Thank you Mr. Chairman and members of the Committee for the opportunity to testify today.

Gasoline prices have begun declining, as expected, from this spring's apparent peak price of $1.71 on May 14, with the national average for regular gasoline at $1.65 per gallon as of June 11 (Figure 1). Between late March and mid-May, retail prices rose 31 cents per gallon, with some regions experiencing even greater increases. Like last year, Midwest consumers saw some of the largest increases, and along with California, some of the highest prices. Prices in the Midwest increased 43 cents per gallon over a 7-week period, peaking at $1.81 on May 14. However, since then, Midwest gasoline prices have fallen faster than the national average, down 9 cents in the latest EIA survey. Most of the factors that affected prices last year were again at work this year: a relatively tight crude oil markets resulting in low petroleum inventories; relatively tight spring gasoline supply/demand balance, compounded by extensive refinery maintenance and unplanned outages; unique regional and seasonal products; high refinery capacity utilization; and dependence on distant supplies. When these factors come together just as they did last year, rapid price runups can occur. The principal difference from last year's pattern has been timing, with this year’s increases occurring a month earlier. Barring any major infrastructure problems over the remainder of the summer, we expect the current decline to continue, just as we saw last summer. I’d like to turn next to a brief summary of these factors, beginning with …

Low stocks set the stage for gasoline price increases this spring, just as they did last year both for heating oil and gasoline. Low inventories originate in the tight global crude oil supply/demand balance that evolved in early 1999. This ongoing tightness has been a key factor in maintaining both low crude and product inventories since then.

Actions taken by OPEC are largely responsible for the sharp increase in oil prices from the $10 levels seen in December 1998. OPEC dramatically reduced crude oil production in 1998 and early 1999, so much so, that, even after four production increases last year, inventories remained at relatively low levels this spring, especially in the developed countries of the Organization for Economic Cooperation and Development (OECD). Furthermore, scarce crude supplies encourage high near-term prices relative to those for future delivery. This situation, referred to as backwardation, discourages discretionary inventory growth, and maximum refinery production. Thus, with crude oil and product inventories relatively low again entering Spring, little cushion existed to absorb unexpected imbalances in supply and demand, setting the stage for volatility. Although world demand is projected to continue growing this year, OPEC’s current plans imply even less production than last year. This is expected to limit global inventory growth, and maintain crude oil prices close to $30 per barrel for the remainder of the year.

The recent OPEC meeting and Iraqi exports cutoff could result in oil production levels low enough to cause us to enter the 4th quarter with low crude and heating oil inventories. Last year, in a similar situation, OPEC did not increase its quotas significantly until Fall. Thus, there was insufficient time to build up heating oil inventories by the time winter started. Even if Iraqi exports are suspended for only a brief time, petroleum markets will be tight. But if Iraqi exports are cut off for a month or more, and are not fully offset by increased production from other oil producers, market conditions will be even tighter.

Returning to U.S. markets and gasoline in particular, inventories were even lower this spring than last year (Figure 2). In recent weeks, there has been significant improvement, and as of June 8, stocks were about 2% above their seasonal 5-year average. Midwest inventories, however, were 1% lower than their 5- year average. However, both conventional and RFG gasoline markets exhibited low stocks and tight market conditions over the mid-March to mid-May period. Low inventory levels were partially a consequence of refineries focusing strongly on distillate production last winter, given that the United States entered the heating season with very low stocks. They were also a consequence of high natural gas prices, which encouraged fuel switching to distillate, heightening the focus on distillate production at the expense of gasoline. Furthermore, high natural gas prices undercut production of key clean gasoline components, including MTBE. In addition, relatively strong late winter gasoline demand combined with extensive refinery maintenance to sustain downward pressure on inventories. Finally, gasoline prices were in steep backwardation until recently, discouraging inventory growth at the margin. Several other factors are also at work, adding to the potential for volatility when inventories are low, including the …

Today’s gasoline market is comprised of many types of gasoline that serve different regional markets to meet varying environmental requirements. While producing specialized products can be an efficient approach for individual refineries to meet regional air quality needs, it is not necessarily efficient for the overall marketplace. The large number of product types adds a level of complexity to production, distribution and storage of gasoline.

The result of this targeted approach has been to create gasoline islands. The primary examples are California and the Chicago/Milwaukee areas, in which the required gasolines are unique, and only a limited number of refineries make these products. When inventories in these regions are drawn down rapidly, gasoline prices surge. Even if other gasoline markets are not tight, these price surges may be extended since these specialized fuels cannot be quickly re-supplied. Another factor affecting the U.S. gasoline market, especially during periods of low inventories is …

The summer of 1997 was the first time the U.S. refinery system was pushed to its practical operating limits and was unable to respond adequately to unusually high gasoline demand (Figure 4). As a result, seasonally low inventories were rapidly depleted and prices surged. Since then, capacity has grown slightly more than demand, but capacity is still tight during the summer.

With little inventory to cover supply/demand imbalances, and many refineries running at their practical limits, any supply problems such as refinery outages may not be resolved quickly. This increases the time required for re-supply and thus increases both the height and duration of any price spike.

This year we again saw what can happen when low inventories combine with regional capacity limitations and unique gasoline requirements. First, in the Midwest, the shutdown of the Blue Island refinery in Illinois created a level of concern about RFG supplies in Chicago and Milwaukee. The closure also created the need for greater volumes to move from the Gulf Coast to the Midwest. Economic incentives to build inventories were further eroded as Gulf Coast prices surged in response to strong demand not only from the Midwest and West Coast, but also from the East Coast, where refineries underwent extended maintenance. During April, with little inventory cushion in place, the transition from winter to summer grade reformulated gasoline in the Midwest required running tanks down to very low levels, further undercutting stock levels. Just as tanks were beginning to refill, Tosco’s Wood River, Illinois refinery had a fire that reduced its ability to produce both conventional and reformulated gasolines for a period of 2-3 weeks.

While East Coast prices did not surge as much as the Midwest, the East Coast endured extended refinery maintenance in early spring. In addition, several foreign refineries that are key suppliers of reformulated gasoline to the East Coast had extended outages.

California frequently sees price surges due to its tight supply/demand balance, the unique nature of its gasoline, and its long distance from other supply sources. This spring has been no exception.

In closing, I wanted to note that almost exactly one month ago, EIA, in testimony before another House Committee, stated that we thought gasoline prices were nearing the peak for this summer. At that time, we noted that the United States was nearing the end of what usually is one of the tightest times of the year for gasoline markets – the period when gasoline demand begins rising seasonally yet refineries are still winding up maintenance. Since the end of March, production has increased significantly, as refineries have ramped up to full capacity. The Wood River refinery is now fully operational, boosting Midwest supplies, while imports have continued to stream into East Coast markets at an unprecedented pace. As a result, stocks have returned to the normal range nationally, albeit some regions remain tighter than others, primarily those using RFG.

Barring further major refinery or other infrastructure problems, we expect prices to continue declining this summer, much like last year’s drop. Our latest forecast, released one week ago, has monthly average prices peaking at $1.69 per gallon in May, before dropping to $1.55 by September. Weekly price decreases may be even greater. Nevertheless, we must caution that gasoline markets remain exposed to volatility, particularly towards to the end of summer when demand peaks. Factors suggesting the potential return of late summer volatility include likely low global oil inventories, even with an early return of Iraqi exports, and gasoline markets here and in Europe already signaling a potential reduction in crude runs and gasoline production.

That concludes my testimony and I would be happy to answer any questions the Committee might have on the current gasoline situation.