Better reasons to produce ULSD than to avoid it: Mathpro study

Diesel Fuel News, March 4, 2002 by Jack Peckham

Economic incentives to produce ultra-low sulfur diesel (ULSD) to comply with upcoming U.S. EPA 2006/7 highway diesel rules outweigh the supposed refining cost disincentives, according to a new MathPro study for the Engine Manufacturers Association and the Alliance of Automobile Manufacturers.

What's more, the incentives are so strong that even short-term (2006 to 2008) ULSD shortages are unlikely to occur, the study finds. Nearly everyone agrees that longer-term ULSD supply/demand upsets eventually would flatten out anyway, due to natural market forces.

Key reasons: Diverting non-ULSD fuel to non-road diesel markets would wreck refiner margins in that sector, while even relatively "high-cost" ULSD producers often enjoy niche markets that can produce margins high enough to offset refining costs, the MathPro study finds (see: www.autoalliance.org).

The conclusions contradict an earlier study by Charles River Associates (CRA)/Baker & O'Brien (BOB) for the American Petroleum Institute, as well as a ULSD supply warning-flag raised by a U.S. Energy Information Administration (EIA) study (see Diesel Fuel News 5/14/2001, p1; 8/28/2000, p1).

Diverting to non-road the up-to-320,000 barrels/day of diesel that CRA claims isn't economic to convert to ULSD would wreck refiner non-road margins by between 5-20 cents/gallon, the MathPro study shows. Nor are there big foreign markets likely to become dumping ground for U.S. diesel failing to meet ULSD specs.

What's more, "high-cost" ULSD producers could cut their cost via joint processing or tolling agreements (see Diesel Fuel News 10/29/2001, p1; 10/1/2001, p1), becoming competitive with the "low-cost" producers, the study shows. Canada and Virgin Islands exporters to the U.S. likewise would seek to defend their U.S. market share by investing in ULSD, although Venezuela might divert distillate now going to the U.S. to other Latin American markets, the study finds.

Meantime, other U.S. EPA regulatory breaks for small refiners offer huge financial incentives for early production of ULSD (in exchange for delaying low-sulfur gasoline compliance), and sulfur credits trading will also ease the up-front cost burden for some, the report finds.

Even more, EPA's plan to publish a ULSD refinery compliance survey next year will give refiners clear information on the likely ULSD supply situation for 2006, in time to make ULSD investment decisions appropriate to likely supply/demand curves, the MathPro report says.

The Rocky Mountain region (PADD 4) is considered by the CPA study to be most vulnerable to ULSD shortages, yet the MathPro study shows just the opposite is the likely outcome. That's because PADD 4 refiners have much higher average margins (about 3-6 c/gal higher than PADDs 2 or 3), overcoming their higher relative production costs compared to the much larger Gulf Coast/PADD 3 refiners.

"Capital charges associated with ULSD investments by PADD 4 refineries would be small in relation to their average cash operating margin - on the order of 10-15% of average cash operating margin in 1999 and 2000," the study says. Bottom line: "Refinery closures due to the ULSD program [would be] unlikely."

Trying to import ULSD into PADD 4 involves very costly long-distance shipping charges and building a big, new Gulf-to-Rockies pipeline would mean a 7-10 cents/gallon cost penalty that would be greater than the incremental cost of local ULSD production, the study shows. Most PADD 4 refiners could produce ULSD at a 5-8 c/gal. premium over today's lowsulfur (500 ppm) diesel, while other higher-cost refiners could cut joint-production deals to slash net cost.

Some Gulf refiners might have production costs half that. Even at half the production cost, Gulf-to-Rockies pipeline penalties would wipe out any net cost advantage.

"A refinery's decision on investing to produce ULSD depends not only on its absolute (or relative) cost of ULSD production, as the CRA/BOB and EIA analyses assume, but rather on the refinery's ability to recover its cost (including return on capital) in the marketplace," the study finds.

Not only do some PADD 4 refiners enjoy compensating higher margins, but so do some higher-cost refiners in other PADDs, the study finds. This would greatly reduce the assumed ULSD supply shortage seen arising from the cost-only model used by CRA or EIA, the study finds.

What's more, process tolling arrangements for tough-to-desulfurize streams (such as cracked stocks) could save refiners about 2.5 cents/gallon, meaning that about 90% of today's diesel fuel could be converted to ULSD at less than 5 cents/gallon.

* Study Limitations

MathPro concedes that EPA's upcoming non-road diesel rule (expected to duplicate the 15 ppm sulfur ULSD requirement) would have another impact on refiner investment plans and total ULSD supplies, depending upon the sulfur limits and compliance deadlines. EPA plans to announce a "Tier 4" non-road rule by year-end.

MathPro's study also didn't include individual corporate strategic or capital decisions that might affect individual ULSD investment, nor look at the total capacity of engineering & construction to complete ULSD projects by EPA's deadlines.