The recently closed Delaware City refinery. Formerly, it was one of Delaware’s largest employers. (image: s.wsj.net)

“Oil production creates wealth, but oil refining has often destroyed it.” That’s in the words of a Barclay’s analyst, and it sums up what’s been happening in the oil industry. As the New York Times reported on December 24, US refiners are losing money and shutting down plants.

The problem is overcapacity—US refineries have the potential to distill far more fuel from crude oil than the nation needs. The reasons for that overcapacity are many. First and most obviously, there’s the recession, which has depressed economic activity, including travel and shipping—the main uses of refined petroleum fuels. (Almost 32 gallons of each 42 gallons of crude oil are turned into gasoline, diesel, or jet fuel; by contrast, less than 2 gallons will become heating oil.)

However, if the recession were the only problem, refiners would be—comparatively—happy. After all, recessions eventually end. Unfortunately for refiners, there are longer-term trends, as well as legislative and administrative changes, that suggest that reduced fuel demand is now built into the structure of American society. For several reasons, experts believe that gasoline consumption peaked in 2007 and will never reach that level again:

• Higher fuel-efficiency standards for cars. By 2016, average fuel economy will be 35.5 miles per gallon, up 40 percent from today’s 25 mpg average. This alone is expected to reduce oil consumption by almost 2 billion barrels over a 4-year period.

• Greater use of ethanol. Government mandates for the inclusion of ethanol keep rising. At present, at many pumps, “gasoline” is 10-percent ethanol, and that percentage is expected to rise.

• Demographics. The US population is aging with the Baby Boomers. As it ages, it drives less.

• Conservation. People are becoming more conservation-minded; to draw a metaphor from the fashion industry, “green is the new black” and conspicuous conservation is chic. This is reflected in the growing sales of hybrid cars, as well as in the electric cars that are in the works.

• Climate legislation. Whether it’s cap and trade as currently envisioned or some other scheme, any legislation that increases the price of emitting carbon will create incentives to burn less fossil fuel, including gasoline.

Of course, there are significant upsides to the nation in these trends. Reduced fuel consumption decreases both our carbon footprint and our dependence on imported oil. Ethanol mandates support the biofuel industry, increasing utilization of this renewable (even if not always carbon-friendly) fuel. Biofuel supplies (which includes biodiesel and biofuel heating oil) have gone from trivial just a few years ago to significant: there are projected to be 15 billion gallons in 2012 and 36 billion gallons by 2022. Indeed, many refiners, like Valero, are expanding their ethanol production and refining capacities, looking to shift to biofuel as a hedge against reduced demand for gasoline and other fossil fuels. They believe that biofuel is where “the future of demand growth and transportion fuels” will be, in the words of a Valero spokesman. This should help increase the availability of biofuel for home heating as well.

However, while there are good effects for the nation, the consequences for refiners are strongly negative. Seven hundred thousand barrels of refining capacity have been shut down or mothballed in North America in just the last year alone. Five mainland US refineries were shut down entirely in 2009, including plants in Delaware and New Jersey. The overall number of US refineries has declined to 150, from a peak of 300 in the early 1980s. Even after all these cuts, there’s still too much capacity; the chief economist at one refiner estimates that current industry capacity of 18 million barrels per day must be cut by another 5 to 8 percent (or around 1.35 million barrels) to bring it more in line with demand.

Squeezed between reduced demand and the persistently high cost of crude oil—which is keeping gasoline prices in the upper $2’s—refineries are losing money. Exxon Mobil, for example, lost $203 million on US refinery operations in the third quarter alone. That high crude price is why oil production remains profitable, but refining has become, in many cases, a money-losing proposition—hence, the shutdowns.

The human cost of shutting refineries is high. They provided steady, highly compensated blue-collar work at a time when such jobs are scarce. They were often also the largest employer in their communities, and a significant pillar of the local tax base. When refineries cut back or close, there may be no other good economic options for their workers, municipalities, or counties.

However, if you’re not invested in or employed by a refiner, their bad news may be your good news. Besides the previously mentioned positive environmental effects of reduced gasoline and diesel demand, or the growing availability of biofuel, the combination of refinery overcapacity and diminished demand has the potential to reduce gasoline prices on a sustained basis. Once the economy improves and Americans can afford to travel again, they may be traveling less expensively.

Valero’s already making money on ethanol, and now plans to make biodiesel from algae. (image: tour.diabetes.org)

Sometimes profitability can come from the most unlikely places. As the San Antonio Express-News reported on Thursday, Valero Energy Corp. may have had a tough year in the refining business, but is seeing unexpected gains in its production of ethanol. The company is making money with the green fuel after buying seven corn ethanol plants for $477 million. While Valero posted losses for its total business, its ethanol business reported earnings of $49 million for one quarter, and $71 million for the next.

Valero officials have seen an increase in demand for ethanol, most likely due to low prices of corn and government mandates to boost usage. The government does subsidize ethanol production, and producers are more likely to make a profit these days because of cheaper prices of corn and natural gas.

While the sustainability of Valero’s profits is subject to debate, it is prompting further action from producers, who are asking the EPA to allow for a higher blend of ethanol in gasoline. The current blend is 10 percent, while ethanol producers are shooting for 15 percent by next year. The EPA will rule on the matter on Dec. 1, and will likely start out with a compromise of 12 percent.

Valero isn’t the only large company getting into the biofuels game. As HeatingOil.com reported last week, oil giant BP is set to begin commercial production on several different types of biofuel as early as next year. Middlebury College has found alternative uses for willow trees as energy, and an increasing number of commercial jets are turning to biofuel as their power source. Valero itself is looking into the production of biodiesel from algae in addition to their current ethanol production business.

The success of Valero’s ethanol arm of the company is great news for green industry. If the corn-based fuel can prove profitable, it could pave the way for other industries, like the heating oil industry, to use more biofuels in their own dealings. The use of ethanol and other biofuels is a positive development because they burn cleaner and reduce our dependence on foreign oil. This, in turn, likely helps to lower costs for home heating oil and other energy consumers.