<DOC> [108th Congress House Hearings] [From the U.S. Government Printing Office via GPO Access] [DOCID: f:89970.wais] CALIFORNIA GASOLINE MARKETS: FROM MTBE TO ETHANOL ======================================================================= HEARING before the SUBCOMMITTEE ON ENERGY POLICY, NATURAL RESOURCES AND REGULATORY AFFAIRS of the COMMITTEE ON GOVERNMENT REFORM HOUSE OF REPRESENTATIVES ONE HUNDRED EIGHTH CONGRESS FIRST SESSION __________ JULY 2, 2003 __________ Serial No. 108-65 __________ Printed for the use of the Committee on Government Reform Available via the World Wide Web: http://www.gpo.gov/congress/house http://www.house.gov/reform ______ 89-970 U.S. GOVERNMENT PRINTING OFFICE WASHINGTON : 2003 ____________________________________________________________________________ For Sale by the Superintendent of Documents, U.S. Government Printing Office Internet: bookstore.gpo.gov Phone: toll free (866) 512-1800; (202) 512ÿ091800 Fax: (202) 512ÿ092250 Mail: Stop SSOP, Washington, DC 20402ÿ090001 COMMITTEE ON GOVERNMENT REFORM TOM DAVIS, Virginia, Chairman DAN BURTON, Indiana HENRY A. WAXMAN, California CHRISTOPHER SHAYS, Connecticut TOM LANTOS, California ILEANA ROS-LEHTINEN, Florida MAJOR R. OWENS, New York JOHN M. McHUGH, New York EDOLPHUS TOWNS, New York JOHN L. MICA, Florida PAUL E. KANJORSKI, Pennsylvania MARK E. SOUDER, Indiana CAROLYN B. MALONEY, New York STEVEN C. LaTOURETTE, Ohio ELIJAH E. CUMMINGS, Maryland DOUG OSE, California DENNIS J. KUCINICH, Ohio RON LEWIS, Kentucky DANNY K. DAVIS, Illinois JO ANN DAVIS, Virginia JOHN F. TIERNEY, Massachusetts TODD RUSSELL PLATTS, Pennsylvania WM. LACY CLAY, Missouri CHRIS CANNON, Utah DIANE E. WATSON, California ADAM H. PUTNAM, Florida STEPHEN F. LYNCH, Massachusetts EDWARD L. SCHROCK, Virginia CHRIS VAN HOLLEN, Maryland JOHN J. DUNCAN, Jr., Tennessee LINDA T. SANCHEZ, California JOHN SULLIVAN, Oklahoma C.A. ``DUTCH'' RUPPERSBERGER, NATHAN DEAL, Georgia Maryland CANDICE S. MILLER, Michigan ELEANOR HOLMES NORTON, District of TIM MURPHY, Pennsylvania Columbia MICHAEL R. TURNER, Ohio JIM COOPER, Tennessee JOHN R. CARTER, Texas ------ WILLIAM J. JANKLOW, South Dakota BERNARD SANDERS, Vermont MARSHA BLACKBURN, Tennessee (Independent) Peter Sirh, Staff Director Melissa Wojciak, Deputy Staff Director Rob Borden, Parliamentarian Teresa Austin, Chief Clerk Philip M. Schiliro, Minority Staff Director Subcommittee on Energy Policy, Natural Resources and Regulatory Affairs DOUG OSE, California, Chairman WILLIAM J. JANKLOW, South Dakota JOHN F. TIERNEY, Massachusetts CHRISTOPHER SHAYS, Connecticut TOM LANTOS, California JOHN M. McHUGH, New York PAUL E. KANJORSKI, Pennsylvania CHRIS CANNON, Utah DENNIS J. KUCINICH, Ohio JOHN SULLIVAN, Oklahoma CHRIS VAN HOLLEN, Maryland NATHAN DEAL, Georgia JIM COOPER, Tennessee CANDICE S. MILLER, Michigan Ex Officio TOM DAVIS, Virginia HENRY A. WAXMAN, California Dan Skopec, Staff Director Melanie Tory, Clerk C O N T E N T S ---------- Page Hearing held on July 2, 2003..................................... 1 Statement of: Caruso, Guy, Administrator, Department of Energy............. 12 Gregory, Bob, vice president and general manager, Valero Wilmington Refinery........................................ 44 Keese, William, chairman, California Energy Commission....... 29 Kiesling, Dr. Lynne, director of economic policy, Reason Public Policy Institute.................................... 52 Sparano, Joe, president, Western States Petroleum Association 36 Letters, statements, etc., submitted for the record by: Caruso, Guy, Administrator, Department of Energy, prepared statement of............................................... 15 Gregory, Bob, vice president and general manager, Valero Wilmington Refinery, prepared statement of................. 47 Keese, William, chairman, California Energy Commission, prepared statement of...................................... 31 Kiesling, Dr. Lynne, director of economic policy, Reason Public Policy Institute, prepared statement of............. 54 Ose, Hon. Doug, a Representative in Congress from the State of California, prepared statement of....................... 5 Sparano, Joe, president, Western States Petroleum Association, prepared statement of......................... 39 CALIFORNIA GASOLINE MARKETS: FROM MTBE TO ETHANOL ---------- WEDNESDAY, JULY 2, 2003 House of Representatives, Subcommittee on Energy Policy, Natural Resources and Regulatory Affairs, Committee on Government Reform, Diamond Bar, CA. The subcommittee met, pursuant to notice, at 10 a.m., at the South Coast Air Quality Management District, 21865 East Copley Drive, Diamond Bar, CA, Hon. Doug Ose (chairman of the subcommittee) presiding. Present: Representatives Ose and Gary Miller. Staff present: Dan Skopec, staff director; Melanie Tory, clerk; and Yier Shi, press secretary. Mr. Ose. Good morning, everybody. Thanks for joining us today here in Diamond Bar for this hearing on the Subcommittee on Energy Policy, Natural Resources and Regulatory Affairs. I ask that we allow Members not on the subcommittee to join us today for the purpose of the hearing. Hearing no objections, so ordered. I am joined on the dais today by a very good friend of mine and an excellent representative of this area. That would be Congressman Gary Miller, who I will recognize for as much time as he'd like. Mr. Miller. Well, thank you very much. I'm here to welcome my good friend Doug Ose to the 42nd Congressional District. It's good to be up here with you because when I used to serve in Diamond Bar City Council, this is where I used to work, so it's like going back home temporarily, not for very long, but for a little while. Doug serves as a chairman of the Subcommittee on Energy Policy, Natural Resources and Regulatory Affairs, and an issue of great concern in my district and throughout California has been in recent months the price of gas, why it's like it is, issues from MTBE to ethanol. I applaud Doug for coming in to this district to discuss this issue, because this is an issue of great importance to California. When I was first elected to Congress, I was elected with the class with Doug Ose, and I'm sad to say that because of his family and other reasons, he is deciding to retire after this term, and I'm really going to miss him. He's been a good friend of mine. We've had a lot of fun together in Congress. He has a passion, a passion for things that are right, and he has also a passion to eliminate things that are wrong. I applaud him for taking on a very difficult issue, going throughout California and offering himself as a dart board occasionally to discuss issues with people who might take opposition to the prices we pay for gas, not knowing why it's happening, but politicians are good people to blame. Doug is doing this for the right reasons and I'm glad to welcome him here. Doug, I'm looking forward to the hearing. Mr. Ose. I thank the gentleman. It's nice to be here in your hometown. They were telling me stories about you out in the hallway. Half of them have to be true. We are joined today by a distinguished panel of witnesses. Just to educate everybody on how we do this, this is a subcommittee of the Government Reform Committee, an oversight committee in Congress. There are a couple of things that we do routinely in the course of these hearings. First of all, we swear everybody in, so your testimony, written and otherwise, is going to be taken under oath. We have a 5-minute rule. That is, since we were fortunate enough to receive the testimony of folks who have been invited to testify, we have reviewed that testimony, and we provide our witnesses 5 minutes to review their testimony orally and to summarize it. Unfortunately, under the rules of Congress and the rules of this committee, there is no open testimony; in other words, this isn't like a board of supervisors or a city council hearing where citizens can come up and testify at will. These are in many respects organized for the purpose of addressing a specific subject, and the experts that we bring in to testify have extensive background on these issues that we will discuss, and they come from different perspectives. I'm going to introduce them now. We'll go all the way through the introductions and then we will come back for their testimonies. This is in the order of their testimony today. We are joined today by the Administrator of the Energy Information Administration at the Department of Energy, the Honorable Guy Caruso. We are also joined by the Chair of the California Energy Commission, William Keese. We have with us the president of the Western States Petroleum Association, Joe Sparano. We also have the vice president and general manager for the Valero Wilmington Refinery, Mr. Bob Gregory. We also have the director of economic policy for the Reason Public Policy Institute, Dr. Lynne Kiesling. I want to welcome our guests. We need to make sure everybody in the audience knows that we have copies of the briefing memorandum. They are in the back of the room. Typically in these hearings the Members of Congress will make opening statements to address a couple of the issues that we have. Mr. Miller has kindly consented to pass on that, which in the interest of time is always appreciated. I do have an opening statement and I'm going to give it, and then we will go into swearing in the witnesses and then we will take their testimony. At today's hearing we will review the transition from using MTBE to ethanol in California's reformulated gasoline and the cause of the recent gasoline price spikes. The fact that we are holding today's hearing in the headquarters of the South Coast Air Quality Management District is no accident. Automobiles produce 65 percent of the air pollution in California. The standards set for gasoline are important because they not only affect the pocketbook of every single Californian, but also affect the quality of the air we breathe and the water we drink. The seeds of this transition to ethanol were sown in a 1998 study by the University of California, which concluded that, the use of MTBE had contaminated our groundwater. The following year Governor Davis announced a ban on MTBE use in gasoline, beginning in 2003. The MTBE ban forced refineries to blend ethanol into our gasoline in order to satisfy the reformulated gasoline requirements of the Clean Air Act. The Governor subsequently pushed back the ban to 2004 when it became clear that not all of California's refineries could make the transition in time. From January 1 of this year to March 17, retail prices of gasoline in California increased 57 cents a gallon. Gas prices soared above the $2 per gallon range up and down the State, both here in Diamond Bar and in Sacramento, where I live, San Francisco, and all the way up to Crescent City. Now, in California we consume about 1.1 billion gallons of fuel each month, so this increase equates to about $20 million per day extra being spent on gasoline. On March 27 I sent a letter to the Energy Information Administration requesting a report on the cause of these price spikes. Administrator Caruso will present the preliminary findings of that report today. Under the Energy Information Administration's preliminary report and reports from the California Energy Commission, we can start, hopefully, to understand the causes of the recent gasoline price spike. One cause appears to be the sharp increase in prices for crude oil. The loss of Iraqi oil fields, the crippling strike in Venezuela, and historically low inventories of crude oil were also significant factors in the high prices at the gas pump. Further, California has had the misfortune of experiencing a large number of refinery outages. Since January, we have had no less than 12 major outages, planned and unplanned, that have occurred here in California alone. This high number is significant, because California is essentially a fuel island, if you will. Due to our stringent air standards, our reformulated gasoline is very difficult to make, and with very few exceptions, California cannot simply, as they do in other States, bring in supplies from out of State when its refineries go down. Now, obviously, the whole world is susceptible to high prices for crude oil and it is no secret--anybody that looks at the market--it is no secret that California has operated as an island, if you will, on fuel and the like for years. The biggest difference between this year's price spike and previous price spikes has to do with perhaps what the components of the fuel are, and that brings us to a consideration of ethanol. Unfortunately for California, ethanol is a product when compared to MTBE inferior in terms of performance as a gasoline additive and its effect on air quality is dubious. Ethanol has a greater propensity to evaporate than MTBE. If you substitute ethanol for MTBE, you will have a higher level of volatile organic compounds that lead to ozone formation. To mitigate this problem, refineries have had to make complicated adjustments to their gasoline blends. These adjustments result in reduced refining capacity and add cost to the final product. In its preliminary report responding to our questions, the Energy Information Administration predicted that the transition to ethanol-blended gasoline in the summertime would result in up to a 10 percent loss in gasoline production capability. While refineries will attempt to make up some of this loss through expansions, a net loss to California gasoline production will undoubtedly cause gasoline prices to rise over what they otherwise might have been. Furthermore, to account for the loss in refining production, California will have to import more gasoline components and finished products from out of State. Some of these imports will come from domestic sources, but much will come from abroad. In other words, the use of ethanol may actually result in an increase in our reliance on overseas sources. Today's hearing offers an important look into the challenges of using ethanol-blended gasoline outside the Midwest, not only here in California but perhaps on the East Coast also. So far, in addition to California, 15 States have banned the use of MTBE. Gasoline market observers are particularly concerned about New York and Connecticut. These States have done much less to prepare for the transition away from MTBE and toward ethanol. The lessons we have learned here in California may very well be relevant nationwide. Congress is currently considering a proposal to mandate the use of 5 billion gallons of ethanol by the year 2015. If this bill becomes law, every American living outside the ethanol-producing centers in the Midwest could experience the gasoline price increases that California has seen, due in part to ethanol. Again, I want to welcome our witnesses today and our host Member of Congress. By the way, I do want to add, I did come to Congress at the same time as Congressman Miller and it has been a pleasure serving with him. I thank him for those kind words earlier. I'd be happy to yield time, if you care to offer a statement. [The prepared statement of Hon. Doug Ose follows:] [GRAPHIC] [TIFF OMITTED] T9970.001 [GRAPHIC] [TIFF OMITTED] T9970.002 [GRAPHIC] [TIFF OMITTED] T9970.003 [GRAPHIC] [TIFF OMITTED] T9970.004 [GRAPHIC] [TIFF OMITTED] T9970.005 [GRAPHIC] [TIFF OMITTED] T9970.006 [GRAPHIC] [TIFF OMITTED] T9970.007 Mr. Miller. Well, Doug, again, I'm going to miss you when you go. This is probably one of the most important issues that I've heard the constituency that I represent in southern California represent to me. I mean, I hear it when I go to church-- especially when the prices are extremely high. You would hear people in the community who drive a lot back and forth to work talking about the impact this places on their family's budgets and such. I hear it at church, at the shopping centers. It's amazing. It's probably one of the most significant issues, other than raising the car tax in California, that has the attention of people, and the reason is because it has significant financial impact to the daily budget of the average family. So for that reason, I'm looking forward to hearing the panel. I'm going to have to excuse myself. I've got other meetings you know I have to go to, but again I'd like to welcome you to my district, the 42nd in southern California. I think this is a great place for you to have this hearing. Thank you, Mr. Chairman. Mr. Ose. Your hospitality is appreciated. I'm grateful for your appearance and I'm sorry that we dropped it on you so late that you couldn't stay with us, but thank you for appearing. I appreciate it. Our next step here is that we are going to have our witnesses rise. We're going to swear everybody in and then we are going to go to the testimony. Would you all rise please and raise your right hands. [Witnesses sworn.] Mr. Ose. Let the record show that all the witnesses answered in the affirmative. Our first witness is the Administrator for the Energy Information Administration, Department of Energy. That would be the Honorable Guy Caruso. Sir, you are recognized for 5 minutes to summarize your testimony. Before you start, for those in the audience who are interested, we have copies of everybody's testimony in the back. STATEMENT OF GUY CARUSO, ADMINISTRATOR, DEPARTMENT OF ENERGY Mr. Caruso. Thank you, Mr. Chairman, Congressman Miller. I appreciate the opportunity to be here and the confidence that Chairman Ose has shown in the EIA by asking us to prepare the report. The interim results are on the table. The surge in gasoline prices in California early this year moved retail gasoline prices to a high of $2.15, up 63 cents by mid-March. That compares to a 37-cent gasoline price increase in the national average. The first figure which I think we will show in a minute shows that information, and as the chairman mentioned, we are in the process of completing the full report on the causes of this price increase, and that will be completed by September. The interim report was sent to the chairman in May. Retail gasoline prices are influenced by crude oil prices, refining costs, distribution and marketing costs, company profits, and government income from Federal, State and local taxes. This figure illustrates the components of the gasoline price. Earlier this year higher crude oil prices and special California market conditions drove prices markedly higher in this State. As the third chart shows, between December 2002 and mid-March 2003, world crude prices rose almost $11 per barrel, or about 26 cents when put into the price of gasoline per gallon. During this same period, California spot prices rose 72 cents or 46 cents per gallon more than just the higher crude price alone can explain. Why did this happen? You recall that California has had a history, as the chairman has mentioned, of more frequent gasoline price spikes than other States in the United States, and that's for well-known reasons. The refinery system here runs very close to or indeed at it's operational limit, leaving little room to make up for any unexpected shortfalls. California is also, in a way, an island and far from supply sources, and it takes as much as 14 days to bring product from gulf coast refineries to California; thus, any quick resolution to a supply and demand imbalance is difficult. Third, California uses a unique and an expensive way to make gasoline that most other suppliers cannot provide quickly, if at all. These conditions provide little room for supply and demand mismatches without the supply price responses that were shown in the earlier chart, and that set the stage for last spring's gasoline prices. Gasoline supplies tightened because of the large amount of refinery maintenance that was undergone during the early part of 2003 in California. The impact was greatest in February when gasoline production was down about 150,000 barrels per day, compared to where it would have been at that time. In addition, the partial phase-out of MTBE from California gasoline and its replacement with ethanol this year added to production costs and to market stress. Production costs are estimated to be 3 to 6 cents per gallon higher for the ethanol-blended California gasoline, compared with MTBE-blended gasoline, which implies that production costs did contribute a small part to this differential; however, since ethanol-blended gasoline cannot be mixed with other gasolines during the summer to assure compliance with emission standards, two distinct fuels must be carried in the distribution system which reduces system flexibility. This split market created a situation earlier this year in which no one could know in advance how much fuel of one type would be needed and where. As the transition unfolded, supplies were temporarily short in some areas and had to be shifted, which takes time and adds to the cost. Prices increased in the interim. In sum, Mr. Chairman, in addition to the higher world crude oil prices, primarily two factors were behind the price surge, a large number of refineries undergoing major maintenance projects and the partial change to ethanol-blended gasoline, which resulted in the split market. EIA found no indication that the supply or price of ethanol or the infrastructure needed to deliver, store and blend ethanol were significant market issues this spring. Mr. Chairman, that concludes my summary and I look forward to your questions when appropriate. Thank you. [The prepared statement of Mr. Caruso follows:] [GRAPHIC] [TIFF OMITTED] T9970.008 [GRAPHIC] [TIFF OMITTED] T9970.009 [GRAPHIC] [TIFF OMITTED] T9970.010 [GRAPHIC] [TIFF OMITTED] T9970.011 [GRAPHIC] [TIFF OMITTED] T9970.012 [GRAPHIC] [TIFF OMITTED] T9970.013 [GRAPHIC] [TIFF OMITTED] T9970.014 [GRAPHIC] [TIFF OMITTED] T9970.015 [GRAPHIC] [TIFF OMITTED] T9970.016 [GRAPHIC] [TIFF OMITTED] T9970.017 [GRAPHIC] [TIFF OMITTED] T9970.018 [GRAPHIC] [TIFF OMITTED] T9970.019 [GRAPHIC] [TIFF OMITTED] T9970.020 [GRAPHIC] [TIFF OMITTED] T9970.021 Mr. Ose. Thank you, Mr. Caruso. Our next witness is the chairman of the California Energy Commission, Mr. William Keese. Chairman, you are recognized for 5 minutes. STATEMENT OF WILLIAM KEESE, CHAIRMAN, CALIFORNIA ENERGY COMMISSION Mr. Keese. Thank you, Mr. Chairman. It is my pleasure to be here. I would say at the outset that we congratulate EIA and Mr. Caruso on an excellent report, and having reviewed in depth the thorough report, we disagree with nothing in his report. I'd like to just talk about California. We had anticipated problems in the changeover from MTBE to ethanol-based gasoline. It went extremely smoothly. We have three refineries yet to go who will make the switch in the fall. Pipelines and terminals seem to be adequate at this time to continue to handle the infrastructure changes. We do agree that we have a 5 percent reduction in supply with the switch to ethanol and a 10 percent reduction in summer, considering the volatility changes that ethanol introduces into the composition of gasoline. We, actually at the Energy Commission, recommended that the Governor postpone the starting date by 1 year, because of the impact that a fixed date of December 31, 2002, would have had on independent refiners and independent marketers. The 5 and 10 percent reductions have been met largely with conversion by the industry converting some MTBE-producing units over to units that can build the blend stock to go with ethanol, and by others making other refinery adjustments. In summation, we anticipate that a 1 or 2 percent reduction is the more accurate figure after refinery reconfiguration. While we lost 5 or 10 percent, the refiners in this State brought that down to the 1 or 2 percent level. As far as the future is concerned with continued growth, we see minimal refinery expansion. We have been historically expecting what we call ``refinery creep,'' a little bit more every year from more efficiency in the refineries. We expect that to be in the one-half of 1 percent range going forward. Therefore, we see increasing imports of gasoline and blending components which will further stress a stressed marine import infrastructure. As far as impacts on prices, we do not at this time see stress from ethanol. The ethanol industry increased their production quite extensively, and until those States that you listed all go, we don't see that as a stress. I do want to emphasize one very strong point. California decided that we could not take MTBE in our gas any more. It was the last thing on our mind to mandate ethanol. We recognized that California would have to use a significant amount of ethanol if we got rid of MTBE, but we wanted flexibility. California's refiners can meet California's air standards and Federal air standards without ethanol. What stresses us is the oxygen mandate, and as you're probably aware, we requested EPA grant us a waiver, we demanded EPA give us a waiver, and we are suing and testified in Federal Court in January that we are entitled to a waiver. We have not received it. I would hark back to prices and say that we do not believe ethanol was the cause of the price increase. It is a cause of some additional costs at the refinery level, but we have to talk about cost. We have to separate costs at the refinery level from prices. The price increase was caused by operational challenges that we have heard before. The refineries logically chose to do maintenance at the same time they were doing the switchover from a winter supply to a summer supply, and a number of refineries doing that had the same problem put us in stress. The causes for increased gasoline prices in California were, as you've heard, world crude prices; they were the maintenance and summer change-over occurring at the same time; and they were both blending complexities for ethanol, and a perceived blending complexity; so speculators drove up the price of what they would sell, expecting that refiners were going to have troubles. We did not have many troubles at the refinery level. In fact, the one major case of difficulty with an ethanol gasoline product was a blending problem where the equipment just didn't put the ethanol in, and this unacceptable product was put in the service stations and had to be withdrawn. I will say the supplier at that time supplied premium grade gasoline at the same price as regular to make up the need, and took a financial hit on that. I want to mention also that there is an excessive impact on the unbranded market. When you make turnovers and things get stressed, a good portion of the unbranded market chooses to go without contract. They make a lot of profit when there's an ample supply and they can buy cheap, but when the market gets tight and they can't find product, they take a hit. Additionally, we are in this transitional period, essentially operating two storage systems, one for MTBE gasoline and one for ethanol gasoline. We had one storage system before and we will have one storage system afterwards, so this does cause stress on the transportation system. I believe I have probably used up my 5 minutes, so I will stop at this point and say that in conclusion, that there is one other thing that we believe and California has pretty much endorsed for the last number of years, and that is better CAFE standards on a Federal level would reduce the stress on the system, and the California government has consistently requested better CAFE standards out of Washington, and we continue to request that. Thank you. [The prepared statement of Mr. Keese follows:] [GRAPHIC] [TIFF OMITTED] T9970.022 [GRAPHIC] [TIFF OMITTED] T9970.023 [GRAPHIC] [TIFF OMITTED] T9970.024 [GRAPHIC] [TIFF OMITTED] T9970.025 [GRAPHIC] [TIFF OMITTED] T9970.026 Mr. Ose. Thank you, Mr. Keese. Our next witness is Joe Sparano with Western States Petroleum Association. You are recognized for 5 minutes. STATEMENT OF JOE SPARANO, PRESIDENT, WESTERN STATES PETROLEUM ASSOCIATION Mr. Sparano. Thank you, Congressman Ose. WSPA represents approximately 30 petroleum companies that explore, produce, manufacture, transport and market petroleum products in six western States--California, Arizona, Nevada, Washington, Oregon and Hawaii. We support petroleum companies in western States. The association typically confines its activities and advocacy to the State level and doesn't engage in Federal issues. That said, California, as usual, seems to be the bellwether State for our Nation when new and improved products and advanced regulatory programs are involved. In this case, our members have already started transitioning from one gasoline oxygenate, MTBE, to another, ethanol, and I'd like to give you some feedback on our experiences so far. At this point we have gained several months of manufacturing, distribution and marketing experience using gasoline blended with ethanol. The majority of our industry members have made the transition, the voluntary transition to ethanol. Although California was one of the first States to ban MTBE effective January 1, 2003, our State government delayed the ban by 1 year to January 2004. This was partially due to the State's early concerns about the availability of and price associated with ethanol supply and the possible market volatility impacts on California's driving public of an abrupt change in product composition. There was some concern by government agencies and others that segregation of the marketplace into gasoline blended with ethanol and gasoline blended with MTBE during a transition phase might by itself lead to market tightness and price spikes. That concern has thus far not really materialized and all our members have publicly reported that they plan to have the transition completed by the January 2004 deadline. One of the conclusions contained in the May 2003 EIA report on California's early transition states that in general the transition to ethanol has gone remarkably well. It further indicates that this seems to be due in part to several years of preparation and collaborative efforts by the private sector and State government agencies. We also believe this type of collaborative effort, including detailed dialog and adequate lead time, is critical to ensure that logistics issues are worked out before a transition. Ethanol supplies were adequate this spring and the infrastructure to deliver, store and blend ethanol at terminals was developed in a timely manner. While the transition to ethanol-blended gasoline is going relatively smoothly in California, there was a price spike this spring, as has been mentioned. It's important to recognize that the price of gasoline is determined by a variety of market conditions at any given point in time, and those conditions are constantly changing. According to EIA and others, the gasoline price spike experienced this spring, as elsewhere in the nation, was due largely to the following factors: There was an exponential increase in the cost of crude oil; refinery maintenance activities and unplanned outages occurred at several plants in California; there was a higher cost of manufacturing California's more-difficult-to-produce special cleaner burning gasoline; and there is a continuing increase in demand versus supply of California quality clean burning gasoline. Coincidentally, the price spike was concurrent with the timing of the transition from winter grade to summertime gasoline. This transition results in the requirement for a lower vapor pressure product that typically is more difficult to produce, and that must be distributed throughout the same delivery system displacing entirely the previous supplies of winter gasoline over a short period of time. It seems clear from this information that no individual factor, including the transition from MTBE-blended to ethanol- blended gasoline, should be singled out as the cause of last spring's price spike in California. However, there's an effort underway by the Energy Commission to determine the causes of periodic swings in California gasoline prices and to recommend measures to the legislature to help stabilize the situation. WSPA and its members are actively involved in this evaluation process, but we oppose any direct government intervention to fix energy markets. There is ample historical experience and data that reminds us that these types of government mandates are almost always counterproductive. The free market actually works very well. There are some specific actions, however, that could help as this nation moves to an ethanol-blended gasoline. First, WSPA strongly encourages repeal of the current Federal RFG 2 percent oxygenate mandate, and has been engaged with other parties in advocating elimination of the requirement for California. Mandating an arbitrary amount of oxygenate in RFG provides no additional environmental benefits and reduces flexibility. Our companies simply want the flexibility to use oxygenates where they make the most economic and environmental sense. It is essential for supply and efficiency reasons that refiners have maximum flexibility in the way they manufacture gasoline. Second, WSPA supports adoption of a provision limiting product defect liability for manufacturers or sellers of any product approved for use in gasoline by Congress or any of the regulatory agencies. Third, there needs to be an overhaul of the permitting process in many States, and definitely in California. Obtaining permits in a timely and efficient manner is a significant hurdle to ensuring a sufficient infrastructure is in place. WSPA supports the government identifying and removing impediments to investments that will improve an already efficiently functioning marketplace, while not impacting negatively the many improvements to the environment already gained through investments and other actions by the petroleum industry. It is essential that the industry be provided with maximum flexibility to use ethanol where it makes the most sense. Repealing the RFG oxygen content requirement would provide such flexibility. Let me repeat an important theme. WSPA's companies fully support free markets, energy diversification and fuel choice. We maintain that government standards should be performance- based and allow for maximum flexibility to meet the desired goals. We believe that a strong and efficient petroleum industry also has an important part to play in ensuring a healthy economy. We are interested in government policies that will facilitate that role by supporting a more favorable business climate in California and elsewhere. In closing, WSPA and its members are prepared to work with you as the remaining companies complete the transition from MTBE by California's year-end 2003 deadline. As always, our industry will continue its longstanding commitment to complying with government regulations as safely, cleanly and cost-effectively as possible. Thank you for the opportunity. [The prepared statement of Mr. Sparano follows:] [GRAPHIC] [TIFF OMITTED] T9970.027 [GRAPHIC] [TIFF OMITTED] T9970.028 [GRAPHIC] [TIFF OMITTED] T9970.029 [GRAPHIC] [TIFF OMITTED] T9970.030 [GRAPHIC] [TIFF OMITTED] T9970.031 Mr. Ose. Thank you, Mr. Sparano. Our next witness is Mr. Bob Gregory. He is the vice president and general manager for the Valero Wilmington Refinery. Sir, you are recognized for 5 minutes. STATEMENT OF BOB GREGORY, VICE PRESIDENT AND GENERAL MANAGER, VALERO WILMINGTON REFINERY Mr. Gregory. Thank you, Chairman Ose. Valero Energy Corp. is a Fortune 500 company based in San Antonio, TX, and with approximately 20,000 employees and revenues of nearly $30 billion. One of the top U.S. refining companies, Valero has an extensive refining system with a throughput capacity of almost 2 million barrels per day. Our Wilmington refinery employs roughly 435 individuals and has a total throughput of approximately 140,000 barrels per day. Mr. Chairman, the decision to examine the dynamics of the California fuels market could not be more timely. Decisions regarding motor fuels policies have substantial economic impacts and a healthy domestic economy requires a stable supply of reasonably priced gasoline. Refiners such as Valero are a vital link in the supply chain. Domestic refiners currently supply approximately 17 million barrels of refined petroleum products out of the 20 million barrels that the U.S. economy demands on a daily basis. 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 economic and political considerations, including site costs, environmental requirements, overall industry profitability and public concerns. U.S. refining capacity has increased because of added capacity at existing refineries, but it has become increasingly difficult for refiners to keep pace with the growing demand for petroleum products because of stringent environmental regulations and tight profit margins. Refiners currently face a massive task of complying with regulatory programs with significant investment requirements. Refiners must shortly invest about $20 billion to sharply reduce the sulphur content of gasoline in both highway and much of off-road diesel. Refining earnings have recently been more volatile than usual, but refining returns are generally quite modest when compared with other industries. The average return on investment in the industry is only about 5 percent. This relatively low level return, which incorporates the cost of investments required to meet environmental regulations, is one reason why domestic refinery capacity additions are modest, and why new facilities are unlikely to be constructed. In some cases, however, where refineries are unable to justify the costs of investment at some facilities, those facilities may have to close. Decisions regarding gasoline and other refined petroleum products should be made consistent with efforts to increase domestic supply of refined petroleum products. As the NPC noted in a landmark report issued in 2000, the limited profit margins and high regulatory costs associated with refining create a precarious situation for the domestic refining industry. As the NPC explained, changes in motor fuels policies must be undertaken with great care because changes in product requirements can have a severe impact on the ability of refiners to provide an adequate supply of refined petroleum products to U.S. consumers. Valero and other refiners are making every effort to produce a reliable and affordable supply of vital petroleum products, and our fuels policy should work in concert with these efforts. MTBE is a clean-burning fuel additive that satisfies the RFG requirements of the 1990 Clean Air Act. The act requires that RFG contain 2 percent of oxygen. Because it is readily available, easy to transport, efficient, and easily integrated into the Nation's gasoline pool, MTBE has become the refining industry's oxygen additive of choice. Banning or reducing the use of MTBE will not only be bad for California, but much of the Nation, because such policies will further tighten gasoline supplies and may cause spikes in gasoline prices for consumers. An EIA study recently showed that the supply reduction from the MTBE ban could increase retail gasoline prices nationwide by an average of 4 cents per gallon and more than 10 cents per gallon in many of the largest metropolitan areas, which requires RFG to keep the air clean. History has shown that single-fuel mandates inevitably lead to higher gasoline costs and tighter and less reliable fuel supplies. Production of ethanol is highly concentrated, with one company alone controlling a large percentage of the ethanol market. While we need to encourage and develop renewable fuels, we must also address energy security. MTBE comprises 3 percent of the U.S. supply and its replacement, ethanol, comprises only 1 percent. The gap resulting from a shift from MTBE to ethanol will yield fuel shortages and potentially higher prices, while demands continue to rise. While ethanol currently has a significant and growing share of the fuel pool, some have suggested that mandating its further use could answer price and supply questions. Valero believes that an ethanol mandate does not provide an acceptable answer to U.S. energy security needs, given ethanol's heavy dependence on fossil fuel inputs and its net negative energy yield. In conclusion, the California gasoline market is highly volatile and consumers are vulnerable to hikes in gasoline prices. The problems of tightness in supply and refining capacity are likely to be with us for some time. As new fuel choices present themselves, we should adopt public policies that do their best to minimize external costs associated with new fuels and fuel additives. We must maintain a robust and competitive market in fuel additives and not allow one particular approach to dominate. Valero Energy Corp. is committed to continuing our efforts with States and the Federal Government aimed at accomplishing these goals. Mr. Chairman and other members of the subcommittee, I thank you for the careful attention to these matters. Valero Energy Corp. looks forward to working with you on a fair and effective national fuels policy, one that protects consumers, human health, and the environment. [The prepared statement of Mr. Gregory follows:] [GRAPHIC] [TIFF OMITTED] T9970.032 [GRAPHIC] [TIFF OMITTED] T9970.033 [GRAPHIC] [TIFF OMITTED] T9970.034 [GRAPHIC] [TIFF OMITTED] T9970.035 [GRAPHIC] [TIFF OMITTED] T9970.036 Mr. Ose. Thank you, Mr. Gregory. I now am pleased to recognize Dr. Lynne Kiesling, who is the director of economic policy at the Reason Public Policy Institute. Ma'am, you are recognized for 5 minutes. STATEMENT OF DR. LYNNE KIESLING, DIRECTOR OF ECONOMIC POLICY, REASON PUBLIC POLICY INSTITUTE Dr. Kiesling. Thank you, Mr. Chairman, for inviting me to participate in this hearing. In addition to my position with Reason Foundation, I'm also senior lecturer of economics at Northwestern University, and among my many roles and responsibilities there, I teach a course in environmental and natural resource economics. I also am a senior policy fellow at the Interdisciplinary Center for Economic Science at George Mason University, where I work with Nobel Laureate Vernon Smith and the other outstanding economists there to bring the insights of experimental economics to real-world policy applications, including energy policy. My written testimony focuses on the economics of ethanol transition in California and on the larger question of the desirability of the Federal oxygenate requirement. Ethanol will be a more costly oxygenate in California than MTBE. The EIA has estimated the increase in retail prices that will accompany the ethanol mandate at 3 to 6 cents per gallon. But is that price increase buying us the environmental benefits that we desire? Increasingly, our scientific knowledge says no. Production of ethanol does not produce additional energy, once we take into account the entire energy chain. Furthermore, both the production and transport of ethanol create pollutants affecting both Californians and non- Californians that must be taken into account when evaluating whether ethanol is worth it. Finally, recent research suggests that ethanol leaking into soil causes increased benzene concentrations. The cost of potential soil and water pollution from ethanol must not be overlooked, just as we did not overlook it with MTBE. I also would add benzene is of particular concern, because it's cumulative. Like mercury, it does not deplete or dissipate over time. Comparing ethanol with MTBE begs the question of whether the Federal oxygenate requirement delivers the environmental benefits at reasonable costs. I believe it does not. The Federal oxygenate requirement fractures and vulcanizes markets, making place-specific fuels less substitutable. In many parts of the country, including California and my home state of Illinois, refineries and pipelines are already operating at capacity, so if anything goes wrong, we could stabilize prices in Chicago by, say importing St. Louis gas, but we cannot. Ethanol, with its physical characteristics, exacerbates this already existing lack of fault tolerance in the refining system. I suggest that our increasing scientific knowledge indicates that both the existing oxygenate requirement and the ethanol provisions of circulating house and senate energy bills are unsound public policies that will not deliver the environmental benefits we desire at the cost that we expect. MTBE is not a clean fuel, but neither is ethanol. Furthermore, the EPA's silo treatment of air, soil and water regulation leads us to make ill-informed regulatory choices that are harmful to the environment. Thank you, Mr. Chairman. I welcome any questions. [The prepared statement of Dr. Kiesling follows:] [GRAPHIC] [TIFF OMITTED] T9970.037 [GRAPHIC] [TIFF OMITTED] T9970.038 [GRAPHIC] [TIFF OMITTED] T9970.039 [GRAPHIC] [TIFF OMITTED] T9970.040 [GRAPHIC] [TIFF OMITTED] T9970.041 [GRAPHIC] [TIFF OMITTED] T9970.042 [GRAPHIC] [TIFF OMITTED] T9970.043 Mr. Ose. Thank you, Dr. Kiesling. What we do here, just for everybody's edification, is that having received all the testimony from the witnesses, we have a number of questions we'd like to ask and put the answers on the record. To the extent we can get to every question, there won't be any necessary followup in writing to you, but it's possible that questions will occur to us after we have otherwise adjourned, in which case, we will send interrogatories to you asking you individually, what about this, what about that? To the extent we do that, we would appreciate a timely response. Typically we will leave the record open for other members of this subcommittee who are unable to make it today, to pose questions as they may see fit. In particular, my vice chairman, Bill Janklow from South Dakota, is very interested in this issue and has evidenced a clear desire to be involved, so I'm just trying to lay the ground work for you, the ground rules for everybody. Now, having reviewed everybody's testimony, I do want to get to the questions. Mr. Caruso and Mr. Keese, one of the purposes of our hearing today is to not only help ourselves but also help the public understand why gasoline prices rose so steeply this past winter and spring. As Mr. Miller said when talking about going to the grocery store or church, what have you, as an elected official, when gasoline prices rise, you hear about it immediately. It's one of those early barometers. Now, gasoline prices remain perhaps one of the most widely distributed and readily available pieces of consumer information. I mean, you drive down the street and you see it posted on the little signs there. Despite that, the components of how you go about pricing gasoline are somewhat less well understood. As a result, oftentimes when prices have quite a bit of variation, I'll hear suggestions of, ``Boy, they sure go up faster than they go down'' or ``How come they are rising so quickly? There is no supply interruption kind of thing.'' What I'm after here is, as experts in the oil markets, both in California and around the world, can you tell us if-- specifically in your opinion, Mr. Caruso, price gouging or manipulative behavior was a cause of the recent gasoline spikes here in California. Mr. Caruso. As we indicated in our interim report to you, we did not find any evidence of price gouging. In other words, what we are saying is that the kind of spikes that we witnessed this spring and the end of the winter period were largely a market-driven phenomenon, partly the crude oil component, partly the stress of switching to the ethanol-based fuel, combined with this heavy maintenance plan and unplanned outages. So those are the real factors in our view, and as we observed over a number of years of supply and demand behavior in California and elsewhere, we did not see anything that was what we would consider to be gouging or anything outside of normal market behavior. Mr. Ose. Mr. Keese, at the Energy Commission, was there any research done on this issue? Did your people look at any of this stuff. Mr. Keese. Yes, we did, Mr. Chairman. We looked at virtually any, virtually all the specific indications of gouging. There was one dealer, if you recall, who had a problem with his supplier and chose to apply, I believe a $4.50 price per gallon, but that was a dealer doing a personal retaliation. We looked at every case that was brought to our attention and we found no indications of manipulation. I would mention one thing. We have a distinction--we should make a distinction here between the electricity markets and the gasoline markets. In the electrical market, you are selling a generic product that just goes out. In the gasoline field, you are selling a branded product, and even what we call unbranded dealers are appealing to an audience who wants to come purchase from them. And therefore there's a tremendous downside from anybody who is trying to build a market share, getting involved in anything that comes close to gouging. It has a negative impact in the long run. I'll say further that these refinery outages--which one in the electricity industry would say you were doing that to drive up the price--if a specific refiner has a refinery outage, they go to great cost to themselves to replace that to supply their contract needs, so the incentive for a refiner to go down is a tremendous disincentive that cannot be made up by higher market prices overall. Mr. Ose. Thank you both. Now, we had a graph on the screen. It was figure 2, I think, in Mr. Caruso's testimony on page 12. I have a question related to the graph, so I want to get the graph up. On this particular graph, this depicts--the red line is California's retail gasoline price in each of those months and the blue line is the U.S. average. The question I have is, in California typically the fuel costs more, there's just a piece of that island structure that causes California's gas to be traditionally a little bit higher than the rest of the Nation, but during the spike, that margin widened. That spread was larger than normal. I'm trying to make sure I get very clear what the contributing factors were to the widened spread. Mr. Caruso. Mr. Caruso. Yes, that's where I think that you could not explain that just from normal activity, let's say additional costs and a little bit of additional tax this year. That was really a reflection of the tight market condition caused by the unavailability of gasoline due to planned and unplanned outages, and the logistical problems that several of the witnesses have alluded to in having to maintain a separate logistics for handling the ethanol-based gasoline versus MTBE. That created additional stress on the system, so the combination of those two led to what appears to be about a 46 cent per gallon difference between the national average on the spot basis and the California average. So there was both the fact of the tightness in supply and this problem caused by having two nonfungible products, an ethanol-based and an MTBE- based gasoline. As Mr. Keese mentioned, there was also a specific spike with respect to unbranded gasoline, which probably was hit harder than the branded gasoline during this period. Mr. Ose. Mr. Keese, the commission's work, would your conclusions concur with Mr. Caruso's? Mr. Keese. Yes, they would. Mr. Ose. I just want to make sure I follow, because if you look over here--let's look at that January 2002. You have the California price and a national price almost hand in glove at the bottom of the trough, and then they both rise, but the national average abates at about $1.40, whereas the California average goes up to about $1.60. That would have been somewhere around February or March 2002, and that margin there, that 20 cent difference in that timeframe--I'm looking at the far right of the chart there-- that 20 cent difference was maintained basically for most of the year, and then come January 2003, we had another rise in both the national and the California price, but the spread in the California versus national widened significantly at its peak. Are you saying that those were logistics issues in terms of a combination of transportation, production and the like, rather than some manipulative behavior on the part of producers? Mr. Caruso. Correct. I'm going to say at the start that there is a tax differential between California and the United States. Mr. Ose. It's built in there, right. Mr. Caruso. There's a reason for a margin, and part of it is the tax that we haven't discussed at all, but that's why the red is a little higher than the blue at all times. Mr. Ose. Let's examine that for a minute, or we can come back to it in a second, if you want. Finish your thought and let's come back to that tax issue. Mr. Caruso. The point I was going to make is that we have to distinguish here between costs and price. When we talk about crude oil doubling, that is clearly something that goes into costs and will be reflected in the product that goes out the door, but that does not directly apply to the price. When a refinery has a major problem and has to go to their neighbor to supply their demand and pay 25 cents more for the product, they lose 25 cents. The other refinery makes 25 cents. So you have things that get introduced into this cost structure that are not directly related to price. On the other hand, when we have the many uncertainties that were taking place here in the market, prices can rise just because somebody says, ``Well, I think the prices are going to go up.'' Now, as you make this transition from winter to summer gasoline, you can understand, everybody draws down their supply, because you have to get rid of it so you wind up with no inventory. Somewhat the same thing happens as you do the ethanol transition. You have to get rid of all the product that doesn't have ethanol in it, so that you can start ethanol. You stress the supply, the storage system, as you do that. I think it's very difficult to apply a direct correlation, but that's what was happening during that period of time. Mr. Ose. If you look at that January 2002 trough--I don't remember which of you put it in your testimony--but the switchover from winter to summer fuel production was accelerated in 2002 from its typical March or April 1st date, if I recall correctly, to February 1st, which would just about correspond with the bottom of the trough overhanging January 2002. Now, is that part of what accounts for the rise in price there, that switchover? I mean, it seems almost to repeat itself, not to the magnitude. Mr. Keese. On the graphs that we have of California, there would be--they all indicate that on an annual basis, there is a price stress during that turnover. I'm not familiar with this graph. Perhaps Mr. Caruso can comment. I'm not familiar with his graph and I don't have mine to put up there. The prices are stressed during the turnaround in the spring. Mr. Ose. In that switchover? Mr. Keese. Right. Mr. Ose. Each year? Mr. Keese. Each year. Mr. Ose. So, say February, March, April 2004, we are going to see some price fluctuation? Mr. Keese. Yes. Mr. Ose. February, March, April 2005, well, actually, maybe that won't hold because we will no longer have the switchover, because the MTBE won't be in the mix. Mr. Keese. As refineries are shut down for maintenance and turnaround--Mr. Sparano can perhaps be more technical and more exact in this--but they have to shut down to do maintenance. A logical time to do it---- Mr. Ose. Is that when you are shutting down for the winter summer switchover? Mr. Keese. It's when you are shutting down and switching over, so it would be nice to make sure that we space all of these out and it doesn't occur at the same time. Refiners do make arrangements to handle all the demands that are going to be made on them so that the refineries do it a little bit by themselves. They either make sure they have adequate supplies going in or that they have somebody else who will accommodate their demands. Mr. Ose. I want to go back to the tax question that you raised here a minute ago. California's taxes relative to national taxes, what's the differential, if you will? And is it reflected? It seems to be reflected there. Mr. Keese. My recollection is that it's a 5-cent difference. Mr. Ose. Mr. Sparano, is it different? Mr. Sparano. I think if you look at the data that's available to us from independent sources, the California tax, including all Federal and State taxes and California sales tax, is almost 51 cents a gallon. Mr. Keese. I would agree with that number. Mr. Sparano. If you look at the average of all the other States and the individual numbers somewhere in the 20's, Congressman, and on average, it's about 42 cents. So not to quibble with Mr. Keese, because he is in the ball park, but my calculations show it's around 9, 10 cents a gallon. Mr. Ose. As an average differential? Mr. Sparano. As the difference between the average U.S. tax on a gallon of gasoline compared to the California tax on a gallon of gasoline. That's what I'm not injecting seasonality or anything into it. There's just a slight difference. Mr. Ose. Mr. Gregory, is that consistent with what you found as a producer? Mr. Gregory. That is consistent. In Texas, combined taxes are 42\1/2\ cents, and I had understood them to be right at 52 cents here, so it's 51, 52 cents, so 9 to 10 cents, just as---- Mr. Ose. Dr. Kiesling, do you agree with that in your analysis? Dr. Kiesling. Yes, those are the numbers I found as well. Mr. Ose. Let me ask this---- Mr. Keese. Mr. Chairman, I'm advised that we can accept 10 cents as the differential. Mr. Ose. All right. We're in the ballpark. Mr. Keese. Having done very quick research, we accept 10. Mr. Ose. Let's look at the immediately available alternatives on a geographic basis. Let's say you live just south of Grants Pass, but on the California side of I-5, versus, say buying in Oregon. Taxes in California are 51 cents for a gallon of gas. Does anybody have any information as to what they are in Oregon? Mr. Sparano. If you will hang on a moment, I've got it in here. Mr. Ose. Because my next question is what about Nevada and what about Arizona? Mr. Sparano. I don't know if I have it here, but I'll try and find it. I do have the chart here, but unfortunately it's buried with a lot of other stuff, but California is the fourth highest in the Nation. Nevada is higher. Nevada and Hawaii are close to tied at a few cents above California. Oregon is down on that list. Nevada, as you may remember, doesn't have a State sales tax, or income tax, and that has an impact on the tax structure. I'm almost sorry now that I said I had it. Mr. Ose. Mr. Sparano, perhaps while we proceed with the questions, somebody who is here helping you could just kind of give us a ballpark estimate of that. Mr. Sparano. I have the exact data, Congressman, I just can't find it. Mr. Ose. OK. We will followup either later today or with a specific question in writing to you. Now, we have amongst us people who have unique experiences. I'm speaking of Mr. Sparano and Mr. Gregory in particular, given your operating experience, what you do on a day-to-day basis. I have some production questions that I want to ask the two of you. For the other three, if you have observations you want to add, I certainly hope you jump in. Mr. Sparano and Mr. Gregory, in an average year California typically--I mean, our information is we experience about nine refinery outages in a typical year. So far this year, we have had 12, and that's all of our refineries around the State. I'm speaking to significant outages. I'm not talking about, you know, 20 minutes, but something significant. Is there an explanation, other than just happenstance, for what seems to be a disproportionately high number of outages this year? Mr. Sparano, any information you can share with us on that. Mr. Sparano. I don't have any specific information. I would like to observe one thing though, that I'm not familiar with where you got the averages. The refiners, the worst thing that can happen to a refiner, as Chairman Keese alluded to, is to have equipment go down on an unplanned basis. It's the worst for operational stability. It's the worst for operational revenue and profitability. It's anathema to any refiner to have that happen. I don't think there's any reason I can put my finger, no specific reason I can put my finger on that would suggest a reason why there may be 1 year where there might be several more outages than in another that are unplanned. Now, on a planned basis, refiners take 2 to 3 years in advance of a turnaround to plan. Each refiner has a specific turnaround schedule. It's specific to each different operating unit within the refinery, and the intervals are probably 3 to 4 to 5 years, and as you can imagine, the longer the interval, the more stable the operation. Mr. Ose. Mr. Gregory. Mr. Gregory. I can cite a few examples. BP in Carson City, they had a cat outage earlier this year in the February March timeframe. Mr. Ose. I learned a long time ago that when you say ``cat outage,'' you need to explain what you mean. Mr. Gregory. Cat cracking---- Mr. Ose. Catalytic cracker. Mr. Gregory. Catalytic cracker. Its outage was prolonged due to some problems within the mechanics of the turnaround itself, some rework that had to be done--welding, that type of thing. So totally unforeseen outages in the Bay area, at Martinez, were totally unforeseen. The one that we experienced with Shell just recently, there was just no--I'd say these were more mechanical reliability issues. Mr. Ose. Let me followup on that. According to the May 2003 report from Mr. Caruso's agency on page 11, I'm going to just read this to you: ``While the major maintenance outages this year were not driven by the shift to ethanol, the shift did require some additional maintenance activity. For example, some refineries doing maintenance made changes to fractionaters to be able to remove the light ends in order to reduce the RVP and to accommodate new distillation cut points. Some refiners who had additional olefin feedstock available also took the opportunity to expand alkylation capacity to help make up for the yield loss when switching from MTBE to ethanol.'' So it seems like the opportunity presented itself and maybe somebody said, you know, ``Rather than have to do this twice, let's do this just once.'' Is there substance to that? Mr. Gregory. Yes, there is. That's an accurate statement. Typically refiners will take down the fluid catalytic cracking units in this February timeframe, like we discussed earlier, and what you do is any expansions that have been proposed for those facilities or any changes, like you say, being able to get stronger fractionation to take care of the light ends, knowing that ethanol has the higher vapor pressure, so we have to do a better job on the fractionation side. Those modifications will be made during those outages. Mr. Ose. When you talk about the light ends, you are talking about the tendency of ethanol to have a much higher evaporative rate and you have to pull the bentanes and the pentanes, the pentanes and the---- Mr. Gregory. Butanes and lighter. Mr. Ose. Yes. Mr. Gregory. Mostly butanes. Mr. Ose. You have to pull them out of the base before you add the ethanol? Mr. Gregory. That's right. Mr. Ose. OK. Mr. Gregory. Just as a side note, that takes away a lot of the flexibility within a refinery. Mr. Ose. All right. Mr. Caruso. Mr. Caruso. Speaking as an analyst and not a technical person, and we have seen this around the world, any time you stress an infrastructure, as we are seeing in California now operating the secondary units nearly 100 percent capacity, the tendency for problems to occur increases. I think that certainly is a component to what we have witnessed. Mr. Ose. One of the reasons this has such fascination to me is that it affects supply and supply affects price. I mean, that's just classic economics. To what extent did these outages contribute to price spikes, such as they were? Well, we don't see it up there now, but such as it was reflected in that graph. Dr. Kiesling, have you done any analysis of this? Dr. Kiesling. None that would be in any way superior to what Mr. Caruso has offered. Mr. Ose. Mr. Caruso, in your written statement and the May 2003 preliminary report, is there any indication, given the September time line for the final report, as to the influence of these outages on price spikes. Mr. Caruso. We were not able to disaggregate it, given the information we had available for the May report, and we are working, of course, with updated information, and hope to be able to say something more definitive in September. However, I think it's going to be very difficult to separate those two components, the maintenance, the reduction in capacity, and the logistical and other market stress factors related to having two nonfungible gasolines during this transition period, but certainly the two together made up for the lion's share of that increase. Mr. Ose. I want to make it clear. Everybody has talked about the fungibility of the gasoline to be mixed and what- have-you. I just want to make clear that from a regulatory standpoint, it's my understanding that producers are not allowed to mix ethanol-based fuel with MTBE fuel, because apparently it chemically changes the compound and you end up with a problem of volatile organic compounds. Am I correct? Mr. Keese. You are correct. It is unlikely. In theory, I guess it could, but it's absolutely unlikely to meet the standards, the air standards. Mr. Ose. The aggregated fuel. Mr. Keese. The aggregated fuel will not meet the standards. The complexity--and we should have the refiners here--but the complexity of our new product is that you make a product at the refinery which is blended with the ethanol in the field and it's got to meet the standard. Mr. Ose. You're talking about the---- Mr. Keese. MTBE was put in the gasoline at the refinery. Mr. Ose. OK. Mr. Keese. You can't do that with ethanol, so you make a, you call it a feedstock, which then goes out and it is blended before it goes to the service station. Perhaps one of the operators---- Mr. Ose. It's my understanding, Mr. Gregory, that the base is mixed, put in the tank, the tank pulls up to the ethanol discharge point, the ethanol is put in the tank and is mixed on the way to the gas stations. Do I have my facts correct there? Mr. Gregory. As a CARBOB gasoline, in our particular case, you export that gasoline to be blended with ethanol, just as you say, at terminals. Dr. Kiesling. Mr. Chairman, if I may. Mr. Ose. Dr. Kiesling. Dr. Kiesling. In reconsidering your question, I thought it might be useful to mention something about the price spike we experienced in the Midwest in 2000. Mr. Ose. Are you talking about the pipeline issue. Dr. Kiesling. That's precisely the point. I think that some of the experience in California echos--there are some potentially insightful similarities between what we have experienced in the Midwest and what we are seeing in California. As I think we have all alluded to, the closeness of supply to operating capacity leaves you very little room for error, so if a pipeline unexpectedly goes down, as we had happen in two instances in the Midwest in 2000, as well as the RFD phase 2 implementation, and of course, it's different in the Midwest, because in Chicago and Milwaukee, we have been ethanol since 1995, and haven't had an MTBE to ethanol transition, but nonetheless, we still do see seasonality of prices and the price fluctuations in February, March, and then again in May, with the start of the summer driving season, but we also are very conscious of how close we are to operating capacity and how little room for flexibility we have, and that's why any unanticipated downside gets reflected pretty quickly in retail prices. Mr. Keese. Mr. Chairman, I would add one anecdotal story to your question. We have an extremely good relationship with the oil industry in that we get the call immediately when there is a refinery problem, which we hold confidential. If a refinery loses 50,000 barrels a day and is going out to the marketplace to replace it, they can probably do it at a modest cost, especially if there's adequate reserves and nobody else knows about it. Now, if this refinery outage resulted in smoke that was seen and reported, the price goes up instantaneously, but if the refinery is able to over a period of 2 days replace their needs without public notification, the price probably doesn't rise, and perhaps may never rise. So, anecdotally, as we see each of these instances and know about them and we watch what happens with prices, it's unexplainable. Sometimes there is no increase, sometimes it's drastic, sometimes they speculate that it's been a disaster and the price goes up and bounces back down after a day or two when the company announces how minor the situation was. Mr. Ose. Market information. Mr. Keese. Exactly. Mr. Sparano. Congressman. Mr. Ose. Yes. Mr. Sparano. If I may, I owe you a response on the Oregon tax. Tax in Oregon is approximately 42 cents a gallon, which would make it a little under 10 cents a gallon lower than California. In another nearby state, Arizona, it's 37 cents a gallon, so I think you can see there is a substantial difference among the States surrounding California, from one higher to two significantly lower. Mr. Ose. Let me go back. I appreciate that information. Mr. Sparano. I have one other observation for you and I'd like to mention it, because it's an area that often gets talked about in a different light than I'm about to say it. What you have heard from the whole panel this morning in response to your questions and fascination about turnarounds and outages and how the effects of those situations, what they engender in the marketplace. One of the reasons we are not mentioning, but is at the heart of it, is that we are an extremely competitive industry. The same people who might sit at a dais and talk to you in general terms, or even specific terms, about their refining and marketing businesses are out in the marketplace competing with one another day in and day out for advantages, for opportunities, and avoiding the kinds of situations that create problems, so that factor there is present all the time. The free market is what's at work. You ask why you see a spike and are they connected to outages. With the fine balance that Dr. Kiesling referred to just a moment ago, when there are supply situations--in fact, Chairman Keese said it well--real or imagined, it doesn't have to be a reality. It has to be someone's perception, if they saw smoke. That can really make an impact, and then the competitors respond to that impact as best they can. I just don't want us to forget that's a very important factor in the type of capitalist economy that this country embraces. Mr. Ose. I want to examine one other aspect of this early part of the year switchover that we have historically had from winter to summer blends. This a derivative of that question. Mr. Gregory, you are probably the one best suited to answer this. When you look at your refinery, in figuring out from a scheduling standpoint, how much time do you have to allot for a switchover from an MTBE-based fuel to an ethanol within certain parameters, it's x-amount of time, depending on your refinery and where you are and all that sort of stuff. Educate me a little bit. How much time, what are the minimum and maximum windows that you need to make that switchover? Mr. Gregory. The switchover depends on the facility. Some facilities are going to be big exporters in the pipelines or they may be waterborne, and depending on if it's one way or the other, it depends on how much storage you have. If you are waterborne, you typically require a great deal more storage, and if that's the case, it's going to take somewhat longer for the turnover. I would just be guessing if I gave you a number. In our particular case, our refinery won't be switching over until sometime later in the third quarter, so I don't have firsthand knowledge how long it would take us to make that transition, but I think that the answer is that it varies from facility to facility. I think to give you a good guess, even though I said I didn't want to guess, I would say anywhere from 2 to 4 weeks, probably, to run through your systems and be able to move MTBE- based and go fully ethanol-based. Mr. Ose. In effect, you take your refinery down? Mr. Gregory. No. All you are doing is that you have many components that make up a blend of a gasoline, MTBE or ethanol being one of them. Of course, those carry the highest octane, so to meet octane balances or octane requirements, octane specs and also vapor pressure specs, it gets somewhat complicated on how you do your blends, and when you make that transition-- let's just present a particular case. Let's say that as you are making that transition you become, because of the loss in volume in the ethanol, you become octane-limited, which requires possibly more import of an output type of material to help with that octane, and then there's other certain parts of your blend that take a period of time to be blended off because of that change to ethanol, so it may be that a lower octane material may take some time to really work that out of the system, because of an inventory that had been built up for an MTBE-based plant. Now, the other side of it is that there's the RVP issue that we talked about. Some refiners will have to import a rafinate-type of material that's a low RVP material. You have the modifications within the refinery, you operate the refinery a little differently, so for that reason, that also may add some time to make that total transition. Mr. Ose. You are almost suggesting that there's not only market influences on price, there's a similar number of influences on how you get from, if you will, MTBE-based fuel mix to an non-MTBE-based fuel mix, that there are analogies. Mr. Gregory. I'd have to say overall that you have to look at the big picture and say, ``Did I lose my capacity because of the switch?'' Yes, there is a one-time loss in capacity, and then, of course, there's a long-term loss in capacity. For instance, at our Venetia refinery, we see that we are going to lose 10 to 10\1/2\ volume percent on our gasoline blends. Mr. Ose. But that's a function of ethanol and its volumetric properties, not to the actual construction of a processing facility. Mr. Gregory. That's true, and it goes back to, once again, the vapor pressure impact, the octane impact, all that. Mr. Ose. All right. Now, it's my understanding that--well, I actually know. According to the EIA's May 2003 report, transitioning from MTBE to ethanol results in a 10 percent loss in production capability for summer fuels, and in California, that's like February to November, and a 5 percent volume loss during the winter for the winter fuels. Is that accurate? Mr. Gregory. Yes, sir. Mr. Ose. All right. What I'm trying to make sure of is that I have a clear understanding of--and this is directed to Mr. Sparano and Mr. Gregory--I need to have you explain why this volume loss occurs. Mr. Gregory. The volume loss occurs--we had talked earlier about the oxygen content of the ethanol versus MTBE. It's higher, so there's less ethanol in the blend. All right? So there's some volume shrinkage associated with that. That's the primary---- Mr. Ose. The oxygen content of the ethanol is higher than MTBE. Mr. Gregory. Yes, sir. Mr. Ose. So you have to put less ethanol into the fuel mix to achieve the oxygenate requirement. Mr. Gregory. That's exactly right. Mr. Ose. All right. Mr. Gregory. Now, also because of some octane constraints within some refineries, then you are going to be limited on how much of your lower octane components you can blend into refiner blend, which means that in some cases some of your lower octane material will have to be sold to a refinery that's not octane- limited. So there could be further reduction in the ability of a refiner to produce gasoline if they are octane-limited, because you have less material that is the higher octane component that goes into the blend, which means that if I can't make the octane requirements, then I cannot blend some of my lower octane components. Mr. Ose. Every time you say something, I get another question. Explain to me--you differentiated between your refineries on the basis of octane in terms of the feedstock or the base material that they were using. Explain that a little bit to me. You have different refineries who have different capabilities, some can start with this quality of a raw product and some start with that quality of a raw product, based on octane in part? Mr. Gregory. Yes. It's a great question, because what it means is that some refiners may have, let's say relatively speaking, a great deal of alkylic capacity. There is an alky unit behind this cat-cracking process that we talked about earlier, that turns an olefin-type material into an alklyd high octane. Its idiluent, it's a clean fuel. Some refiners may have a large alky unit relative to other refiners. Some refiners may be octane-limited because they may have not a great deal of reforming capacity or alky capacity, so each refinery is a little bit different in how they make their blends. So, directionally, and when we talk about ethanol versus MTBE, that's the one common thing that you see across all refiners in California, that directionally it's going to drive you toward less of a high octane component. It makes it that much more difficult to blend to an octane. In our particular case at Wilmington, we are going to have a great deal of difficulty producing any premium, unless we import alklyd from an outside source. What that would do, that would put pressure on the alklyd that's available domestically and from overseas, and drive that price up as well, increase in the cost to produce. Mr. Ose. I just need to make sure I can explain this when I go back home, try to explain it to my 10-year old daughter so she will understand it. What you are saying is that the process of manufacturing MTBE, depending on your refinery, requires you to add this or add that or to cull out this or to cull out that. Compared with the process of adding ethanol as a different formulation, if you will, and depending on your refinery, you might use any number of different ways to produce your final end product. Mr. Gregory. That's exactly right, but directionally each refinery is going to be faced with a loss in octane by going to ethanol, higher vapor pressures associated with ethanol versus MTBE, and those are two things that you have to overcome. Mr. Ose. My original question had to do with the volumetric issue, which is, is it because the ethanol has a higher oxygen content you have to add less of it to meet the requirement that exists in the statute today. Mr. Gregory. Yes, sir. Mr. Ose. Now, that has implications across the price spectrum, I mean as you work that through, because if you only have 97 percent of the volume or 95 percent of the volume that you otherwise had, that means you have less volume for the same number of people that want to drive. Are you telling me that a mandate from the Federal Government to use ethanol may very well lead to higher prices? Just everything else being equal in the marketplace, there will be less---- Mr. Gregory. That's exactly right. I think we are all saying the same thing. That's going to continue. If you go to ethanol nationally, that's going to put that much more pressure on the ethanol itself, and we had talked about that there's a single, pretty much a single producer. The other thing it does is it puts more pressure on the other high octane blending components, like an alklyd. That's what a refiner will typically import to help with octane. Mr. Ose. Now, Mr. Caruso, you indicate that's 3 to 6 cents per gallon. Mr. Caruso. That's correct, sir. Mr. Ose. And we are using, in my opening statement I said 1.1 billion gallons a month; is that right? Mr. Caruso. Right. Mr. Ose. So that's $33 million to $66 million per month transfer from a State such as California to a State that might have serious ethanol production capability; or in the converse, we might have that kind of thing as an incentive to create an ethanol industry here in California. In effect that's the direction we are headed. Mr. Caruso. I think that math is correct, sir. Mr. Ose. All right. Mr. Keese. Mr. Keese. We would concur. We believe the Federal waiver itself costs us 3 cents. Our numbers--it's from 3.4 to 6.4 cents, and the lack of flexibility resulting from the denial of the waiver is 3 cents of that. The 6.4 comes in with lack of a waiver. It would be 3.4 cents without. Mr. Ose. So your $37.4 million to $70.4 million per month? Mr. Caruso. Right. Mr. Ose. Dr. Kiesling, do you read it the same way? You are going to give me the ``on the one hand'' and ``on the other hand'' thing? Dr. Kiesling. No. I'm going to be a one-handed economist, I promise. Mr. Ose. OK. Dr. Kiesling. Rare though that may be. My understanding of ethanol production is that it's highly unlikely to be economically viable to have, to set up ethanol production in California, because of the climate, geography, growing conditions, etc., and also because the most cost effective way to produce ethanol is to generate it close to feedstock, so you grow the corn, you harvest the corn, you create the ethanol--boom, boom, boom--in the same place. So therefore, if you were to grow, try to grow corn and produce ethanol in California, overcoming the geographic and growing condition constraints would probably mean you'd be a very high-cost ethanol producer if you were producing ethanol in California. I just wanted to add that to your observation. Mr. Ose. Well, I appreciate that. I will tell you I come from a district that's very agricultural in nature, in the central valley, and there's a lot of corn growing in the central valley. There's a lot of rice. There's all sorts of agricultural biomass that can be used to create ethanol. My issue is the mandate on the input, rather than the output, but I'm not sure--I may come back to that question. Mr. Sparano. May I make an observation or two? Mr. Ose. Certainly. Mr. Sparano. It would probably be smarter to sit here and keep my mouth shut, but I'm not generally known for that wiseness. Let me just say all of the comments that you've heard and the calculations that have been made, I have no reason to or desire to dispute. What I want to add is that when you look at a piece of an extremely complex--as you heard this morning, the complexity of making a gallon of gasoline different in each refinery and then moving those different gallons throughout a system that has a number of limitations already to it, particularly in California, those complications make it very difficult to say precisely that the value of adding ethanol instead of MTBE or the cost will be ``X,'' whatever ``X'' may be, because at the end of the day when you step back from all of that, it is a free market. There are lots of other factors that contribute to the price of a gallon of gasoline, and they change every day. That's just one observation I think we need to keep out in front of us, again not to dispute the specificity. I think too much precision may not reflect accuracy, actually, when you take the other things into account. The second comment I want to make refers to your observation about the agricultural land in California. In addition to the starch-based, corn-derived ethanol that we see produced in the Midwest, there are processes that do a very fine job of converting biomass waste--rice hulls, sugar cane to bagass, municipal solid waste into ethanol, and lots of other interesting chemical products, and California has hardly tapped that reservoir of opportunity. There are two things that one must face when you look at whether or not that makes sense--what's the cost? Is the science good? What's the cost? Are there investors who are willing to spend the money? And then once you get over those two hurdles, can you get it through the permit process that would actually allow you, you know, in a reasonable amount of time to have confidence that you could build a successful operation. Mr. Ose. Mr. Keese. Mr. Keese. Mr. Chairman, we have 20 active ethanol projects before the Energy Commission at this time. Mr. Ose. For permitting? Mr. Keese. No, for research and development and incentivizing. Mr. Ose. In-house. Mr. Keese. We are aware of 20 projects that we are working with, 20 proponents that we are working with on active projects. Mr. Ose. All right. Mr. Sparano's comment just begs a question, and that is, can California refiners produce a gasoline blend that meets phase 3 requirements without using ethanol. Mr. Keese. Yes. I'll answer yes, but he's the---- Mr. Ose. Mr. Gregory. Mr. Gregory. No, you go ahead and answer. I'm from Texas. Mr. Sparano. I think if you just look at California's petition before the--I guess now it's a lawsuit--the Federal Court suit against the EPA, California, both the Energy Commission and companies within the State have indicated that they can make gasoline without an oxygenate. Name whichever one you want--gasoline, CARB 3 quality material can be made without oxygenate. I'm not saying it's easy. I'm not saying it doesn't take investment and changes in the refinery, as Mr. Gregory was alluding to, but I believe, Mr. Keese, that's where the industry and the State have come out. Mr. Ose. So, from a pure chemistry standpoint, it's not necessary to have a mandate. Mr. Gregory. No. Mr. Sparano. Are you asking me? Mr. Gregory. Well, what I wanted to say, I wanted to make a few more comments about why it is that we can produce the gasoline without the oxygenate. We have already done a lot of the tough things to improve our gasoline quality, and that is in lower sulfur, stronger hydro treating to get the sulfur down, lower vapor pressure. Those have been the big impacts to our air quality. What it ends up being is just--there's the octane that has to be met, there's certain distillations that have to be met within these blends, and once again, vapor pressure. Most refiners have made those modifications to achieve the lower vapor pressure, lower sulphur, as I mentioned. Mr. Ose. Let me ask my question differently then. Is it possible to create phase 3 gasoline without using an oxygenate. Mr. Gregory. Yes. Mr. Ose. All right. Mr. Keese, do you agree with that? Mr. Keese. We agree with that, and with absolutely no negative impact on air quality and perhaps a positive impact on air quality. Mr. Ose. So, actually, the situation exists that we can create fuel that meets our environmental requirements and desires with an oxygenate and we can make it without an oxygenate. Mr. Keese. Correct, and in both cases meet Federal and State--the Federal air standards and the more stringent State standards. Mr. Ose. Thank you. I appreciate that. I feel vindicated. One of the consequences, as we talked about earlier as an example, for instance as an example, adding ethanol as opposed to MTBE, is that volumetrically we reduce the amount of fuel we have, and we do that without any compensating in reduction and demand. In other words, demand is static and all we are doing is reducing supply, which tells me that we have to bring fuel from elsewhere to fill that hole. Now, where will those imports, whether they be domestic or from overseas, where will they come from? Mr. Caruso, have you guys looked at any of that? Mr. Caruso. Yes, we have looked at it, and we think that it will come from all three places--Gulf Coast refiners, Washington State, and some foreign sources have blending components to add to make up for this volumetric loss, and I think Mr. Keese mentioned in his comment that there has been some investment already made by California refiners to improve their ability as well. Mr. Ose. It's called production creep or capacity creep. Mr. Caruso. Exactly. Mr. Keese. We do see an expansion in the import of both gasoline and blended products that will result directly from what we are talking about here. It could be as large, in our opinion, as 10 or 20 percent of the amount currently being imported. An item that I raised very briefly in my written statement was that we are seeing additional stress in our marine terminal infrastructure. One simple example is that ports in California have generally determined that they like container cargos better than tankage, so what we are seeing is less tankage on the ocean than in the past, which goes exactly the opposite direction from a need to import more, and this is something we are looking at very closely and working with all the ports in California. Mr. Ose. The source locations of these new imports, is it Indonesia? Mr. Keese. Well, depending on which company you have sitting here, you will hear yes or no. Historically, we had always used in our equations how long it takes, outages, how long it takes to get here from Houston, because that's where it could come quickest if we had a refinery out. Not quickly, but say 3 weeks to get the order, find the ship, get the product in, and make the trip. It's a very risky proposal because by the time you get it to California, we may be out of the crisis. We would expect that in the future it will be coming from Indonesia and that part of the world. Mr. Ose. Mr. Sparano, what do your members, when you talk with them, without revealing any confidences--are Mr. Keese's comments accurate? Mr. Sparano. Well, the members--as an association, that's not the kind of data that gets shared with me. In fact, we take a lot of pain not to delve into individual company preferences and actions. That's just not something the association does, but I would like to comment and to try to respond to your question. I don't know where barrels will come from. I think Mr. Keese is accurate when he describes that there will be a gap, and that gap will have to be filled, and I think he is most accurate when he comments about the infrastructure and the shortcomings of our waterborne delivery system in California, and there's a reason for that. While this industry I think can be characterized fairly as having done a pretty terrific job of responding to regulatory requirements, doing things on its own that have made an enormous leap in cleaning up the air in California, in particular. In the last 20 years, the air is probably twice as clean as it was as measured by smog ozone levels. Mr. Ose. Half as polluted. Let's put it the other way. Mr. Sparano. One might characterize it that way as well. The fact of the matter is, there's less pollutants in the air. CBG3 will take another 14 million tons a year out of the equation, mainly sulphur, and we haven't talked about what's in CBG3. I don't want to deflect from my point. The fact of the matter is, regulations and the permits required to meet those regulations, and almost as importantly, maybe more importantly from a supply side standpoint, the inability of investors, be they a petroleum company, a transportation company, a terminaling company, a shipping company, a land developer, anyone who wants to add to the infrastructure runs a risk that he or she might spend millions of dollars over periods of time from 2, 3, 4, 5 years, to reach a point where they might actually understand whether their particular project may be permitted. That's part of the regulatory process. We all abide by it, but I have to suggest to you that it's a significant influence over whether we have to accept foreign imports to fill the gap or whether there are opportunities for our own industry to help do that. Mr. Ose. Dr. Kiesling, as an economist, it seems to me that much of the raw product is quite substitutable. I mean, there are variations, but does it really matter where it comes from. Dr. Kiesling. A lot of times people describe the global oil market as a big bathtub, and that's how supply fluctuations get transmitted through price. When we talk about energy security issues for our country that--for example, it doesn't matter if we buy less from Kuwait because it all goes into one big bathtub. I think technically and operationally speaking, and my colleagues here can speak better to that than I can, there are some important differences, according to where you get your oil, but that in general, supply is a lot more fungible and a lot more substitutable of the raw product than of the refined product with all the additives added. Mr. Ose. Your concern focuses on whether it's light or heavy, what it's---- Dr. Kiesling. Exactly. Mr. Ose. Mr. Gregory, the operator amongst us, is that pretty accurate? Mr. Gregory. Well, yes, it's a true statement. I mean, Venezuela produces a certain grade of gasoline that is not acceptable under our regulations. Mr. Ose. All right. Mr. Gregory. It will not meet our specs. Mr. Ose. Now, given the difficulty--I just want to touch on this. I don't want to dwell on it. I want to touch on it. Given the difficulty in the economy right now, with increases in unemployment and the like, to the extent that we buy refined or finished product that then comes in through Long Beach or L.A. Harbor, are we exporting jobs? Is that the net effect of this? I know that--Mr. Sparano, your members have a huge number of jobs in a very stranded, if you will, capital plant, I know Valero does, and I'm sure your competitors do, but, Mr. Sparano, you have been trying to say that it's very difficult to get permits to build new capacity in the State of California. The alternative to building new capacity, other than, say capacity creep, the alternative to capacity creep is to build new capital or put new capital to work somewhere else. Are we losing jobs as a result? I mean, we are making a choice, and I'm asking, is that the choice we are making? Is that a consequence of our choice, that we are losing jobs that at least in many past decades have been located here? Mr. Sparano. I'm not sure I'm qualified to answer that on an economist basis, but just as an American, if I see the balance of payments tilt toward where we are paying more and selling less, I get uncomfortable, and if that translates to fewer jobs, it may, and directionally, my guess is that it does, but it's just a guess. The fact of the matter is, it isn't just building new capacity. I was responding to your question when you asked me about Mr. Keese's comments. The infrastructure is critical even if you are importing. We have problems--you can't even dredge a harbor within a timely manner sometimes, and that relates to what kind of ships you can bring in, it relates to the preferences that Mr. Keese talked about for container ships, probably lower draft ships, not as deep draft ships that can navigate more easily than some of the deep draft heavier tankers, which have their own set of concerns from the public in respect to them. So it's still--the whole matter is pretty complicated and my pitch is just that the permit system, if improved, would probably help the entire situation that you have been asking questions about this morning. Mr. Ose. Dr. Kiesling, from an economist's standpoint, are these jobs going elsewhere? Is that an accurate read? We are making choices? Dr. Kiesling. We are making choices. I don't know the specifics in terms of job numbers, but what I can say is that the difficulties to which Mr. Sparano is referring highlight the extent to which the existing regulatory environment distorts our ability to read what jobs should be done where and by whom, which is obviously the efficiency--you know, are the right jobs being done where they should be, by whom and paid as they should be. The existing regulatory environment drives a wedge into our ability to read that. Mr. Ose. We are making choices. Dr. Kiesling. We are making choices. Mr. Ose. Right. Dr. Kiesling. And then I guess my question is what benefit are we getting when we make those choices, in terms of environmental protection and environmental improvement? Mr. Ose. We are going to get to that issue in a couple of minutes. Dr. Kiesling. OK. Mr. Ose. Mr. Keese, one of the issues that keeps coming back is the support infrastructure. I think you raised it first. I have been down to L.A.-Long Beach Harbor. I've sat with Larry Keller and his board. They do have infrastructural challenges there in terms of moving significant amounts of additional product through there. I'd be curious whether anything comes to mind in terms of, like top three projects that elected officials need to focus on relative to that infrastructure, particularly at L.A.-Long Beach. Mr. Keese. I'm going to have to take a pass. I have not been involved with those discussions, and I just---- Mr. Ose. All right. Mr. Keese. I can get you an answer, but---- Mr. Ose. I'll tell you what. That will be one of questions we will send you in writing and you can give us some feedback on that. Mr. Keese. Thank you. Mr. Ose. We have talked about MTBE versus ethanol versus product that doesn't have a mandate behind it. Once MTBE is phased out at the end of 2004, as I read the charts and the testimony, the volatility attributable to the switchover from winter to summer will lessen. Will the price in everybody's estimation here--and I'm asking you for an opinion, not factual or absolutes--will the price of fuel drop? Mr. Caruso. Mr. Caruso. In my opinion, no, and the reason is that I think you've got even a more or I should say a less flexible system, so the potential for having spikes. You see the experience in that chart just over 8 years. I think you probably have a system that perhaps would be no less volatile. Mr. Ose. Mr. Keese, would you agree with that? Mr. Keese. We see over the next few years the danger or the likelihood of additional spikes. We are running so on the margin that any incident, whether it's in a pipeline or in a refinery, can cause a spike. We would expect that we are going to see spikes. Mr. Ose. Mr. Sparano. Mr. Sparano. I won't guess at price. I can't predict price, but I think it's important to remember that there are so many factors that go into what happens to the market, to the prices, that putting emphasis on one particular factor to try and make a prediction is, I think, not a reasonable exercise, certainly not for me to engage in. Mr. Ose. Mr. Gregory, you have capital at risk. Mr. Gregory. I don't want to speculate on that answer. Mr. Ose. Dr. Kiesling. Dr. Kiesling. I don't want to speculate either, but I would say that removing the winter to summer transition, as Mr. Sparano said, it's only one very small part of a very complex dynamic, so it's unlikely to remove a lot of the inherent volatility that is still in there. Mr. Ose. I'm tempted to observe that the issue of which or whether we have an oxygenate as part and parcel of this debate is kind of a sideshow. It's more related to the base production capacity. Whether you are adding this, or taking that out, still, how much can you put through the pipe? Mr. Keese. Mr. Keese. It's an addition of another risk factor. You know, once we have made this turnaround on January 1st in California, without a waiver, you can't sell the product without ethanol, so we have introduced another risk factor. Mr. Ose. Now, Dr. Kiesling, we are going to get to the environmental issues here that I do want to touch on. According to a recently published report by a professor at UC Berkeley, and it's here somewhere, by Tad Patzek, which we are going to put this study in the record, according to Dr. Patzek's study, production of ethanol actually results in a negative energy balance, which as I understand Patzek's analysis, means that it takes more energy to produce it than it provides. This runs--trust me, I have heard the different arguments by both the opponents and proponents of ethanol, and it's energy efficient or otherwise, and it will reduce our dependence on foreign oil or otherwise. My question is, Dr. Kiesling, whether you have done any analysis of this energy balance as it relates to using ethanol in gasoline specifically? Dr. Kiesling. Mr. Chairman, I should say, being neither an engineer nor a chemist, I take work such as Professor Patzek's as an input into what I do, so I don't necessarily do any direct research on the energy balance question, but the energy balance question is very important when you ask is this an economically sound choice. My interpretation of Professor Patzek's result is that just in terms of production, ethanol is an energy wash. Once you bring in the burn--burning the ethanol as a fuel is what turns it to a negative, because the ethanol is replacing something that burns with more intensity and more--gives you more energy output when you burn it, so it's really the burn of ethanol that flips it over to being in that negative. He finds that the production part of it is pretty much a wash. With that being said, does that mean that ethanol is an economically sensible choice? I think leaving that up to consumers and refiners to decide whether or not that is the economically sensible choice would be a better alternative than having an input-based oxygenate mandate. Mr. Ose. Let me rephrase that. Are you saying that Congress should say, ``This is what we want coming out of your tail pipe and we don't care how you get there?'' Dr. Kiesling. That is precisely what I'm saying. Mr. Ose. Mr. Gregory, you are nodding your head enthusiastically. Mr. Gregory. Yeah, I actually smiled and the whole works. Yeah, that makes more sense. It just makes more sense. The other thing is, something that comes to mind is you hear a lot of discussion about how we want to become less dependent on energy from outside sources, and to me that's what this whole argument comes back to, it's totally countercurrent to what our vision is as a country. Mr. Ose. Because of the volumetric issues. Mr. Gregory. No, more so the--I'm just now really talking now about the energy side that requires actually 30 percent more energy to produce the ethanol than you get out of it. Mr. Ose. All right. Mr. Sparano, any observations on this? You have members on both sides, I believe, who have gone to the ethanol already and are still with MTBE. Mr. Sparano. We have almost 30 members and probably 30 opinions on many subjects, so, yes, you---- Mr. Ose. You want to just sit back in your chair, don't you? Mr. Sparano. Well, if I wanted to do that, I wouldn't have shown up in the first place. It is an issue that we deal with all the time. These are individual companies and they make individual investments based on how they see the landscape to do so. I think I react as Mr. Gregory does to your comment, with a nod of the head and a smile. I think mandates overall tend to create an artificiality in a system that could do very well without it. Mr. Ose. Mr. Keese, from the Energy Commission's standpoint, is the mandate a good idea, or otherwise? Mr. Keese. We absolutely oppose the mandate. We would like flexibility. As to your specific question, I would comment that the draft paper by Professor Patzek is undergoing considerable scrutiny by the technical community and its findings are being disputed. We are in possession of several other analyses that staff finds much more authoritative and compelling than the Patzek paper, which relies on previous outdated and heavily criticized analysis by Professor Pimentel at Cornell. Most other analysis by Argonne National Laboratory, the U.S. Department of Agriculture, and others find a significant positive energy balance for the current MTBE to ethanol fuel cycle. Mr. Ose. Would you care to enter those additional studies in the record? Mr. Keese. We'd would be happy to do so, to answer in writing. Mr. Ose. We will do so then. I just want to make sure we get those additional studies in the record. [Note.--The information referred to is on file in the subcommittee.] Mr. Ose. Mr. Caruso, any input on this? Mr. Caruso. I haven't had a chance to review that report, so I have no comment. Mr. Ose. The other issue that we struggle with here in California is having adopted MTBE from an air standpoint back in the mid-nineties, it's consequences on water were largely, as near as I can tell anyway, unaccounted for, and we have ourselves a problem with MTBE that has now contaminated many of our water sources. Is there any evidence, pro or con, as it relates to substituting ethanol for MTBE regarding a potential similar situation to contamination of other media within the environment, Dr. Kiesling? Dr. Kiesling. The primary one that I am aware of is what I mentioned in my overview is the concern about benzene plumes when ethanol leaks into soil, and these benzene plumes apparently occur when ethanol leaks into soil and there are microbes that live in the soil, and they enthusiastically eat the carbohydrates in the ethanol. They have a great preference for the carbohydrates in the ethanol, whereas in the absence of the ethanol, they would eat the carbohydrates in the hydrocarbons. I'll apologize if I'm doing grave injustice to the science, but this is my lay person understanding of it. Therefore, because they eat the ethanol with such alacrity, they leave these reservoirs of petroleum hydrocarbons in the soil that can leave benzene deposits. Mr. Ose. Has that analysis been vetted? Dr. Kiesling. I don't know. I haven't seen what I would like to see, and I'm going to look for more--I should say also I use the ethanol versus MTBE as a large case study in my environmental economics class, and we work through all of these. What I would like to see is some empirical research on the Midwest, especially Chicago, Milwaukee, where we have had ethanol oxygenate fuel since 1995, to see whether or not there has been an increase in benzene deposits in our soil. Mr. Ose. Do you have such research now? Dr. Kiesling. I have not seen, I have not located any such research. I have been looking. Mr. Ose. Mr. Gregory, I want to make sure I have it correct in my head as to what the MTBE issue is. As I understand it, the problems we are having in our aquifers are related to leaks in the storage tanks into which MTBE based fuel is placed prior to its retail sale in large part. In other words, as tanks leak, the chemicals drop right down through into the aquifers as a result and that the MTBE pollution issue we struggle with is not a function of its combustion within an engine. Is that accurate? Mr. Gregory. It's all accurate. Mr. Ose. So if you fix the tanks, if the tanks didn't leak, you wouldn't have an MTBE problem? Mr. Gregory. Yes, sir. Mr. Ose. Mr. Keese, do you have anything, do you have any comment on that? Mr. Keese. I will comment as a lay person who is involved in the analysis and made the recommendation to the Governor on this subject. Gasoline leakage generally stays close to home. I'm interested in Dr. Kiesling's comments that ethanol gasoline may move farther, but gasoline generally stays pretty close to the tank. Ethers don't, so MTBE does not stay there. It migrates. Now, the problem with MTBE occurs in areas where the tankages, also where you have low water tables, so in Santa Monica and Lake Tahoe we have the greatest problems. In Fresno, you might have clay layers between the tankage and the underground service, and you might not have a problem. We just found that because of leakage and because of disposal into the water systems of lakes by outboard motors and water scooters, it was just unacceptable to continue to have MTBE in the gasoline. It was a very practical decision, not necessarily based on health concerns. As you know, MTBE is so obnoxious that you could not possibly drink enough water with MTBE in it and not get sick, because you'd pass the point way before that. You can't stand it at very low levels. Mr. Ose. I just want to be clear on this, that the MTBE challenge that we face relative to our water sources is not solely a function of these tanks leaking? That's a question not a statement. Mr. Keese. That's correct, and it's clearly not solely a problem of service station companies when you figure that we probably could have as many as 500,000 of these tanks on agricultural facilities in the State of California. Mr. Ose. I expect to have any number of members from the East Coast eventually get around to having to deal with the challenges we have been dealing with here in California. It will largely probably start in New York or Connecticut and travel accordingly. I'm curious, Mr. Keese, from your perspective, how well are New York and Connecticut dealing with the transition from MTBE to ethanol or otherwise? Mr. Keese. I'm not familiar, Mr. Chairman. Mr. Ose. Mr. Caruso. Mr. Caruso. Well, I hate to say anything negative about my great home State of Connecticut, but both Connecticut and New York have MTBE bans going into effect January 1, 2004. We have had staff interacting with regulators and others in both those States, and we are concerned that they are not quite as proactive in the early preparation that Mr. Keese mentioned, as has occurred here in California, enough time to prepare, which he mentioned and we think is critically important, good dialog between those governments and the industry in those States, and the facilitation of the permitting and regulatory aspects that will be needed to make a smooth transition. Frankly, we think they could learn a lot from California, and I know there's some concerns there. Mr. Ose. On the screen we have a depiction of States with bans on MTBE, together with the years in which they come into effect. The green are States that have banned MTBE in the fuels, and I can't quite read the years there, but some of you in the audience might be able to. In New York and Connecticut, given the condition or the state of their preparedness, what will an imposition of a ban on MTBE cause to the price of their fuel? Mr. Caruso. We haven't actually studied that, but certainly there's a good chance that there will be some increase, certainly the 3 to 6 cents as we mentioned, the production cost alone, and then there are also concerns about other permitting and regulatory matters that could certainly make them vulnerable to the tight markets that we saw here. Mr. Ose. Well, Connecticut says 2003 and New York says 2004. Mr. Caruso. Yes. My understanding is that Connecticut was originally October 1, 2003, but I believe that they have extended that to January 1, 2004. Mr. Ose. So they are both January 1, 2004? Mr. Caruso. Yes, sir. Mr. Ose. Like 6 months from yesterday. Mr. Caruso. Yes, sir. And the other aspect that both those States face that California does not is there are some issues with respect to transshipments between the States that have to be resolved. That adds a further complication. Mr. Ose. That blue line there is a major pipeline. I believe the name of that pipeline is Colonial, and you will see that its terminus is there in New York City. Being at the end of that pipeline going through States without bans, you're going to have a dynamic in which consumers and retailers in those States along that path that have no ban are going to be seeking a very price-competitive product, and you are going to have somebody at the far end of the line, that meaning New York and Connecticut, who might not be able to use the most price-competitive product. I mean, this doesn't seem to me to be like a scenario made for a particularly fruitful outcome. Mr. Caruso. I think that's accurate. It will limit the number of options they have available to them, certainly, in 2004. Mr. Ose. Mr. Sparano, do you know whether or not their infrastructural ability to bring stuff in through port is as challenged, for instance as say that which we have at L.A. or Long Beach? I mean, how are they going to get fuel there? That's what I'm trying to figure out. Mr. Caruso. I'm not familiar with the details, Mr. Chairman. Mr. Ose. Does anybody have any more information? Mr. Caruso. There is a little more on a positive note. The New York Harbor area, of course, is a large importer of European gasoline, so to the extent that there are suppliers who could meet these requirements, which I admit may be limited, there is at least that aspect, that it is a bit more positive on the transportation and the marine side of the New York-Connecticut area, but again, there's this issue of transshipping between the States that has to be resolved. Mr. Ose. I'm a little bit curious how that's even material. Mr. Caruso. It seems to me that---- Mr. Ose. Well, let me ask the question. Do you know how much of New York's or Connecticut's total fuel demand is met by European sources? Mr. Caruso. I don't have that, but I can certainly supply it for the record. [The information referred to follows:] [GRAPHIC] [TIFF OMITTED] T9970.148 [GRAPHIC] [TIFF OMITTED] T9970.149 [GRAPHIC] [TIFF OMITTED] T9970.150 [GRAPHIC] [TIFF OMITTED] T9970.151 Mr. Ose. How much of those European sources meets or produces an exhaust that would otherwise meet our air quality requirements? Mr. Caruso. I think it's quite limited, and with other restrictions, be even more limited. Mr. Ose. In effect, the manufacturers who would ship it from Europe would have to retool accordingly? Mr. Caruso. Yes, sir. Mr. Ose. So it doesn't seem like we have--let me phrase it the other way. It seems pretty dismal in terms of the outlook. Mr. Caruso. It's a concern, for sure. Mr. Ose. You're very careful, Mr. Caruso. Mr. Caruso. Well, I will add one more caution then, that those States are also subject to the mobile toxic source rule as well, which would add something to the complexity of dealing with this ban. Mr. Ose. One other question, if I might, we have struggled with the issue of the fungibility of the gasoline types; in other words, MTBE-based fuel and non-MTBE-based fuel, particularly ethanol-based fuel, can't be mixed together at the manufacturers' level, yet when I pull into a gas station I don't run up and ask the gas dealer, ``Do you have MTBE-based fuel or do you have ethanol-based fuel?'' I just buy the fuel and put it in my tank. One of the difficulties we have had here in California, and granted it's only going to be for a specific period of time, is the issue of fungibility of fuel and how it plays out at the manufacturers' level. Is that going to replay itself up in New York and Connecticut? Mr. Gregory, do you see any reason one way or the other? Mr. Gregory. No, sir, I don't. Mr. Ose. Dr. Kiesling. [No response.] Mr. Ose. Mr. Caruso. Mr. Caruso. I don't know if there's a transitional period. I think that it's supposed to go into effect January 1st, so there's certainly potential for volatility during the period when there's conversion, so that there will be some rigidity in the marketplace. Mr. Ose. When my fellow Members of Congress ask me if I have any recommendations, I mean, I'm tempted to say, ``Make sure that you don't box yourself in on the fungibility of the fuels, that is a cul-de-sac that you will regret, unless you plan it properly.'' Have you studied the New York-Connecticut market to the extent that perhaps you studied the California market? Mr. Caruso. We have not, but as I mentioned, we have participated in some regulatory hearings in Connecticut just recently to provide them with the experience that we learned from the California study. Mr. Ose. When will that information be available, September? Mr. Caruso. Yes, sir. Mr. Ose. All right. I always like to ask people for their solutions, if you will. I mean, everybody can snipe; how many people can come up with solutions? So, Dr. Kiesling, we're going to start with you. If what we are after is clean air and a reliable fuel supply, what solutions would you propose to move us in that direction, knowing what you know today, knowing that tomorrow there might be more information? Dr. Kiesling. Tomorrow there is always more information, and that is precisely the foundation of my entire body of work, I think, that we are constantly learning and constantly discovering new things. I would recommend, as we have discussed before, that we focus our environmental regulations, air, water quality, soil quality, more on an output and performance basis, and less on input basis. We have seen, and again this is a set of case studies that my students walked through in my class, that historically input-based environmental regulations tend to not generate the anticipated and hoped-for outcomes, and tend not to perform at great cost, and I often cite the Federal oxygenate mandate as an example of that. I think it's very prone to that criticism and therefore I would recommend, as you said before, something output-based. You know, we don't care how you do it, but you have to achieve this, this and this, coming out of the tail pipe when we burn your gas, and that would give the refiners the flexibility to harness what I think is a core and important part of human nature that often gets overlooked, which is the striving to figure out how to solve a problem. If presented with a problem, given the flexibility to be able to solve that problem, I think we have seen a lot of examples in the petroleum industry, as well as other industries, that human creativity and technological change can get us, if not over the goal line, pretty far down the field. Mr. Ose. Mr. Caruso. You thought I was going to Mr. Gregory next, didn't you? Mr. Caruso. Well, I think it's the point I mentioned earlier, early preparation and not boxing yourself in, as you point out, by having thorough discussions, as Chairman Keese has mentioned, that they have here with the industry, so that, if there are permitting issues or regulatory issues, government and industry can work closely together. It's a lot better to do it right than to do it fast, in my view. Mr. Ose. Mr. Keese. Mr. Keese. I would have an observation that you have two governmental types here and two industry types here, and one representing the public. If you would just appoint the five of us as a committee, I think we'd have a unanimity of intention here and we could handle the elimination of the mandate. Another point--I will say we may seek your help. I'm reminded that as we are going through an integrated energy policy proceeding at the Energy Commission with 20 staff, that we have been working on this for a November 1st deadline for about 8 months now. On July 11, we are having a workshop specifically on the marine infrastructure constraints and potential recommendations for, for example, streamlined permitting to help alleviate the current near-term congestion problems in the ports. We will be working with the industry members who are here on that subject on July 11th, and we will make sure that you get that report, which I think will answer the question you asked me earlier. Clearly, the flexibility, getting rid of the oxygen mandate and letting people handle this as best they could--if we are going to incentify ethanol, incentify ethanol, but don't do it backhanded through a mandate that purportedly results in cleaner air and does not accomplish that. Mr. Ose. Thank you. Mr. Sparano. Mr. Sparano. Mr. Chairman, to step back a bit from the specificity of ethanol mandates and other mandates, I think the real key here is the recognition on the part of whichever government entity feels that it needs to or must create a goal for any industry to meet. In particular, today we are talking about the petroleum industry. Create the goal, we will meet it. Don't tell us the formula that we need to use to get there. I think if any guiding principle that might be worth hearing from me and from our industry, that would be it. Flexibility, options, we have the ability, the interest, the wherewithal, and the track record to meet environmental requirements, and other requirements that help keep this country economically and environmentally healthy. It's always complicated by having a set of specific requirements that one needs to follow to get there, and oftentimes those requirements have unintended consequences, and you have heard some of those this morning. Mr. Ose. Mr. Gregory, a real world view. Mr. Gregory. Mr. Chairman, Valero is a green refiner. It's very important to us to continue to improve the environment. At the same time, we have built now a network of 13 refineries, bought a network of 13 refineries, and we have worked diligently to integrate all these refineries to become a low cost producer, so that side of it is keeping the consumer in mind. I agree with the comments that the others have made about leaving the flexibility in to be able to supply the consumer with the lowest cost product and at the same time taking care of the environment. Mr. Ose. Thank you. I want to thank each of you for being here today. This has been very educational for me. It's clear to me that we have much to do, and what our actions are may result in higher prices or lower prices, and Californian's may pay accordingly, and as we heard earlier, the New Yorkers and the Connecticut residents may get a similar outcome, a 5-cent increase on 1.1 billion gallons, $660 million a year in terms of added costs for fuel. Now, as Congress considers this energy bill, I think we need to be very cautious about the policy we ultimately enact. We need to account for our needs for affordable fuel. We need to account for our needs to protect the environment. We need to make sure that what we mandate by policy doesn't give us a lot of adverse unintended consequences. Coming from California, people often ask me what do I focus on. I focus on things that affect people's everyday lives and their pocketbook. I dare say half of us went by a gas station today and maybe a quarter of us actually stopped. This is the kind of thing that is important to every Californian. I look forward to continuing to work on this. I do thank you all for coming in today. I'm serious when I say that this is educational for me. To the extent that we can save Californians and Californians' money and fellow Americans' the turmoil that we've suffered, that would be a great step in the right direction. I appreciate, again, your coming. This hearing is adjourned. 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