Journal of Business Valuation and Economic Loss Analysis Volume 4, Issue 2 2009 Article 3 HURRICANE KATRINA AND ECONOMIC LOSS Petroleum-Refining Industry Business Interruption Losses due to Hurricane Katrina Kivanc Kirgiz∗ Michelle Burtis† David A. Lunin‡ ∗Cornerstone Research, [email protected] †Cornerstone Research, [email protected] ‡Cornerstone Research, [email protected] Copyright c 2009 The Berkeley Electronic Press. All rights reserved. Petroleum-Refining Industry Business Interruption Losses due to Hurricane Katrina∗ Kivanc Kirgiz, Michelle Burtis, and David A. Lunin Abstract Hurricane Katrina had a significant destructive effect on the Gulf Coast’s petroleum-refining industry. In many cases, refineries sustained considerable damage and had to suspend operations for extended periods of time. Multiple Gulf Coast refineries filed substantial business interruption loss insurance claims following Hurricane Katrina’s disruption of their production. This paper presents a methodology to calculate refinery business interruption losses taking into account the effect of Hurricane Katrina on input and output market prices during the period of restoration. Our results indicate that adjusting for Hurricane Katrina’s effects on crude oil and petroleum product market prices significantly changes the magnitude of refinery business interruption loss claims. KEYWORDS: Hurricane Katrina, business interruption loss, business interruption insurance, re- finery margins, gasoline, petroleum, refinery ∗Opinions expressed in this paper are solely those of the authors and do not necessarily represent the views of Cornerstone Research. We would like to thank Bradley Ewing and an anonymous reviewer for comments. Kirgiz et al.: Hurricane Katrina Refinery Losses 1 Introduction Hurricane Katrina was one of the most destructive hurricanes in the history of the United States. In addition to the tragic loss of lives, Hurricane Katrina caused more economic damage than any recent catastrophe in the United States.1 In particular, Hurricane Katrina’s effect on the Gulf Coast’s petroleum refining industry was significant. Many refineries sustained considerable physical flood and wind damage to their equipment and facilities and had to suspend operations, some for extended periods of time. Between August 29 and September 8, 2005, approximately two million barrels a day of capacity were shut down, accounting for a substantial amount of Gulf Coast and U.S. refining capacity. Some refineries that suffered physical damage during this period also experienced lost profits and consequently filed business interruption insurance claims to recover or offset those amounts. Business interruption insurance is a means to recoup earnings lost as a result of an occurrence of a covered risk that disrupts the insured’s business operations.2 Typically, the claimed lost profits due to business interruptions are calculated on the basis of historical production volumes and prices observed during the period of restoration.3 This approach is based on the assumption that the event causing the business disruption does not have a significant effect on input and output markets; therefore, prices observed during the interruption period accurately reflect the prices that would have existed had the interruption not occurred. This assumption did not apply to the petroleum refining industry after Hurricane Katrina. As a result of extensive damage to oil extraction and refining facilities in the Gulf Coast and the consequent reduction in market supply, prices of crude oil and petroleum products were higher immediately after the hurricane compared to prehurricane and historical levels.4 That is, crude oil and petroleum product prices observed in the days following Hurricane Katrina may not have 1 According to Congressional Budget Office estimates, 570,000 or more people lost jobs at least temporarily, and the loss of physical capital approached $110 billion. See Congressional Budget Office, 2006, “The Budget and Economic Outlook: Fiscal Years 2007 to 2006,” p. 28. 2 See Lyon Metal Products, L.L.C. v. Protection Mutual Ins. Co., 2001, 321 Ill. App. 3d 330, 747 N.E.2d 495, 505, 254 Ill. Dec. 455 (Ill. App. 2001). 3 For example, see Torpey (2004). 4 Hurricane Katrina made landfall in Louisiana on August 29, 2005. The average U.S. Gulf Coast conventional gasoline spot price between August 22 and August 26, 2005, was $1.83 per gallon. On August 30, 2005, U.S. Gulf Coast conventional gasoline spot price reached $2.91 per gallon. The average U.S. Gulf Coast heating oil spot price between August 22 and August 26, 2005, was $1.81 per gallon. On September 1, 2005, U.S. Gulf Coast heating oil spot price reached $2.16 per gallon. The average West Texas Intermediate crude oil spot price between August 22 and August 26, 2005, was $66.3 per barrel. Crude oil price reached $69.9 per barrel on August 30, 2005. Published by The Berkeley Electronic Press, 2009 1 Journal of Business Valuation and Economic Loss Analysis, Vol. 4 [2009], Iss. 2, Art. 3 reflected the expected prices that would have existed in the absence of the hurricane, thus using them to calculate the refineries’ lost profits may overstate the business losses due to the interruption. The purpose of this paper is to present a methodology to calculate the business interruption loss of a refinery damaged by Hurricane Katrina, taking into account the hurricane’s impact on crude oil and petroleum product markets. The approach statistically determines the duration and the magnitude of Hurricane Katrina’s effect on the spread between crude oil and petroleum products prices and estimates what the price spreads would have been in the absence of the hurricane. These estimated price spreads are then used along with estimates of production volumes to calculate the lost profits. The results indicate that Hurricane Katrina’s effect on the spread between crude oil and petroleum product prices lasted for two weeks. During this period of significant supply disruption, the observed average price spread was approximately 180 percent higher than estimates of what it would have been in the absence of the hurricane. If the actual price spreads, rather than the spreads adjusted for the effect of Hurricane Katrina, are used to estimate the two-week business loss of a hypothetical refinery with a capacity of 150 thousand barrels a day, the refinery’s lost profits would be overstated by $36 million. An insurance policy’s language determines whether the calculation of business interruption losses include the wider market impact of a catastrophic event. However, standard business interruption policies either do not address this issue or have ambiguous language that is open to interpretation. In addition, case law provides little guidance. For example, in Levitz Furniture Corp. v. Houston Casualty Co., the court found that “business interruption loss earnings may include sales [the insured] would have made in the aftermath of the [peril] had it been open for business during that period.”5 In contrast, the court in Prudential LMI Commercial Ins. Co. v. Colleton Enterprises, Inc. decided that the policyholder could not take advantage of any increase in earnings due to the favorable economic effects of a hurricane.6 This issue has important policy implications regarding the pricing and availability of business interruption policies. These policy implications are discussed in the conclusion. 5 Levitz Furniture Corp. v. Houston Casualty Co., 1997, WL 218256 (E.D. La. Apr. 28, 1997). 6 See Prudential LMI Commercial Ins. Co. v. Colleton Enterprises, Inc. 1992. 976 F.2d 727, 1992 WL 252507 (4th Cir. Oct. 5, 1992). See also Brown and Borow (2007) for a more detailed discussion of legal perspectives on post-catastrophe business interruption losses. http://www.bepress.com/jbvela/vol4/iss2/art3 2 DOI: 10.2202/1932-9156.1045 Kirgiz et al.: Hurricane Katrina Refinery Losses 2 Hurricane Katrina’s Impact on the Refining Industry The Gulf Coast region is the center of the U.S. oil and petroleum refining industries. The region provides over 50 percent of the U.S. crude oil production and almost 50 percent of the national refining capacity.7 The region also receives 60 percent of total U.S. crude oil imports and sends over 1.5 billion barrels of refined petroleum products per year to other regions of the U.S., primarily via pipelines.8 Hurricane Katrina’s effect on the Gulf Coast oil production and petroleum refining industries was significant.9 The Hurricane destroyed 46 oil production platforms and damaged 20 others as well as 100 pipelines.10 Initially, 95 percent of daily crude oil production in the Gulf of Mexico, accounting for approximately 2 percent of the world’s production, was shut down.11 Over 50 percent of the region’s daily crude oil production capacity was still nonoperational before Hurricane Rita forced additional shut-ins. Similarly, Hurricane Katrina shut down 25 percent of the Gulf Coast refining capacity, accounting for over 10 percent of the U.S. refining capacity.12 Although half of this capacity came back on line in two weeks, the refinery shut downs caused a significant drop in U.S. gasoline production during early September 2005.13 Figure 1 below summarizes Hurricane Katrina’s disruption to the U.S. Gulf Coast refinery capacity. These supply disruptions had varying degrees of impact on crude oil and petroleum product prices due to the different dynamics of crude oil and petroleum product markets. For example, the weekly average spot price of conventional gasoline immediately after the hurricane was 50 percent higher than the average price in the week before the hurricane (see Figure 1). In comparison, this 7 Energy Information Administration (EIA) data, http://tonto.eia.doe.gov/dnav/pet/ pet_pnp_top.asp. 8 Movements by Tanker, Pipeline and Barge Between PAD Districts, Energy Information Administration, http://tonto.eia.doe.gov/dnav/pet/pet_move_ptb_dc_R10-R30_mbbl_a.htm. 9 Between August 26 and August 27, 2005, Hurricane Katrina began to threaten the Gulf of Mexico oil and gas production facilities.