Midwest Gasoline and Distillate Fuel Near-Term Outlook

Introduction

Within the overall U.S. energy outlook, the supply, demand, and prices of petroleum products in Petroleum Administration for Defense District 2 (PADD 2), the Midwest ⁽¹⁾, recently have been an area of special concern. While prices for gasoline and diesel fuel have posted periods of sharp increases nationally several times in the past two years, these runups have been particularly pronounced in the Midwest. Among the contributing factors cited for these periods of price volatility, relatively low crude oil and product inventory levels are often seen as a major issue. Additionally, the August shutdown of the crude oil distillation unit at the Citgo refinery in Lemont, Illinois due to fire has reduced local production capacity, causing further concerns about supply adequacy over the expected 6-month duration of repairs, and possibly beyond. In particular, during the next few months, several other refineries must perform maintenance, which will require further reduction in local production. As a result, the Energy Information Administration (EIA) reviewed the potential Midwest petroleum supply-demand balance and its implications for price behavior in the fourth quarter of 2001. It appears that a tighter supply-demand balance in the Midwest may result in higher prices in this region compared to the national average for gasoline and distillate fuels over the next few months (U.S. Short Term Energy Outlook). By December, both gasoline and distillate demand in the Midwest will be lower and the refineries undergoing planned maintenance should be back in full operation. While the remainder of the winter is still likely to feature a relatively tight supply-demand balance, much will depend on the regional status at year end.

Demand

Petroleum product demand in the Midwest has grown at relatively modest rates, compared to the nation as a whole, in recent years. Annual growth in Midwest gasoline demand (as represented by product supplied) has averaged 0.7 percent over the past 5 years, reflecting relatively flat population growth in the region (Figure 1). For distillate fuel oil (diesel fuel and heating oil), demand in the Midwest rose by 2.1 percent on average during the past 5 years, attributed to strong growth in diesel fuel with relatively flat demand for heating oil (Figure 2). In comparison to other regions of the United States, only a small portion (about 4 percent) of distillate demand in the Midwest is attributable to home heating, while agricultural consumption of diesel fuel is greater (over 8 percent). Recent events and trends are expected to result in lower demand for petroleum products in the Midwest over the coming fall and winter than would otherwise have been forecast. Recessionary economic conditions in the United States and worldwide will likely reduce commercial and industrial demand, while an expected decline in air travel due to the terrorist attacks on September 11 could result in reduced consumption of jet fuel, easing the supply-demand balance for other products (see below).

Supply

Each region of the United States has its own unique combination of petroleum supply sources to satisfy local demand. As a whole, the nation produces most of the finished petroleum products it consumes (though more than half are refined from imported crude oil), with product imports a small but growing percentage. In the case of the Midwest, local refineries produce about 80 percent of the gasoline and diesel fuel consumed in the region, while most of the remainder is shipped in from other regions, primarily the Gulf Coast. There are virtually no direct foreign imports of these products into the Midwest.

As is the case in many parts of the country, the ability of the Midwest petroleum product supply system to meet demand during peak periods has tightened in recent years, largely due to the combination of rising demand and the closure of a number of marginal refineries. Because this region is partially dependent on shipments from elsewhere in the United States, the capacity of pipeline and barge shipping from other supply regions, particularly the Gulf Coast, has become a constraint to meeting sudden surges in demand or losses of supply. Peak Midwest gasoline demand occurs during the July/August period, and distillate demand reaches its high in September/October, each requiring the utilization of all available transportation to move supplemental supplies from Gulf Coast refineries. This constraint will be lessened with the opening of the Centennial Pipeline from Texas to Illinois, currently scheduled for the first quarter of 2002.

At least until more transportation capacity from other regions is available, refinery production within the Midwest will continue to be the critical factor in petroleum product supply for the region. A fire at Citgo=s Lemont, Illinois refinery during August resulted in the collapse of the crude oil distillation unit and shutdown of the entire plant. This refinery represents almost 5 percent of the operable capacity in the Midwest. Repairs to the unit are expected to take about 6 months. Recently, Citgo has reported that it has restarted selected units at the refinery, using feedstocks brought in from outside. Additionally, several other refineries in the region have scheduled maintenance during the fall, which will result in reduced gasoline and distillate production.

A much-watched indicator of the petroleum supply-demand balance in any area is the level of inventories (stocks) over time. Stocks are built up during periods when new supply (production and net imports) exceeds demand, then drawn down when the balance tilts to an excess of demand. In the Midwest, as elsewhere, stock levels have been an issue of some concern in recent years, with low inventory levels contributing to price runups. The largest gasoline inventory build in the Midwest is usually in January when demand is low. Inventories tend to remain high in February before being drawn down during refinery maintenance in the spring and during the high summer demand period. Additionally, the switch in the spring between winter and summer gasoline specifications in some areas prompts a drawing down of inventories ahead of the high gasoline demand season.

Midwest distillate stocks, by contrast, tend to build in the summer, are drawn down in October by the fall harvest, then are rebuilt in November and December (Figure 3). Last year, low distillate stocks in January kept refiners focusing on distillate with higher than usual yields. As a result, gasoline yields were lower than typical, which tended to erode gasoline inventories prior to the spring increase in gasoline demand.

As of September 28, 2001, primary inventories of gasoline in the Midwest were estimated at 52.6 million barrels, about 4.5 million barrels (9 percent) higher than a year ago, but below levels seen at the same point in the previous two years. Midwest distillate inventories stood at 27.2 million barrels, about 1.9 million barrels lower (6.5 percent) than a year ago, and the lowest at this time of year in over 20 years. The low distillate inventories entering the Midwest's peak demand period in the face of the region's capacity reduction due to accidents and required maintenance leaves little cushion against price volatility. The already low distillate inventories, which normally would build by year's end, may very well end the year at very low levels. Refiners would then likely have to produce at very high distillate yields throughout the remainder of the winter, which would set the stage for low gasoline stocks going into next spring's gasoline season. Thus, the Midwest could see upward distillate price pressure this fall and winter and upward price pressure in the gasoline market next spring.

Forecast Supply-Demand Balance

For the remainder of the year, EIA sees the Midwest gasoline and distillate supply-demand balance being very tight. Table 1 shows the drop in Midwest refinery capacity anticipated from the loss of the Citgo refinery, as well as other refinery maintenance, during the fall months. Periodic refinery maintenance is necessary for both safety and reliability. Refineries run 24 hours per day, 7 days per week, and as with any equipment, parts wear out and need to be serviced or replaced. In many cases, safety issues preclude maintenance delays. Refiners generally build extra inventories in advance of planned outages, and make arrangements with other companies for replacement supplies. Maintenance is normally performed during fall and spring. But this fall, with the Citgo refinery producing much less product than it would otherwise and with the closure of Premcor's Blue Island refinery in January 2001, there will be extra strain on the system.

Midwest petroleum product demand growth this fall is assumed to be lower than historical averages, in keeping with the lower U.S. demand projections. Midwest gasoline demand is projected to grow only at 0.5 percent from the previous year, which is slightly lower than the 0.7 percent U.S. demand growth rate being projected over this same period. Midwest distillate (diesel fuel and heating oil) demand is projected to grow between 0 and 1.0 percent, which is much lower than the 5 percent growth seen through July of this year, but higher than the U.S. forecast, which is projected to decline about 2.2 percent during the last four months of this year than last. The lower forecasts for both gasoline and distillate reflect the decline in the economy. Distillate demand also reflects the impact of warmer weather this winter over last (last winter was colder than normal) and a dropoff in fuel-switching demand that is not thought to be as large in the Midwest as in other parts of the country. However, if Midwest fuel switching is more typical of other areas, distillate demand would possibly follow the U.S. pattern of decline.

Jet fuel is projected to help balance the distillate situation in the Midwest. Normally, if jet fuel demand grew at its typical historical rate of 3 percent, the region would need to supply 11 thousand barrels per day more jet fuel. But this forecast assumes commercial passenger demand will be down about 20 percent, resulting in a drop in jet fuel demand of almost 60 thousand barrels per day from what we would have expected prior to the terrorist attack. The net effect is a reduction of almost 50 thousand barrels per day over what was used last year. The associated net reduction in jet fuel supply can be expected to allow for an increase in distillate supply - both from refineries and through increased distillate pipeline and barge flows from the Gulf Coast.

A detailed balance between supply and demand is shown for the case in which demand for gasoline grows at 0.5 percent and for distillate at 1.0 percent. Because gasoline and distillate production within the region are expected to be lower than last year during this time, and demand in this scenario is higher, extra product must move in from other regions of the country. Table 2 summarizes the pipeline and barge movement assumptions. This scenario requires high movements, but the levels seem to be within the capability of the system. Since much of the unusual barge movement would be taking place before December, frozen waterways are less of a concern. Still, the size of the movements to keep the system balanced indicates the degree of strain relative to historical levels.

Tables 3 and 4 show a projection for the gasoline and distillate balance, taking into consideration planned refinery maintenance and demand growth relative to last year. Table 3 shows that finished gasoline and gasoline blending component production is projected to decline about 22 thousand barrels per day during the last 4 months of 2001 from last year's production. For this scenario, it is assumed that the unaffected refineries are producing about 2 percent more gasoline and almost 5 percent more distillate than last year, which are in the range of their historical capabilities. Pipeline and barge gasoline flows into the region are assumed to increase over last year's levels, and some gasoline that normally would move to the East Coast (reduction in movements from PADD 2 to PADD 1) is assumed to stay in the region. That is, the net movements of gasoline into the Midwest are assumed to make up for the loss of refinery production. However, inventories helped meet demand during these four months last year, and we assume we will see some demand growth over last year. That requires inventories to cover both what was covered last year and the additional volumes for demand growth this year, which results in a total inventory decline of 27 thousand barrels per day. Even with no gasoline demand growth, inventories would decline 15 thousand barrels per day over this period.

Table 4 shows that distillate production is expected to fall by 27 thousand barrels per day. But with the decline in jet fuel demand, extra distillate can move through the pipelines and barges in its place. This allows for increased movements of distillate into the region and allows inventories to build if demand growth remains at 1 percent or lower.

The resulting stock levels are summarized in Table 5. Both gasoline and distillate inventories would reach record low levels in this situation, again emphasizing the tightness of the Midwest market. Any unexpected cold weather, giving rise to a sudden demand increase or additional refinery problems, could cause distillate prices to rise sharply.

Should demand be even lower than projected in Tables 3 and 4, the supply-demand balance will improve. But even zero growth in both gasoline and distillate show a very tight balance. With no demand growth from last year, and production and flows into the PADD remaining unchanged, distillate inventories would end the year at 29,963 thousand barrels and gasoline at 35,872, just above the twenty year lows experienced in December 2000. If, however, distillate demand declined 2 percent, 23 thousand barrels per day less demand would have to be met, and all else staying the same, distillate inventories could build back to more typical levels by the end of December.

Prices

Retail gasoline and diesel fuel prices in the Midwest have historically averaged slightly less than those nationwide, and have tended to move in parallel with the national average (Figure 4). From 1995 through 1999, the average retail gasoline price in the Midwest was $1.110 per gallon, compared to a national average of $1.135. Similarly, the Midwest average retail on-highway diesel fuel price during that period was $1.128, while the national average was $1.149. The Midwest average price ranged from 7 cents below to 2 cents above the national price for gasoline, and from 4 cents below to equal the national average for diesel fuel. However, in 2000 and 2001, the relationship between Midwest and national average prices has become more unpredictable. Although the Midwest average price for both products over the past two years has remained slightly below the national average, the differentials have ranged from 15 cents below to 19 cents above for gasoline, and from 7 cents below to 7 cents above for diesel fuel. The largest differences seen have generally been the result of sharp price runups, particularly for gasoline, near the beginning of the summer driving season the past two years.

Except in very rare instances, changes in retail petroleum product prices tend to directly follow changes at the wholesale level, with a consistent lag between the two. EIA analysis has shown that a given change in the spot market price for gasoline or diesel fuel is transmitted, over a period of several weeks, to the retail market. Because of the time lag and the Aspreading out@ of changes in spot markets, which can sometimes rise or fall significantly in a single day, retail price changes tend to be more gradual, and cover a narrower range. For instance, in May and June of 2000, spot gasoline prices in Chicago rose by as much as 80 cents per gallon over a 7-week period, while average retail prices in the region rose by about 50 cents. Because of the lag in markets Apassing through@ these price changes, spot prices had already begun to decline sharply before retail prices had caught up with the earlier increases. In general, EIA has found that, following a sharp increase in spot prices, retail prices will generally rise and fall at a slower rate, not reflecting the entire amount of the peak wholesale increase, but sustaining some degree of price elevation over a longer time.

Midwest diesel fuel prices normally run 1-2 cents less than the national average, which is currently forecast at $1.46 per gallon for September through December. With the expected tighter regional distillate supply-demand balance this fall, Midwest diesel fuel could easily average 5-6 cents above its typical relationship to the U.S. average, as it has during the May/June and August/September periods this year, or closer to $1.50 per gallon if no price spikes occur. Last year, diesel fuel prices in the Midwest averaged $1.57 during the last 4 months of the year, mainly due to higher crude oil prices last year than are being forecast for this fall.

If the distillate supply-demand balance in the Midwest were not so tight, we could expect to see residential heating oil prices averaging about 7-8 cents per gallon lower than the U.S. prices. With U.S residential prices expected to average about $1.16 from September through December, the Midwest would normally see prices below $1.10 per gallon. However, the current tight market could easily bring Midwest prices closer to the national average, even if everything works smoothly. With the balance this tight, any unexpected demand strength or supply interruptions could see prices spike, as we saw with gasoline earlier this year.

The gasoline supply-demand balance is not as tight as distillate. Like diesel fuel, gasoline prices usually run several cents lower than the national average in the Midwest, but this year it could run several cents higher than the forecasted national average price of $1.41 cents per gallon. Last year, the Midwest averaged about $1.49 per gallon during the same period. If, however, the region must maintain distillate production at higher than typical levels through the winter, gasoline inventories could fail to build adequately early in 2002 and erode to low levels again by next spring.

Summary

Although U.S. petroleum prices are expected to remain at relatively moderate levels this fall and winter, kept in check by lower world crude oil prices, a tighter supply-demand balance in the Midwest may result in somewhat stronger prices in that region. Distillate fuels, including diesel fuel and heating oil, are likely to be the most strongly affected, as refinery outages, coinciding with peak fall demand, are expected to keep depleted inventories from recovering to seasonal average levels. Gasoline, with relatively more adequate inventories and out of its peak demand season, is likely to be less affected in the near term, but the situation could erode by next spring if distillate markets stay tight through the winter, taking away from potential gasoline supply.

^1. PADD 1 (East Coast area): Connecticut, Maine, Massachusetts, New Hampshire, Rhode Island, Vermont, Delaware, District of Columbia, Maryland, New Jersey, New York, Pennsylvania, Florida, Georgia, North Carolina, South Carolina, Virginia, West Virginia

PADD 2 (Midwest): Illinois, Indiana, Iowa, Kansas, Kentucky, Michigan, Minnesota, Missouri, Nebraska, North Dakota, Ohio, Oklahoma, South Dakota, Tennessee, Wisconsin.

PADD 3 (Gulf Coast): Alabama, Arkansas, Louisiana, Mississippi, New Mexico, Texas.