A drama has been playing out in the eastern portion of the United States at a time when the nation has been primarily focused on the dramatic rise in national gasoline prices and the political hunt for oil speculators. This regional drama portends higher and more volatile petroleum prices ahead for the populous and prosperous residents of the Eastern seaboard states, especially those in the mid-Atlantic and New England regions.

The drama arose from decisions by ConocoPhillips (COP-NYSE) and Sunoco Inc. (SUN-NYSE) to close and/or sell their refineries located in the Philadelphia, Pennsylvania area. Those two companies own three refineries in the region, two of which were shut down last fall.

The three refineries accounted for roughly 40% of the U.S. East Coast refining capacity as of last summer. The single refinery still operating is Sunoco's Philadelphia plant with 335,000 barrels of capacity per day, representing roughly 24% of the region's 2011 total capacity. The industry also had previously shut down two small refineries in Virginia and New Jersey during 2010 so capacity was already tight.

The Northeast refineries have supplied about 40% of the gasoline, 60% of the ultra-low sulfur diesel (ULSD) and 45% of the home heating oil consumed in the region in recent years with the balance of supply coming from the Gulf Coast.

The Energy Information Administration (EIA) prepared a study of the impact of the closure of these refineries on the supply situation for these petroleum products in the region. The EIA has continually updated the study as events have transpired, probably because there is the potential that these refinery shutdowns will impact Washington, D.C., the site of our politicians, government workers and importantly EIA employees.

The refinery shutdowns are highlighting various challenges the energy industry confronts and will continue to have to deal with as it faces shrinking oil processing capacity in the region.

The first challenge is how to deal with the shifting product mix that will occur as the various states in the Northeast implement their mandated shifts to ULSD for heating oil use. This will add meaningful demand to a market that is already supply-challenged. The issue is further compounded by the seasonal nature of heating oil demand, which exaggerates the level of demand and as a result will strain the petroleum storage and distribution system throughout the region.

A second challenge will be how to get additional supply either from domestic or international sources into the region. The Jones Act transportation restrictions involved in moving additional domestic oil and/or refined petroleum product from the Gulf Coast to the Northeast by sea will complicate and add costs to the supply effort. Importing more international oil will create transportation challenges and add more expensive foreign oil to the supply mix boosting consumer prices.

In order to manage limited refined petroleum supplies during World War II, the federal government grouped states together and created the Petroleum Administration for Defense Districts (PADD) for ease of regulation and control. All the states along the Atlantic Seaboard, with the addition of Pennsylvania and West Virginia, were grouped into PADD 1. In turn, that region was subdivided into three geographic regions -- New England, Central Atlantic and Lower Atlantic. Each of these sub-regions have their own unique supply and demand dynamics.

As of July 2011, the estimated population of the states comprising PADD 1 is 116.1 million, which represents over 37% of America's total residents. The refining capacity in PADD 1 is 1.4 million barrels per day, which includes the two refineries that have already been shut, but falls short of meeting the region's consumption. The closed refineries had a total capacity of 363,000 barrels per day, or about 26% of the region's total capacity.

The EIA publishes data on the operating capacity of refineries by PADD, their gross inputs and their utilization. As shown in Exhibit 15, PADD 1 is the only region in the country that has lost refinery capacity over the six-year span 2005 to 2011. Last year, PADD 1 had the lowest utilization of any region in the country and had experienced the largest utilization decline during the six-years. These statistics demonstrate that the Northeast refineries are experiencing challenging economics despite being situated in the midst of over a third of the nation's population.

Most people are focused on the impact the possible shutdowns of these refineries will have on the supply and price of gasoline. To understand the outlook for this fuel, we turn to the historical data for gasoline supply and demand in the region and the forecast the EIA has prepared. The forecast is derived from the short-term outlook report prepared quarterly by the EIA.

The closure of the refineries will result in a deficit of gasoline supply for 2012 and an even larger deficit in 2013. The challenge will be how the industry can eliminate this shortfall. Getting more supply into the region is the primary goal, but if additional supply is not available, or cannot be secured in a timely manner, the gap between supply and consumption will be closed through sharply higher retail gasoline prices.

In order to assess the capability of the current regional petroleum distribution system to bring in additional supplies, it helps to understand what resources are available and what hurdles they face. Exhibit 17 shows a graphic from the EIA's website that locates the ports, pipelines, product terminals, refineries and ethanol facilities located east of the Mississippi River, which is a larger area than PADD 1.

The EIA's PADD 1 gasoline supply and demand forecast calls for consumption to decline by about 120,000 barrels per day (b/d) while refinery output is projected to decline by 170,000 b/d. The shortage has been offset by increased movement of supplies into the region from other areas of the country.

The question is whether, given the sharply reduced refinery output due to the planned closure of the three local refineries, additional gasoline supplies can be moved from other areas of the country, notably the Gulf Coast, to offset the output cut. Or will the industry need to ramp up imports?

As Exhibit 18 shows, gasoline imports into PADD 1 have declined since 2007 with the major reduction being Western European imports. A meaningful amount of imports come from Canada and from refineries in the U.S. Virgin Islands. The complicating factor at the present time is that a major refinery in the Virgin Islands has recently been closed.

Securing increased gasoline supplies, along with other petroleum products, from the Gulf Coast will require that these supplies be moved in tankers or barges that meet Jones Act requirements. The Jones Act regulates maritime commerce in U.S. waters and between U.S. ports. The Jones Act mandates that vessels operating in U.S. trade be built in U.S. shipyards, be owned by U.S. companies (they cannot have more than 25% ownership by non-Americans) and be operated by U.S. crews.

According to MARAD, there are only 56 Jones Act tankers representing four million deadweight tons available. These tankers and their capacity represent less than 1% of the world's tanker fleet. In response to this situation, the coastal barge industry has stepped up with claims that it can help meet the transportation needs for this region. Of course, vessels that operate under the Jones Act are more expensive, which will boost the cost of petroleum products that move into PADD 1.

In the case of ULSD, demand in the region will be boosted by the mandated use of this fuel for home-heating oil in various states. Beginning this year, New York State is the first of five Northeastern states to require ULSD be used for space heating replacing higher-sulfur distillate fuels. This phase-out of higher-sulfur distillate in favor of ULSD will expand in 2014 to Massachusetts, New Jersey and Vermont and to Maine in 2016. The EIA estimates that this switch will increase ULSD consumption in the Northeast by 20%.

The complicating factor of the switch to ULSD is the seasonal nature of heating oil demand. The peaks and valleys of heating oil demand mean that supply volumes need to be brought in during the low demand period and stored in order to meet the peaks of winter consumption. This seasonality will tax the existing terminal facilities in the region. The volatility of demand is shown in Exhibit 20.

The final petroleum fuel market is regular heating oil. As shown in the supply/demand analysis prepared by the EIA along with its forecast (Exhibit 21), the in-region supply decline will be offset by the elimination of heating oil exports.

When we focus on the petroleum infrastructure in PADD 1A and 1B, it becomes clearer that significant changes will be necessary to deal with the permanent closure of the three Philadelphia refineries. Those refineries have been the primary source of supply for the region, especially for areas such as Pittsburgh and central Pennsylvania as well as western New York State. It is possible that those product pipelines that serve those areas now may eventually need to be reversed in order to haul refined product from Canada and the Midwest to the demand centers in the mid-Atlantic and Northeast states.

The recent news reports suggest that the ConocoPhillips Trainer, Pennsylvania refinery, currently shut down, may be sold to a group headed by Delta Air Lines Inc. (DAL-NYSE) and restarted. The news reports also suggest there is a local buyer for the Sunoco Philadelphia refinery. If both of these transactions occur, then the crisis scenario outlined by the EIA's report may be avoided. While that would be good news for PADD 1, it does not eliminate the structural challenges the domestic petroleum industry is facing and will continue to face in the future as demand trends and supply sources shift.

We suggest readers of the Musings should go to the EIA web site and read the series of reports dealing with this Northeast refining capacity issue. The reports are instructive in educating people about the challenges the public and the petroleum industry will confront in the future, and what the options are to overcome them. The challenges and obstacles for resolving the issues are many and often subtle. An educated public, however, will greatly assist the debate about what changes society is willing to accept, since each choice will carry a cost.