result of an imbalance between increased consumer demand
    for gasoline and diesel fuel and reduced domestic refining capacity. It
    is simple fact that consumer demand has grown at a rate faster than
    domestic refining capacity has been able to expand. The simple laws of
    economics provide that when demand outpaces supply, prices go up. This
    year, aided by high crude oil prices, the retail price of gasoline
    topped $2.00 per gallon on a national average because of an extremely
    tight supply-demand situation.
        Congress has a choice--it can either pursue policies that will
    encourage the expansion of domestic refining capacity, or it can turn
    its gaze overseas for our nation's future gasoline and diesel fuel
    needs. We have listened for years as Congress lamented America's
    dependence on foreign crude oil. A similar situation is developing with
    respect to finished crude oil products, including gasoline and diesel
    fuel.
        NACS and SIGMA may differ with our friends in the refining industry
    on the issue of expanding domestic refining capacity. Their position is
    understandable. If you were to ask me if I wanted additional retailers
    opening gasoline facilities in the Dallas-Fort Worth market, I would
    respond emphatically ``NO.'' I have witnessed first hand what happens
    when new competitors enter the market and it does not benefit my
    business interests. Understandably, if one asks our nation's domestic
    refiners if they want additional refining capacity on the market, the
    answer should be an emphatic ``NO'' as well. However, it is your role
    as the elected representatives of our nation's citizens to determine
    what public policies are in the best interests of the nation as a
    whole, not a small segment of it.
        The refining industry has outlined the regulatory and financial
    impediments that are preventing significant capacity expansion or the
    construction of new refineries. NACS and SIGMA believe Congress should
    take the initiative to address these stated impediments and open the
    door to new capacity.

        IV. THE STATISTICS ON DOMESTIC REFINING CAPACITY

        Other witnesses at this hearing will offer detailed information on
    the current status of the domestic refining industry and I will not
    repeat this information here. However, it is important to acknowledge
    several statistics that highlight the problems our nation's refining
    industry is facing.
        Consumer demand for gasoline and diesel fuel continues to grow. The
    Energy Information Administration (``EIA'') projects that consumer
    demand for motor fuels will increase by almost 30 percent between now
    and 2025. At the same time, due to limited domestic refining capacity,
    EIA projects that America will import at least 20 percent of our
    finished motor fuels by 2025.
        This imbalance between domestic refining capacity and demand has
    been building for decades. According to EIA, the number of refineries
    in the United States has declined by more than 50 percent in the past
    20 years. And, as this Subcommittee is well aware, the last new
    domestic refinery was built 28 years ago.
        In 1981, the combined capacity of the nation's 324 refineries was
    18.6 million barrels per day. In 2002, there were only 153 refineries,
    but capacity had only declined to 16.8 million barrels per day. I must
    commend the refining industry for its efforts to improve its
    efficiencies and expand capacity at remaining facilities. Since 1981,
    the average capacity per refinery has increased from 57,000 barrels per
    day to 110,000 barrels per day. This is an outstanding accomplishment,
    but it has not come without costs.
        Our nation's refineries are now routinely operating above 95
    percent capacity, which is in effect 100 percent capacity with respect
    to production of gasoline and diesel fuel. We have witnessed in recent
    years that such a high level of performance carries with it an
    increased risk of unanticipated interruption due to refinery
    breakdowns. The pressure on the industry to produce more and more
    gasoline and diesel fuel from fewer facilities is taking its toll on
    the industry's equipment. And each time one of these refineries goes
    off-line, there is not sufficient extra supply in the refining industry
    to offset this temporary supply shortfall. The result, for marketers
    and motorists, is constant demand, decreased supplies, and price
    spikes.
        To supplement domestic refining capacity in order to meet consumer
    demand, the nation in recent years has turned to more imported gasoline
    and diesel fuel. In 1983, the United States relied on foreign suppliers
    for 223,000 barrels per day of motor gasoline. Between 2000 and 2003,
    the nation imported an average of 716,000 barrels per day and thus far
    in 2004 imports have averaged 868,000 barrels per day. The EIA projects
    that, in order to meet demand and build stocks to normal levels, the
    nation must, at a minimum import approximately one million barrels per
    day through the end of the year.

        V. POLICY RECOMMENDATIONS FOR A NEW REFINING POLICY PATH

        Consumers want reliable and plentiful supplies of gasoline at
    reasonable prices. In order to satisfy these consumer demands while
    easing the pressure on existing domestic refineries and providing
    additional capacity to permit refiners to respond to emergencies, we
    must increase our domestic refining capacity. Unfortunately, this goal
    will be very difficult to accomplish.
        Congress has a choice to make with respect to motor fuel refining
    policy. It can continue down the path followed for the past two
    decades. This path, as we have witnessed, results in static or reduced
    domestic refining capacity, balkanization of the motor fuel markets,
    increased imports, increased volatility in wholesale and retail prices,
    and rising costs for consumers. Over the past ten years, there has been
    disincentive for refiners to increase capacity due to the costs
    involved and the lack of opportunity to achieve a reasonable return on
    that investment.
        Alternatively, we can embark on a different path. One that
    continues to encourage clean fuels. One that encourages, rather than
    discourages, expansion of domestic refining capacity. One that changes
    the fundamental economic calculus that a refiner makes when it decides
    whether to spend the huge sums necessary to make the upgrades required
    to produce clean fuels or to close the refinery.
        NACS and SIGMA recommend that this Subcommittee consider three
    different, and yet related, areas of public policy for changing the
    path on which we currently travel. I will discuss each in turn.
    A. Regulatory Reform
        Currently, a disincentive exists for domestic refiners to add new
    capacity to their existing facilities. If they expand capacity, they
    expose themselves to the potential application of EPA's New Source
    Review (``NSR'') regulations, which could impose tens of millions of
    dollars in additional environmental protection costs. NACS and SIGMA
    urge Congress and EPA to move forward with NSR reform that will
    continue to protect the environment while enabling facilities to expand
    capacity and satisfy consumer demand.
        Second, it is virtually impossible to obtain the necessary federal
    and state permits to expand an existing refinery or build a new one.
    NACS and SIGMA urge Congress to streamline this process, without
    sacrificing environmental protections, to encourage, rather than
    discourage, the expansion of domestic refining capacity. Last month,
    the House passed H.R. 4517, a refinery revitalization bill sponsored by
    Chairman Barton which takes important steps toward streamlining the
    permitting process in certain circumstances. We supported that bill and
    urge Congress to expand its provisions to further incentivize the
    additional expansion of domestic refining capacity.
    B. Incentivize Expansion of Refining Capacity
        NACS and SIGMA posit that Congress should adopt federal tax code
    changes to incentivize domestic refiners to expand refining capacity.
    Such changes could include faster depreciation periods for refining
    assets, the ability to expense environmental upgrades investments when
    capacity also is expanded, or an investment tax credit aimed at
    encouraging the construction of new, state-of-the-art, clean fuels
    refineries. Whatever course Congress chooses to follow, it is clear
    that the status quo does nothing to encourage expansion of domestic
    refining capacity. If we want capacity to increase, then we must change
    the fundamental economics of such expansions.
    C. Address ``Boutique'' Fuels
        Additional refining capacity will go a long way to restoring the
    balance between supply and demand. However, additional capacity alone
    is not enough to reduce the incidence of regional supply shortages and
    price spikes. Expanding capacity will help the industry respond to
    outages, but the balkanization of our nation's motor fuel distribution
    system remains a major problem.
        The proliferation of unique formulations of gasoline and diesel
    fuel, or ``boutique'' fuels, has destroyed the efficiencies of our
    nation's motor fuel distribution system. States and localities, in an
    effort to avoid the Reformulated Gasoline program and its oxygenate
    mandate, worked with their local refiners to develop fuels that would
    satisfy their air quality needs and fit the refiners' production
    streams. Unfortunately, no thought has been given to ensuring that the
    gasoline and diesel fuel supply remains fungible--or interchangeable--
    between markets.
        The balkanization of our nation's fuels markets into distinct
    islands of boutique fuels must be stopped and, possibly, reversed. The
    first step toward achieving this goal is to repeal the federal
    reformulated gasoline program's oxygenate mandate. This mandate is not
    necessary to improve air quality and has led many states to adopt
    boutique gasolines over the past decade in order to avoid being forced
    to bring MTBE or ethanol into their markets. A repeal of the RFG
    oxygenate mandate is contained in the conference report on H.R. 6, the
    national energy policy legislation. SIGMA and NACS strongly support
    H.R. 6 and urge its adoption before Congress adjourns for the year.
        The second step towards stopping further balkanization is to
    prevent additional boutique fuels from being mandated in the future.
    Over the next several years, many states will submit plans to implement
    the new ozone clean air standard. Many of these state implementation
    plans likely will contain additional proposals to further balkanize the
    gasoline and diesel fuel markets through the adoption of new fuel
    blends developed to address local and regional air quality concerns.
    SIGMA and NACS posit that there already is an ample slate of fuel
    blends from which these states can choose to achieve their air quality
    needs. H.R. 4545, a boutique fuels moratorium bill introduced by
    Congressmen Blunt and Ryan last month and supported by SIGMA and NACS,
    would put a stop of the balkanization of these markets. Although this
    bill failed to receive the two-thirds majority required under
    suspension of the rules, it did receive a clear majority of support
    when considered on the House floor last month. We urge the House to
    revisit H.R. 4545 in the near future.
        Both H.R. 6 and H.R. 4545 contain provisions that require federal
    agencies to study ways to reduce the number of boutique fuels that
    already exist in the market. We strongly support these studies, but
    caution again that there is no short-term fix to this problem. A NACS
    study on boutique fuels completed in 2003 demonstrated that reducing
    the number of fuels in the market will improve distribution
    efficiencies and facilitate the transfer of product between markets in
    order to respond to supply/demand imbalances. Fewer fuels reduces the
    stress on the pipeline system and improves the availability of product
    to specific markets.
        Reducing the number of fuels, however, will reduce refining
    capacity. This is true because Congress must not allow any
    environmental backsliding and, therefore, any reduction in the number
    of fuels will result in a ratcheting down to the cleaner fuels in
    inventory. Each cleaner fuel is more complicated to produce and reduces
    the amount of gasoline available from each barrel of oil. Therefore, it
    is essential that Congress help expand domestic refining capacity in
    order to embark on a campaign to rationalize the motor fuels market.
        The two track approach will provide significant benefits to the
    consumer. Gasoline and diesel fuel will be in greater supply throughout
    the nation and markets will be better able to efficiently and promptly
    respond to supply disruptions. The result will likely be less
    volatility in the marketplace with fewer regional shortages and price
    spikes.

                                 VI. CONCLUSION

        Mr. Chairman, once again I thank you for this opportunity to
    express the interests of NACS and SIGMA to this committee. I hope I
    have provided some fresh insight into the challenges facing the market
    today and will be happy to answer any questions that my testimony may
    have raised in your minds.

        Mr. Hall. Thank you, Mr. Douglass. Well, we are down to the
    questions now.
        Mr. Murti, as I read your testimony, you favor expanding--
    well, let me just start all over.
        How many of you believe we need to expand domestic refining
    capacity? Raise your hands, please.
        [Hands]
        Everybody? We have an agreeable panel. How many of you
    believe legislation is needed for that to happen?
        [Hands]
        One, 2, 3, 4 of you. Mr. Murti, what is wrong with the
    legislation?
        Mr. Murti. It is not so much legislation, I think we just
    need to get to a condition where the return on capital in the
    refining industry is attractive enough, and that will then
    inspire companies to consider investing in new capacity. It is
    really a profitability question.
        Mr. Hall. I liked your testimony, it was very helpful, but
    what is wrong with the legislation if we take into account the
    recommendations that this learned panel here has suggested?
        Mr. Murti. If one can legislate easing some of the
    permitting processes, that is fine, but you still need to have
    adequate profitability, that absolutely has to be the first
    step. And I don't think--and please forgive me if I am
    inaccurate--I don't think you can legislate better
    profitability unless you give these companies some minimum rate
    of return, which I don't think you are going to do.
        All we would ask from a legislation standpoint would be to
    please not enact windfall profit taxes that takes away from
    profitability.
        Mr. Hall. Well, you have hit on another situation there.
    Dr. Cooper, you proposed a windfall profits tax, I believe, did
    you not?
        Mr. Cooper. I haven't proposed a windfall profits tax in my
    testimony for this committee the last two or three times I have
    testified. We have a different set of concerns. We want to
    reintroduce competition so we can get prices responding to
    competition.
        Mr. Hall. But am I incorrect in saying you proposed a
    windfall profits tax to, as you said, I think, discourage
    profiteering?
        Mr. Cooper. We have a severe concern about profiteering in
    the industry because of tight supplies. Our preferred approach
    is to find ways to introduce more competition. I don't believe
    this testimony supports windfall profits taxes. We would like
    to take the profit out of market manipulation, and if we can't
    get these firms behaving, then we have to look at that. But our
    primary objective is to have more competition.
        Mr. Hall. As I read your statement, you said in a paragraph
    on page 6, ``A windfall profits tax that kicks in under
    specific circumstances would take the fun and profit out of
    market manipulation'' so, you, under some circumstances,
    recommend it?
        Mr. Cooper. That is right, we want to take----
        Mr. Hall. Because I want to ask you at what point, what
    figure, what dollar figure--you know, the old windfall profits
    tax was around, I think, $18 or $19--and what happens when it
    drops below that, and people who are producers are still stuck
    with all those expensive reporting things, reporting that they
    owe no--they weren't even able to do that in the 1980's. But
    your testimony was good, and we appreciate it.
        I think my time--I have another minute left. Let me see if
    I have something else to ask. Mr. Murti, as I read your
    testimony, you favor expanding domestic refining capacity
    versus relying on imports, and I like that. You stated ``jobs
    stay in the United States, product supply will be more
    reliable, greater assurance that the products will meet U.S.
    environmental standards''--is that an accurate summary of your
    statement? Do you want to expand on that?
        Mr. Murti. Yes, sir. If you rely on refined product
    imports, you then subject yourself to two sources of
    disruption, because these foreign refineries will also be
    relying on imported crude from geopolitically challenged areas,
    and we have already seen this happen.
        When Venezuela shut its economy down due to a protest
    strike against President Chavez, you lost not only the crude
    supply from Venezuela, you lost the motor gasoline supply that
    came into our country from Venezuela. You also lost crude
    supply to a number of Caribbean refineries which then, in turn,
    had to reduce their gasoline supply to this country. So, you
    are still going to be dependent upon crude imports, but better
    to at least be dependent on only one potential source of
    disruption rather than two.
        You also can't guarantee that foreign refineries will meet
    our environmental standards, and we are supportive of
    maintaining environmental standards. You just have to travel
    around the world to cities that don't have good environmental
    standards to appreciate what we do have here. And there is no
    guarantee a foreign refinery would meet our strict
    environmental standards.
        Mr. Hall. We have smoked a ``peace pipe'' with Venezuela,
    though, and we are working on that. You are very accurate in
    pointing that out.
        Mr. Douglass, as a purchaser of the refinery output, you
    feel we need more refineries, or need to enlarge the ones we
    have, what is your suggestion there?
        Mr. Douglass. Well, absolutely, we need more capacity. How
    that is done is up to the Congress and up to the individual
    investors, but if we got more supply, we have got obviously the
    stabilization of the market that, even when you have supply
    disruptions, you don't end up with in the shortfall--that is,
    markets that spike 50 and 60 cents a gallon because they have
    been cutoff by the supply system.
        Mr. Hall. Thank you. My time is up. Recognize Mr. Green.
        Mr. Green. Thank you, Mr. Chairman, and thank you again for
    calling the hearing.
        Mr. Edwards, your testimony--and, of course, hearing the
    whole panel--I think what Valero has done is an example of
    mergers increasing capacity not only domestically, but
    offshore. I know in the testimony concerning Orion project or
    Orion facility in Louisiana, is it up and running now?
        Mr. Edwards. Yes, it is. I think that is what my colleague
    pointed out, the Orion Refinery that had all the operating
    issues prior to us buying it. We have invested in reliability
    to make it more to where it operates onstream, and also to
    clean up some of the environmental problems they had in the
    past, and we are continuing that trend.
        Mr. Green. And have you reached out to the fenceline folks,
    so to speak, or the people who may had a bad image of dealing
    with the earlier owners?
        Mr. Edwards. We are really big into community relations,
    and we have had barbecues in the area with the public and the
    community, trying to win back the support that they had lost
    with the previous owner.
        Mr. Green. I know I have a Valero Refinery in my area
    working with my community, and it has been a good experience in
    working together.
        Mr. Murti, you talked about the need to add 260,000 barrels
    every 2 years, a new refinery every 2 years, or expansion. And
    I notice in the testimony earlier from Mr. Edwards, with the
    loss of MTBE we are going to lose about 300,000 barrels per day
    of premium blend stock, do you agree with that?
        Mr. Murti. Yes, sir. We think we have been actually
    optimistic in saying we only need 260,000 barrels a day of new
    refining capacity. We would assume, first of all, that rather
    than losing supply, we actually have continued debottlenecking
    growth. Now, that has been the experience. So, as an analyst,
    we say we need to be proven otherwise before we stop assuming
    debottlenecking, but it is certainly possible, as the good
    folks at Valero suggest, that not only could you go from not
    having debottlenecking growth, but you could actually lose
    supply. And that will almost guarantee we will have an energy
    crisis in the very near future, rather than later on down the
    road.
        Mr. Green. Mr. Slaughter, you testified that Congress
    should enact legislation that streamlines the permitting
    process, and I know that there is contradictory testimony, but
    for expansion projects, new refineries, and others--and you
    heard from my opening statement I am sympathetic to it--was the
    Refinery Revitalization Act the best answer, that we passed a
    couple of weeks ago, or should we focus our attention on
    expanding capacity in the existing refineries?
        Mr. Schaeffer. Congressman Green, I think it was helpful in
    one direction. I think it indicated the House's interest in
    commitment to the domestic refining industry and expanding the
    domestic refining industry. As I mentioned in my oral
    statement, however, I think expansion of capacity of existing
    sites probably offers the most promise because that is a site
    that already has a refinery on it, you don't run into so many
    of the problems as you do with a completely new site and,
    historically, that is where the capacity additions have
    occurred.
        Mr. Green. And I understand, at least in the facilities I
    represent, there is always an effort for debottlenecking. I
    mean, that is an ongoing process to see how much more you can
    get out of an existing facility with, again, maybe re-
    engineering or whatever.
        Mr. Schaeffer. Mr. Green, if I could, I just wanted to
    mention that there has been mention of one project for building
    a new refinery in Arizona that is going on. They have been
    trying to get a permit there for 10 years, and they haven't got
    one yet. So, I think that puts into context why people are
    focusing on existing sites.
        Mr. Green. Sounds like we need a pipeline from the Gulf
    Coast out there, but I worked on that in an earlier lifetime.
        One of the concerns I have is the amount of--Mr. Slaughter,
    what countries do we actually receive refined products from
    now? Typically, I would say it is Venezuela, maybe Valero
    from--I don't know if Valero, in your Aruba facility, exports
    to the United States--but what countries do we have? Very
    little from the Middle East now.
        Mr. Schaeffer. Well, there are some, as you pointed out,
    from Venezuela, from Brazil, we do get some cargoes from Europe
    sometimes, it varies--you know, areas like New England, the
    Northeast Coast, are essentially 20 percent dependent on
    imports to meet their supply. Across the U.S., the figure is
    less than that, but the East Coast is very heavily impacted by
    these imports, and we do have problems--for instance, early
    this year, apparently some of the sources did not invest in
    gasoline sulfur reduction so they could meet the new sulfur
    spec. So, there was some impact in reduced imports of gasoline
    for a period of time. And with an import dependence, those are
    essentially suppliers who look to see whether they have got a
    market opportunity here or not. And they also look at other
    places in the world where gasoline demand is growing even
    faster than ours. They may decide not to make an investment and
    sell their product there.
        Mr. Green. Mr. Cavaney, the Federal Clean Air Act of 1990
    established the RFG Program requiring the Nation's most
    polluted cities to use 2 percent oxygenates. And I can tell you
    that at least in the Houston area, we have benefited from that.
    We know that Congress intended substantial use of MTBE which
    made great progress in the air quality, but again we found out
    that it is unpleasant to taste or smell, and water
    contamination associated with leaky storage tanks has resulted
    in a lot of defective product lawsuits against refiners.
        How does the threat of defective product lawsuits against
    refiners for meeting the Government standard through the use of
    that Government requirement on product affect refining capacity
    or gasoline supply?
        Mr. Cavaney. Well, first of all, the Clean Air Act--you can
    go back and look at the record--required the use of an
    oxygenate, and it was clear from looking at the record at the
    time that the only volumes that could be created to satisfy
    that Government requirement was going to be MTBE principally,
    and to a much lesser degree ethanol. The use of that MTBE, in
    essence, then was known to everyone and was used by us. And now
    that it has been taken out of--by certain State actions--the
    mix, we are required to continue to use ethanol. And so there
    is a great deal of movement from ethanol in places where it is
    traditionally grown, using corn to the products.
        Now, the thing that we are concerned about is that there is
    a whole flurry of lawsuits that claim that the industry should
    be held liable. And what that does is it adds yet further
    concern, looking to the future, about whether or not this is an
    industry that one ought to invest in because one only need look
    at other industries that have been faced with huge actions of
    this nature by trial lawyers, and you can see that it is an
    additional cloud.
        The industry, if you look at the current law, anything that
    we spill in MTBE that we do, we are accountable for. Current
    law takes care of that. So, it is not anything to let us off
    the hook, but yet these lawsuits continue to pursue this
    particular thing.
        Mr. Green. I don't mean to cut you off, but I am on a time
    limit. I know Mr. Douglass is representing convenience stores,
    and we have talked about the leaky storage tank that goes back
    to the refiners. In all honesty, we have been paying money into
    a trust fund to be able to correct that, and we are not
    utilizing as much as possible--and, again, I am almost out of
    even my extra 3 minutes, the chairman told me now as ranking
    member I have--but it is interesting because of the importation
    that you talked about, Mr. Slaughter, from Europe--and I know
    most European countries use MTBE--so if the New England States
    eliminate MTBE, then you have to find it somewhere else, or
    they produce it only for New England consumption.
        Mr. Chairman, I appreciate your understanding, and look
    forward to additional questions if we have that time.
        Mr. Hall. T note the presence of Mr. Waxman. Mr. Waxman,
    would you have any questions at all?
        Mr. Waxman. I would like to have an opportunity.
        Mr. Hall. The Chair recognizes the gentleman for 5 minutes.
        Mr. Waxman. Thank you very much, Mr. Chairman. Mr.
    Schaeffer, I would like you to address a statement made by Mr.
    Cavaney from API. In his testimony, Mr. Cavaney said, ``For
    years, getting permission to build a new refinery or expand
    existing refineries in the U.S. has been an extremely
    difficult, inefficient, and inordinately time-consuming
    process.''
        My understanding is that in recent years many refineries
    have simply ignored the permit requirements. Refineries have
    conducted major capacity expansion with significant increases
    in air pollution, but without applying for the New Source
    Review permits required under the Clean Air Act.
        For years, you were in charge of EPA's effort to enforce
    these Clean Air requirements. Could you please address Mr.
    Cavaney's claim in light of the refineries' actual practices?
        Mr. Schaeffer. Thank you for the opportunity to answer that
    question, Congressman. I think, first of all, the facts are the
    average refineries have--the ones that are still in existence
    now--have approximately doubled in size, and that is Department
    of Energy data.
        We did find that a number of those capacity expansions were
    not permitted. We did issue some Notices of Violation, and we
    actually approached large companies like BP and Motiva, invited
    them into settlement discussion and, interestingly, in those
    conversations, we didn't hear a lot about the vagueness of New
    Source Review and the lack of certainty. We actually got right
    down to brass tacks and were able to negotiate, I think, some
    pretty successful settlements. BP and Motiva together are
    spending close to a billion dollars upgrading their plants and
    adding pollution controls. Companies like Exxon-Mobile, I
    think, following their long tradition, chose to fight instead.
    That is their right, of course, under the law. What concerns me
    is the Administration's failure to do any followup enforcement.
    And, again, you have the list in the attachment of cases that
    have been sitting now for 4, 5 and 6 years, with no action from
    the government.
        Mr. Waxman. Mr. Schaeffer, Mr. Cavaney also claims that in
    areas not meeting the new National Air Quality Standards to
    protect human health from fine particulate matter, it will ``be
    difficult or impossible to obtain construction and operating
    permits for expansions or new refineries.''
        What have we actually seen occur in nonattainment areas? Is
    there any basis whatsoever for claiming that it will be
    impossible for industry to expand?
        Mr. Schaeffer. I don't think so. I think expansions have
    been fairly brisk in nonattainment areas, and that again is
    easily checked with the Department of Energy. I would point you
    to the Port Arthur-Beaumont areas where there are some
    significant expansions going on, and we could find other
    examples.
        Mr. Waxman. Well, all evidence to the contrary, we are
    likely to continue to hear from the industry that environmental
    protections are to blame for high gas prices. No one claims
    that requirements to operate with less pollution are cost-free,
    but Americans have decided that they should be able to breathe
    the air and drink the water without endangering their health
    and lives from avoidable industrial pollution.
        I think we need to stop wasting our time and focus on the
    real energy challenges, how to manage and meet strongly rising
    demand for oil with supplies largely located in unstable areas,
    and the increasingly urgent problems of climate change.
        Mr. Chairman, I would like to also ask unanimous consent to
    introduce the charts I used in my opening statement into the
    record, along with a Government Reform Committee report on oil
    dependence and the February EIA analysis of the Energy Bill.
        Mr. Hall. Without objection. I thought Mr. Green had
    already done that.
        Mr. Green. I was going to before we ended.
        Mr. Hall. Without objection, they will be admitted.
        Mr. Waxman. Thank you very much, Mr. Chairman.

        [The EIA report submitted for the record is available at
    http://www.eia.doe.gov/oaif/servicerpt/pceb/pdf/
    sroiaf(2004)02.pdf and the Government Reform Committee report
    is available at http://www.house.gov/reform/min/pdfs_108_2/
    pdfs_
    inves_pdf_energy_national_energy_policy_oil_dep]

        Mr. Cavaney. Mr. Chairman, may I respond, since the
    question was pointed to me. First of all, we have not claimed
    that environmental costs are responsible for the very high
    prices. Appropriately, crude oil is the principal amount.
    Second largest component is taxes. It is a factor. The returns
    from the industry, as has been said by several of the panelists
    here, are historically low, well below the all-industry
    average. So, every little bit of extra cost that can be avoided
    or is not needed helps you be able to deliver the product. We
    do not argue that any environmental regulations be rolled back.
    There are honest differences on how you interpret them and, as
    was said, there is a system where you can approach those kind
    of things.
        We feel that our viability of serving the consumer is that
    we want to have the minimum emissions that we can, consistent
    with providing health and have clean products, and we are
    working in that regard. I think our most recent regulatory work
    with EPA on the sulfur removal from diesel and non-road diesel,
    which was supported strongly by the environmental groups, by
    the municipalities, and all, is evidence of our interest in
    working toward having clean fuels, having a clean environment,
    but making sure that we have the kind of returns that are going
    to be necessary to invest and grow the capacity that people are
    needing.
        Mr. Waxman. I appreciate your comments. Thank you, Mr.
    Chairman.
        Mr. Hall. All right. That concludes our questions. I really
    want to thank this panel. At this time, the hearing is
    adjourned.
        [Whereupon, at 2:40 p.m., the subcommittee was adjourned.]
        [Additional material submitted for the record follows:]
                                                        August 17, 2004
    The Honorable Ralph Hall
    Chairman,
    House Subcommittee on Energy and Air Quality
    2125 Rayburn House Office Building
    Washington, DC 20515
        Dear Mr. Chairman: Thank you again for the opportunity to testify
    before the Subcommittee on Energy and Air Quality July 15, 2004,
    regarding the ``Status of the U.S. Refining Industry.'' I hope my
    comments were informative and prove helpful as you consider issues
    affecting the petroleum industry.
        In response to questions posed in your July 22, 2004, letter, I
    submit the following comments:
        Question 1. Mr. Douglass, in your testimony you call for a
    moratorium on the creation of new boutique fuels. I understand that
    many States with ozone non-attainment areas are preparing
    implementation plans to comply with the new ozone air quality standard.
    Are you concerned that these new SIPs will contain mandates for new
    boutique fuels that will further balkanize the nation's gasoline and
    diesel fuel markets, making the price spikes we have seen recently more
    likely?
        Response: That is precisely my concern. As more and more
    communities are designated in non-attainment, States will consider many
    strategies to bring their environmental performance into compliance
    with the new, more stringent ozone standard. In past SIP submissions,
    many States have opted to avoid the Federal Reformulated Gasoline
    program and its oxygenate mandate by adopting ``boutique'' fuel
    formations that are designed to meet their air quality needs but do not
    adequately take into account supply and distribution issues. This
    process has fragmented the nation's motor fuels distribution system,
    removing the efficiency and flexibility necessary to respond promptly
    to supply disruptions. The result has been an increase in the incidence
    of regional supply shortages and price spikes.
        As States prepare their new SIPs, NACS and SIGMA believe there are
    sufficient fuel formulations currently in the market that can satisfy
    the compliance challenges posed by the new ozone standard. By requiring
    that States select from these currently available fuel blends rather
    than developing new formulations, Congress would prevent the further
    fragmentation of the gasoline refining and distribution system and
    prevent the current balkanization of the nation's gasoline marketers
    from becoming worse. This is a necessary first step towards
    rationalizing the gasoline distribution market and restoring
    fungibility to the system.
        Question 2. Mr. Douglass, for several years witnesses before this
    Committee, including federal officials, analysts, refiner
    representatives, and your marketer organizations have identified
    boutique fuels as a prime cause in the gasoline price spike we have
    experienced in various regions of the country over the past five years.
    In your testimony, you advocate a moratorium on new boutique fuels and
    a study on rationalizing the number of fuels across the country.
    Shouldn't we be seeking to reduce the number of unique fuel blends
    across the country and restore fungibility between markets, rather than
    just imposing a moratorium on new boutique fuels?
        Response: Restoring fungibility to the system in order to address
    the price spikes experienced throughout the country in recent years is
    a considerable challenge. Reducing the number of fuel blends permitted
    in the market would immediately restore a degree of fungibility and
    flexibility to the market, but at what cost?
        According to a study released by NACS last year (Executive Summary
    attached), reducing the number of fuel blends in the market without
    backsliding on environmental protections will result in reduced
    domestic gasoline production capacity. This is true because as fuels
    are taken from the market, the remaining fuel blends must be the most
    environmentally friendly. These fuels, which require the removal of
    certain gasoline constituents to attain clean fuel standards, are more
    difficult to produce, yield fewer gallons from a barrel of oil, and are
    not available from all refineries.
        Consequently, it is important that Congress understand fully the
    market implications of reducing the number of fuels in the market
    before it determines what would be an appropriate number of blends. For
    this reason, NACS and SIGMA advocate a multi-step approach:

    1) Enact a moratorium on the approval of new fuel blends in order to
            stop the further proliferation of boutique fuels and do no
            additional harm to market fungibility;
    2) Expand domestic refining capacity in order to enhance the industry's
            ability to satisfy consumer demand and to offset any lost
            capacity associated with a possible reduction in the number of
            fuel blends; and
    3) Direct the Environmental Protection Agency and the Department of
            Energy to complete a comprehensive study to determine the most
            appropriate composition of the motor fuel inventory in the
            nation, with proper attention paid to supply availability and
            distribution fungibility. Such a study should return to
            Congress specific recommendations for legislative changes to
            the system.
        Question 3. Mr. Douglass, what is the single most important action
    this Congress could take to both alleviate the pressure for new
    boutique fuels and reduce the number of boutique fuels nationwide?
        Response: Congress must repeal the oxygenate mandate of the Clean
    Air Act's reformulated gasoline program. More than any other provision
    in the Clean Air Act, the oxygenate mandate has contributed to the
    proliferation of boutique fuels and the fragmentation of the nation's
    motor fuels distribution system as States have opted for their own
    boutique fuel programs rather than relying upon fuels containing either
    MTBE or ethanol. The time has come to repeal this provision. It has
    outlived its usefulness as advancements in gasoline formulations and
    engine performance have rendered it obsolete.
        While NACS and SIGMA believe this is the most important action
    Congress can take, we disagree with some others in the industry who
    believe this is the only step Congress should take. Repealing the
    oxygenate mandate will significantly improve the market's performance,
    but it alone will not satisfy the long-term needs of the motor fuel
    production and distribution system. Congress must pursue a
    comprehensive approach to increased domestic refining capacity and
    restored supply fungibility. Repealing the oxygenate mandate is simply
    the necessary first step.
        Question 4. Mr. Douglass, your testimony cites several statistics
    regarding the reduction in the number of domestic refineries and in
    domestic refining capacity. Your testimony calls for regulatory reform
    and tax incentives to stimulate the addition of domestic refining
    capacity. If Congress does not consider such proposals, are we as a
    nation going to become more dependent on imports of gasoline and diesel
    fuel in the future?
        Response: Yes, if Congress fails to act the nation will become more
    dependent upon imported gasoline and diesel fuel. Consumer demand for
    motor fuels continues to grow, despite efforts to promote conservation.
    Without a coordinated strategy to expand domestic refining capacity,
    the gap between supply and demand will widen and the nation will
    increasingly look overseas to fill that gap.
        We are already on the path to greater dependence on imports. This
    year, the nation is importing close to 1 million barrels of motor
    gasoline every day and the Energy Information Administration predicts
    that imports will account for at least 20 percent of our demand in
    2025. Congress can improve the nation's energy security by encouraging
    an expansion of domestic refining capacity and reducing its reliance on
    imports.
        Question 5. Mr. Douglass, if I understand your testimony, you are
    stating that our nation is at a cross-road when it comes to domestic
    refining capacity. We can continue on our current course and face ever
    increasing imports of gasoline and diesel fuel in the future.
    Alternatively, we can recognize the regulatory and financial challenges
    being faced by our nation's domestic refiners and pass legislation to
    alleviate these challenges while at the same time preserving our
    environmental protection laws. Is that correct?
        Response: That is correct. Federal and state governments have
    enacted environmental protection laws and regulations that ignore the
    realities of the motor fuels production and distribution industry.
    Congress must change course if it wishes to promote domestic energy
    security and provide the transportation fuels vital for the economy.
    This does not mean that environmental protection goals should be
    ignored or discarded. Instead, it means that renewed attention must be
    paid to producing adequate domestic supplies of clean fuels.
        In recent testimony, the refining industry has identified specific
    regulatory hurdles that have inhibited the expansion of refining
    capacity. Mr. Red Cavaney detailed on July 15 detailing the various
    regulatory impediments the industry faces. NACS and SIGMA believe that
    unless some balance is introduced into our regulatory system, the
    industry will continue invest its available capital in regulatory
    compliance upgrades rather than capacity expansion.
        The refiners have also detailed the economic conditions impacting
    capacity expansion decisions. Mr. Murti testified July 15 that Wall
    Street typically requires at least a 10 percent return when reviewing
    investment opportunities. The refining sector typically earns a 5
    percent return, far below the threshold reported by Mr. Murti. This is
    an impediment to refinery capacity expansion and demonstrates the need
    for Congress to consider incentivizing expansion projects.
        Congress does have a decision to make. It can continue pursuing an
    environmental agenda that pays no heed to energy and economic realities
    and increases our reliance on imported product, or it can seek a
    balanced agenda that promotes environmental protections while
    supporting the energy and economic interests of the nation.
        Question 6. Mr. Douglass, you state in your testimony that the
    marketer groups you represent support environmental protection
    programs. I think I hear you asserting that affordable and plentiful
    supplies of gasoline and diesel fuel do not have to come at the price
    of environmental protection. Do you believe that the proposals you are
    advancing can be achieved without sacrificing the significant advances
    our nation has made in improving our air quality and producing cleaner
    gasoline and diesel fuel?
        Response: Yes, I do believe that the nation can expand refining
    capacity and restore fungibility to the marketplace without sacrificing
    environmental protections. It is a question of balance, and Congress
    must take a careful look at all aspects of the policies it promotes.
    Focusing on only one segment of the issue, whether it be supply
    availability or environmental protections, without regards to the other
    is short-sighted and doomed to failure. The supply-oriented proposals I
    outlined in my testimony were influenced by the assumption that
    environmental quality will be protected.
        Congress must promote a balanced approach to motor fuels policy
    that continues to advance the cause of clean air while ensuring that
    America's consumers can access the vital resources of gasoline and
    diesel fuel.
        Mr. Chairman, thank you again for the opportunity to present the
    views of NACS and SIMGA to the Subcommittee. If you have any additional
    questions, please do not hesitate to contact me.
                Sincerely,
                                                  Bill Douglass
                                     CEO, Douglass Distributing Company
    cc: The Honorable John Sullivan
                                     ______

         MOTOR FUELS SUPPLY FUNGIBILITY AND MARKET VOLATILITY ANALYSIS

                               EXECUTIVE SUMMARY

            Produced for: National Association of Convenience Stores

        In 1990, gasoline sold in the United States was distinguished only
    by three grades (regular, midgrade and premium) and volatility
    restrictions in two geographies (northern and southern) and two seasons
    (winter and summer). Today, the number of different U.S. gasoline
    blends has increased to no fewer than 15 (excluding the various octane
    grades). These new and varied gasoline formulations have proliferated
    over the intervening years primarily due to more restrictive federal,
    state and local air quality standards
        In late 2002, the National Association of Convenience Stores (NACS)
    asked Hart Downstream Energy Services (Hart) to conduct a comprehensive
    analysis of the current gasoline market situation in the United States.
    NACS inquired about potential problems associated with the continued
    proliferation of unique, non-fungible federal, state and local fuel
    blends--commonly referred to as ``boutique fuels.'' NACS requested Hart
    to analyze the current impact these boutique fuels are having on
    national and regional markets in the United States and the refining
    industry's ability to produce, distribute and deliver sufficient
    quantities of these fuels to the consuming public.
        In particular, NACS was interested in assessing the impact of
    various regulatory scenarios on four primary criteria: overall gasoline
    supply, gasoline fungibility, ultimate costs to the consumer and
    environmental quality. To lay the foundation for this analysis, NACS
    requested that Hart examine the following eight cases:

     Baseline Analysis 2001: A characterization of the current ``state of
            the refining industry'' in terms of regional gasoline supply,
            demand and quality, and overall refining operations and
            production capability.
     Baseline Analysis 2007: Extends the 2001 Baseline through 2007
            incorporating those market, regulatory and refining changes
            that are expected to occur. Baseline 2007 assumes state bans of
            MTBE in California, Connecticut and New York are implemented,
            the RFG oxygen standard remains in place and no renewable fuel
            standard is imposed. In addition, this Baseline assumes the
            implementation of Tier 2 sulfur standards for gasoline, the
            Mobile Source Air Toxics (MSAT) program and the ultra-low
            sulfur diesel rule
     Flex Case 1--No MTBE Bans: Models market conditions if California,
            Connecticut and New York did not ban MTBE. Assumes the RFG
            oxygen standard remains in place and no renewable fuel
            standard.
     Flex Case 2--Based on House Energy Bill (H.R. 6): Assumes
            implementation of an MTBE ban in California, Connecticut and
            New York, without the RFG oxygen standard in place and with
            implementation of a renewable fuel standard.
     Flex Case 3--Based on Senate Energy Bill (S. 14): Assumes a Federal
            MTBE ban, without the RFG oxygen standard and with
            implementation of a renewable fuel standard.
     Flex Case 4--Four Fuels Program: Assumes a Federal MTBE ban, with the
            RFG oxygen standard in place and no renewable fuel standard.
            Conventional gasoline RVP grades are consolidated into one RVP
            grade. All RFG is consolidated into a single oxygen content
            grade.
     Flex Case 5--Regional Fuels Program: Assumes implementation of an
            MTBE ban in California, Connecticut and New York, without the
            RFG oxygen standard in place and with implementation of a
            renewable fuel standard. Conventional gasoline RVP grades are
            consolidated into two RVP grades in each PADD (7.0 and 9.0 psi
            for PADDs 1, 3, 5 and 9.0 psi for PADD 2).
     Flex Case 6--RFG Only Program: Assumes implementation of an MTBE ban
            in California, Connecticut and New York, without the RFG oxygen
            standard in place and no renewable fuel standard. Conventional
            gasoline is consolidated to meet RFG specifications.
    Current Market Conditions
        A comparison of the various U.S. summertime gasoline blends
    currently required in different parts of the country shows that the top
    four summertime blends represent approximately 83 percent of the U.S.
    gasoline market, while most blends are much less common,
    interchangeable and fungible; each representing only a small market, as
    well as a small portion of the U.S. gasoline pool.
        Most of these gasoline blends are not fully fungible with other
    gasoline blends for a variety of reasons, including:

     Gasoline blended with ethanol cannot be mixed with other gasoline
            blends in the common carrier pipeline system or gasoline
            storage tanks.
     Low-RVP gasolines, while providing a less expensive way than RFG for
            localities to obtain air quality improvements, place additional
            strain on the distribution system.
     Seasonal changes to gasoline formulations (i.e. winter-to-summer
            transition) can reduce refiner flexibility, gasoline
            fungibility and distribution efficiency.
     Market-specific fuel requirements often prohibit the transfer of
            product from one region to another, thereby exacerbating
            gasoline shortages and regional price increases during supply
            disruptions.
     Segmenting the U.S. gasoline system means that fewer domestic and
            international refiners are able to provide product meeting the
            various clean-fuel requirements. This limitation on available
            gasoline supply prevents rapid response from neighboring
            refineries and/or gasoline terminals in the event of a capacity
            shortage, further pressuring the refining system and driving up
            gasoline prices.
        Further complicating the boutique fuel issue is the overall
    reduction in U.S. refining capacity. Since 1981, the total number of
    refineries in the U.S. has fallen from 324 to only 149. Meanwhile,
    domestic refineries operate today at approximately 93 percent of
    maximum capacity.
        Net oil imports are expected to increase from about 55 percent of
    U.S. oil consumption in 2001, to approximately 68 percent by 2025.
    Additionally, U.S. gasoline consumption is projected to rise from 8.7
    million barrels per day in 2001 to 13.8 million barrels per day in
    2025, with gasoline imports continuing to increase. Today, more than
    five percent of America's motor gasoline supply is imported; nearly all
    of that directly to the Northeast market.
        Considering the nation's maximized operational capacity, increased
    reliance on imported oil, and strained refining infrastructure, any
    complicating factors in the gasoline distribution chain, refining
    outages, or multiple small-market fuel formulations can easily impact
    overall supply and consumer costs. Further, overall gasoline demand is
    expected to continue to grow at rates greater than two percent annually
    over the near-term, particularly in the Northeast U.S.--one of the
    regions most sensitive to gasoline supply volatility and price impacts
    due to its reliance on imports.
        Many in the refining industry, environmental community, and
    government, as well as consumer groups, have called for a reasonable,
    gradual and consistent approach to implementing fuels standards.
    Summary of Findings
        Recognizing the ongoing public policy debate over fuels issues,
    NACS requested an examination of several possible real-world scenarios
    that would potentially impact current U.S. gasoline supply,
    distribution and delivery. The following summaries outline the impact
    on gasoline supply compared to the projected production capacity of
    Base Case 2007. Analyzing such production capacities provides valuable
    insight into the potential balance between supply and demand and the
    nation's projected reliance on imported gasoline, each of which can
    ultimately influence consumer costs.
        While striving to preserve current air quality (a prerequisite in
    any fuels regulatory endeavor), the models produced two generally
    competing findings that should be carefully balanced in any future
    policy changes to the U.S. gasoline system: 1). Overall reduction in
    the number of gasoline formulations required throughout the nation can
    be expected to improve overall system fungibility and potentially
    reduce marketplace volatility associated with boutique fuels; and 2).
    Decreasing the number of fuel formulations reduces the domestic
    refining system's capacity to produce compliant fuels.
        In general, findings included:
    Production
     Base Case 2007: Growth in gasoline demand will continue to outpace
            domestic refining production capability. By 2007 the domestic
            gasoline shortfall (or reliance on imported product) will
            increase by 987 thousand barrels per day over 2001. Refinery
            capacity expansion will be necessary and utilization will
            approach the maximum.
     Flex Case 1--No MTBE Bans: Gasoline production is 2.4 percent higher
            from the Baseline 2007. With no state MTBE bans, total MTBE use
            increased by 160 thousand barrels per day and ethanol use
            decreased by 65 thousand barrels per day.
     Flex Case 2--Based on House Energy Bill (H.R. 6): Gasoline production
            is reduced 0.6 percent from Baseline 2007. With state MTBE bans
            as in Baseline 2007, with an RFS, but with no oxygen standard,
            MTBE blending is reduced by 35 thousand barrels per day versus
            the Baseline and ethanol increased by 50 thousand barrels per
            day to satisfy the renewable standard.
     Flex Case 3--Based on Senate Energy Bill (S. 14): Gasoline production
            is reduced 5 percent from Baseline 2007. This case examined a
            national MTBE ban, coupled with an RFS and no oxygen standard.
            This resulted in the removal of 160 thousand barrels per day of
            MTBE from the gasoline pool. Ethanol use is roughly the same as
            Flex Case 2 to satisfy the renewable standard.
     Flex Case 4--Four Fuels Program: Total gasoline production is reduced
            16 percent from Baseline 2007. In this Flex Case, ethanol must
            be used in RFG to satisfy the RFG oxygen requirement, which
            remains in place. Gasoline production capability is further
            curtailed as a result of the additional requirement to lower
            the RVP of a large portion of the conventional gasoline.
     Flex Case 5--Regional Fuels Program: Gasoline production is reduced
            4.5 percent from Baseline 2007. This case considers the state
            MTBE bans and the oxygen standard of Flex Case 2. The
            additional requirement to consolidate conventional gasoline by
            reducing RVP of the higher volatility grades further reduces
            gasoline production (beyond Flex Case 2) by about 330 thousand
            barrels per day.
     Flex Case 6--RFG Only Program: Gasoline production capability is
            reduced by about 9 percent over the 2007 Baseline. This Case
            represents the state MTBE bans without an RFG oxygen or
            renewable fuel standard. In addition, all gasoline is produced
            at RFG quality. The RFG requirements result in slightly higher
            ethanol use to ensure RFG quality. The more stringent RFG
            standards severely constrain gasoline production capability.
            However, increased MTBE use outside the ban areas makes up
            volume and minimizes production loss. Total MTBE use was 275
            thousand barrels per day (only 115 thousand barrels per day
            above Baseline 2007).
        These findings demonstrate that all future regulatory scenarios to
    a varying degree have the potential to reduce the nation's ability to
    produce sufficient quantities of gasoline to meet demand and,
    consequently, to increase the nation's reliance on gasoline imports.
    The analysis indicates that, under the given conditions, Flex Case 1
    would have the most positive impact on the nation's supply balance
    while Flex Case 4 would have the worst impact. The Flex Cases rank
    according to the 2007 Base Case as shown in Table 1.

     Table 1: Gasoline Production, Imports and Percent Change in Flex Cases
    ------------------------------------------------------------------------
                                                    Incremental  % Change in
                                           Net        Imports     Production
                   Case                 Production     Needed    Relative to
                                          (MBPD)       (MBPD       Baseline
    ------------------------------------------------------------------------
    2007 Baseline....................        7,915            -            -
    Flex Case 1......................        8,107         -192         2.4%
    Flex Case 2......................        7,864           51        -0.6%
    Flex Case 5......................        7,560          355        -4.5%
    Flex Case 3......................        7,513          402        -5.1%
    Flex Case 6......................        7,217          698        -8.8%
    Flex Case 4......................        6,672         1243       -15.7%
    ------------------------------------------------------------------------

        This analysis further provides an indication of how each Flex Case
    may impact the ultimate price paid by the consumer. In general, the
    more out of balance the supply-demand relationship, and the greater the
    nation's reliance on imported gasoline, the more susceptible the
    consumer will be to higher gasoline prices. To this end, it can be
    assumed that the same rankings applied to production capacity and
    import reliance could also be applied to anticipated consumer prices.
    Fungibility
        Assuming the environmental impact of each Flex Case is constant or
    improved over Base Case, the final criteria of concern remains gasoline
    fungibility. An analysis of the Flex Case descriptions renders the
    following comparison in terms of impact on fungibility:

     Flex Case 1--No MTBE Bans: Improves fuel fungibility and overall
            product availability by eliminating the pending California, New
            York and Connecticut bans on the fuel additive MTBE. In the
            Northeast, the product distribution infrastructure will be less
            stressed by not having to deliver segregated MTBE- and non-
            MTBE-gasolines to various markets in the region. In addition,
            the market will not have to accommodate two distinct
            oxygenates, one of which (ethanol) cannot be shipped in the
            pipeline. California likewise will not have to transport an
            oxygenate outside of the pipeline and will experience improved
            fungibility over Base Line.
     Flex Case 2--Based on House Energy Bill (H.R. 6): Loosely modeled on
            the House passed energy bill (H.R. 6), this case examines an
            elimination of the RFG oxygenate mandate and an implementation
            of a renewable fuels standard. Like Base Line 2007, state MTBE
            bans remain in place, which reduces fungibility. The repeal of
            the oxygenate mandate could add additional flexibility to the
            system, but the presence of oxygenated and non-oxygenated RFG
            could also pose a fungibility challenge as the two fuels may
            not be commingled in storage tanks.
     Flex Case 3--Based on Senate Energy Bill (S. 14): Loosely modeled on
            the Senate energy bill (S. 14), this case is similar to Flex
            Case #2 with the exception of a national ban on MTBE. The
            legislation simplifies the distribution system by removing the
            state-by-state bans on MTBE, thereby restoring fungibility.
     Flex Case 4--Four Fuels Program: Along with Flex Case #6, perhaps the
            most fungible of the cases modeled, this case includes a
            national ban of MTBE, thereby removing the distribution
            challenges imposed by independent state actions. In addition,
            the model consolidates all conventional gasoline into one RVP
            grade and yields only one RFG formulation--ethanol-RFG.
            Distribution challenges arise with the delivery of ethanol
            throughout the nation.
     Flex Case 5--Regional Fuels Program: Establishes a regional fuels
            program that will improve fungibility within each PADD,
            consolidating conventional gasoline to two RVP formulations and
            RFG, thereby simplifying the distribution system and restoring
            a large degree of fungibility.
     Flex Case 6--RFG Only Program: Along with Flex Case #4, perhaps the
            most fungible of the cases modeled, this case eliminates all
            conventional gasoline and creates a market in which only RFG
            (northern, southern and California) is allowed in the market.
            Ethanol- and MTBE-RFG markets are regionally segregated,
            thereby limiting the distribution challenges to accommodate
            these two fuels.
        The above analysis clearly indicates that restoring fungibility to
    the system will require a compromise in terms of production capacity
    and reliance on foreign product. As the more fungible cases were run
    through the model, production capacity of the domestic refining
    industry was sacrificed. The two most fungible cases (#4 and #6)
    produced the greatest reduction in production capacity and reliance on
    imported gasoline. The case with the most positive impact on production
    capacity (#1) is likely politically unrealistic due to current debate
    over the expanded use of ethanol and restricted use of MTBE.
        The challenge for developing a new fuels program is to
    simultaneously assess the impact on production capacity with that of
    fungibility and determine the best overall solution for the market.
    This report provides the foundation for such an analysis.
        Based on these findings, NACS presents to policymakers the
    following fundamental concepts that must be addressed when developing a
    comprehensive fuels policy:

    1) Recognize that fuel ``Balkanization'' is a growing problem that
            contributes to price volatility;
    2) Acknowledge that domestic gasoline supply will continue to contract;
    3) Ensure that imports of finished gasoline are not restricted;
    4) Develop a coordinated refining industry policy to promote domestic
            capacity expansion; and
    5) Develop a coordinated distribution infrastructure policy to
            facilitate the efficient delivery of product to retail.
        NACS looks forward to working closely with the policymakers and
    other leaders in the fuel refining and distribution system to develop a
    coordinated, thoughtful approach that ensures government and industry
    work together toward a reasonable motor fuels policy.

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