Supply Chain Lesson for Transitioning from Fossil Fuels

2023 State of the Union Address

An off-script remark about big oil companies during President Joe Biden’s State of the Union address gave his political opponents an opportunity to unite in mock laughter. But what shouldn’t be missed in the partisan exchange is that it highlighted the need for a more consistent, incremental and, dare we say it, bipartisan approach to a clean energy transition.

Biden was building his case for quadrupling the tax on corporate stock buybacks and lamenting “record profits” by the oil industry that, he said, “made $200 billion in the midst of a global energy crisis.” Then he departed from the teleprompter to explain why.

“They invested too little of that profit to increase domestic production,” he said. “And when I talked to a couple of them, they say, ‘We’re afraid you’re going to shut down all the oil refineries anyway, so why should we invest in them?’ I said, ‘We’re going to need oil for at least another decade.’”

As Republicans laughed at the 10-year timeline, Biden worked his way back to the prepared remarks. But while the president moved on, the core issue revealed in his comments is worth revisiting. To paraphrase Kermit the Frog, it ain’t easy going green.

The collective global approach to reducing dependance on fossil fuels has, in many ways, been like a series of crash diets — full of short-term wins but also unintended consequences that hinder long-term success and sometimes create more problems than they solve. Constant calls for the next all-or-nothing policy, meanwhile, tend to polarize rather than unify, yielding a lack of buy-in that predictably limits positive results.

For most countries, and especially the United States, quitting fossil fuels “cold turkey” is neither practical nor responsible. Certainly, some pain is inevitable if we are to transition to cleaner energy sources, but the current policy trajectory could result in crippling economic damage.

Current Situation with Distillate Fuels

Last year’s rise in diesel prices provides one way to better understand where the United States stands and how we got here.

Distillate fuel oil, of which diesel is the most important and well-known component, is used in cars, buses, trucks, boats, trains, heavy construction vehicles, tractors, and airplanes, not to mention electricity production. Importantly, it is also used as heating oil, so demand fluctuates seasonally.

Supply Chain Disruptions

On the supply side, distillate fuels are refined from imported and domestically produced crude oils. Both of these sources have become more restricted: U.S. crude production has yet to rebound to pre-COVID-19 levels, while the Russia-Ukraine war has disrupted global crude supplies and trade patterns.

The annual winter increase in demand, combined with the disruption of supplies, predictably caused distillate prices to rise considerably. And those prices aren’t likely to drop significantly, in part because of what is happening with refineries.

Maxed Out and Aging Petrochemical Infrastructure

Those concerned about climate change welcome the idea of gently increasing fossil fuel prices because it reduces consumption and incentivizes cleaner energy alternatives. However, record high “crack spreads” are a warning that the country isn’t easing into this transition. Crack spreads — the difference between the price of crude inputs and refined outputs — are an indicator of short-term refinery profits.

Normally, a high spread would induce refiners to increase production; however, more output is not coming. Why? Because refineries are already operating at maximum capacity.

The next logical expectation is that companies would expand capacity. After all, if there is money to be made, shouldn’t someone be willing to capitalize? But, as with greater output, any additional refinery capacity seems unlikely.

Chevron CEO Michael Wirth told The Washington Post last year:

“I don’t think you are ever going to see a refinery built again in this country. It’s been 50 years since we built a new one. In a country where the policy environment is trying to reduce demand for these products, you are not going to find companies to put billions and billions of dollars into this.”

The same applies to any potential expansion efforts — or even routine upkeep that would allow existing refineries to maintain current production. In fact, between September 2019 and September 2022, the U.S. lost about 786,000 barrels per day in distillation capacity as refineries simply shut down after weighing the costs against the benefits of continued operation.

Activists might applaud this capacity reduction, but they should be more circumspect. Aging refinery infrastructure, much of it located in coastal areas subject to natural disasters, makes the energy supply chain dangerously fragile. Resultant disruptions increase the pain of energy transition and erode popular support for meaningful climate policies in years to come. Thus, urgent action is needed to make the refining industry more resilient.

Supply Chain Principles for Smoothing the Transition

Embracing some basic insights from the field of supply chain management can help policymakers understand and more effectively navigate the transition to cleaner energy, reducing stress on the economy and the lives of consumers. These three areas are starting points to ponder prior to diving headfirst into the next fad approach to policy:

Reduce demand uncertainty. As Biden noted, few companies are willing to invest in maintaining or expanding refinery capacity because of uncertainty in future fossil fuel demand. Refineries are enormous, long-lived and irreversible investments. Returns on these investments are predicated on the demand for refined fossil fuels over 30 years or more.

Climate policy uncertainty makes it impossible for the industry to forecast demand, plan phaseouts and determine where investment is needed. Industry will delay needed supply chain investments until policy uncertainties have been resolved.

A bipartisan approach is essential to creating policies that industry leaders can buy into and plan around. Politicians from both parties need to look beyond their personal horizons of two to six years and compromise to create phased-in, 20-to-30-year solutions.

One potential approach is carbon pricing. This would involve a carbon tax levied against companies emitting carbon dioxide, or a cap-and-trade program. The tax is a fix priced per ton of CO₂ emitted, while the cap-and-trade program limits how much CO₂ a facility can emit.

These policies create incentives to decrease demand but can be phased in slowly and with clearly established timelines, thus creating clarity for refiners. While such programs have strong objectors, supporters aren’t limited to climate-change activists. Industry leaders such as BP recently voiced support for the Climate Commitment Act in Washington state, which involves “cap-and-invest” regulation.

Reduce product assortment and complexity. An excess of refined fuel types has created unnecessarily complex supply chains; e.g., local variation in air pollution regulations has turned the U.S. into a “boutique fuels” market, with more than 50 different gasoline “reformulations” alone. These regulations significantly reduce industrial flexibility, making it difficult to react to disruptions and provide consumers a consistent supply of fuels.

State and local regulators should be encouraged and incentivized to standardize and consolidate requirements across broad geographical markets, making it easier for refiners to forecast and plan for demand. As total fossil fuels consumption falls, so does environmental justification for these diverse standards.

Reduce logistical constraints. The Jones Act has regulated U.S. shipping since 1920 and prevents foreign ships from moving goods between U.S. ports. Only 55 tankers qualify under the act to move diesel from Gulf Coast refineries to the Northeast, where the diesel shortage is more severe. This policy-created dearth of transport capacity leads to conditions where the cost to move oil by ship is twice what it would be in an unrestricted market, according to a report by CNBC.

Eliminating, suspending or redefining elements of such legislation can ease logistical constraints so that the supply chain operates more efficiently and inventories meet demand during the transition period from fossil fuels to cleaner energy options.

No Time to Wait

Whatever approach lawmakers take, efforts need to start immediately. The U.S. is losing refineries every year, and such closures could accelerate as worsening economic conditions make it even less likely that companies will invest sufficiently to maintain production capacity.

Because many homes are heated with petroleum products and virtually everything we consume rides on the backs of diesel-powered trains and trucks, the implications are enormous for both cost and product availability for every U.S. resident.

History has proven that supply chains, like people, don’t respond well to crash diets. A strategic and long-term approach is the only way to offset unintended consequences and produce a healthy transition.

Travis Tokar (PhD, University of Arkansas) is a Professor of Supply Chain Management at the Neeley School of Business, Texas Christian University. His research focuses on issues of both managerial and consumer judgment and decision making in supply chains, with particular interest in demand planning activities such as forecasting and replenishment. He is also interested in the interface between supply chain management and public policy. His work has been published in several leading supply chain management academic journals.

Andrew Balthrop (PhD, Georgia State University) is a research associate within the Supply Chain Management Research Center at the Sam M. Walton College of Business at the University of Arkansas. His research focuses on the interaction between supply chains and public policy.