Oil & Gas Refining

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Oil refinery in Alaska

From crayons to jet fuel, refined petroleum has myriad uses in the modern economy. While we've all seen images of the dark crude oil gushing forth from the earth (remember the Beverley Hillbillies?), end users typically use oil in a very different form. Gasoline, for example, is nearly entirely clear. Oil refining is the process that takes us from crude oil oil to refined finished products.

The central process in refining involves distillation, or heating crude oil at a variety of different temperatures, utilizing the different boiling points of its various components to separate them. These components are then further refined (e.g., "cracked" into shorter chains of hdryocarbons) and/or mixed with additives to create end products. The refining process produces a vast array of end products ,including gaseous fuels such as propoane, liquid fuels, lubricants such as motor oil, paraffin wax (used to package frozen foods), tar (for roofing), asphalt (for paving), and a avariety of petrochemicals for industrial processing.

Oil refining and distribution represents the "downstream" piece of the oil value chain, where crude oil that has been located and extracted (see oil exploration and production) is refined (i.e., enhanced and or blended with additives) for consumer use and ultimately shipped to airports, power plants, and, of course, gas stations, where it is ultimately consumed by end users. Oil refining can either be part and parcel of an integrated oil & gas operation -- think Exxon Mobil (XOM) or ChevronTexaco (CVX), both of which own assets throughout the oil value chain -- or can occur independently.

[edit] Economics of oil refining

Refined crude oil is used for a variety of purposes, but transportation fuel is predominant

Refinery economics are driven by five main factors.

[edit] Inputs

The choice of what type of crude to use as a "raw material" determines the refineries raw material costs and impacts how expensive the refining process will be. In general, sweeter, light crude is more expensive, but much easier to refine, whereas heavier crude is cheaper, but requires significant, and more expensive, refining. This trend is of particular importance in today's markets, as the differential between light and heavy crude has widened as oil prices have risen overall, prompting many refiners in the Middle East and Asia to refine crude locally into lighter crude, for sale to top bidders in the international markets. Refineries in the U.S., under pressure to keep costs down, have frequently turned to the heavier crude. ConocoPhillips, for example, is expanding one of its Illinois refineries to process heavy crude, in partnership with EnCana.

Saudi Aramco is also investing in refineries to process heavy crude, and increase refined goods output. Some of the oil majors, including ConocoPhillips, Total, Exxon, and Sinopec are investing in the project. As light crude becomes more difficult to procure, investment in processing heavy crude may have to increase, as there are approximately 5.4 trillion barrels of heavy and oil sands crude available in the world. Of that, over a third are located in Canada.^[1]

[edit] Refining Technology and Equipment

The more complicated the technology and the equipment used in the refining process, the more expensive it is to refine crude oil. As noted above, heavier crude typically requires more complicated equipment.

[edit] Output Requirements

Crude oil can be refined into myriad different products, but ultimately, the price paid for the refinery's output will be determined by factors such as demand for the specific end-product, quality, etc.

[edit] Utilization Rates

The profitability of refining has often been heavily influenced by utilization rates of refining capacity. As utilization increases, refineries typically have more power to determine which raw materials they will use and which outputs they will produce, improving overall economics.

[edit] Regulations and Environmental Concerns

Environmental regulations, especially recent changes outlawing MBTE and the steady introduction of ultra low-sulfur fuels, have increased the complexity of the refining process and forced refineries to continue to invest in environmentally-friendly capacity. ConocoPhillips' Illinois expansion, which is occurring in partnership with EnCana, hit a snag in early June, 2008, after the federal Environmental Protection Agency (EPA) rejected the Illinois EPA's approval of refinery air permits.

[edit] History of oil refining in the U.S.

ROI on investments in production and exploration consistently top 10%

while ROI on refining investments has hovered around 5%

U.S. refining infrastructure is old and in decline

Margins have historically been consistent and low

Historically, oil refining has been the junior partner (from an investing perspective) in the oil value chain. Refining contributes about 1/5th of the profitability relative to oil exploration and production among the U.S. regulated oil companies. In fact, over the past thirty years, since the EIA has begun tracking such things, the return on investment in downstream activities (i.e., refining) has consistently trailed the return on investment in upstream activities (i.e., exploration).

U.S. refining capacity in particular has declined over the past 30 years. In addition to the lower returns for investment in refining, environmental permitting has become more difficult for new refineries. No new refineries have come on-line in the U.S. since 1976. In fact, a wave of shutdowns and divestitures occurred throughout the 1980's and, when returns on refining were low and there was a glut of capacity in the market.

Recently, the historical situation has largely reversed itself for a number of reasons. The decline in operable refineries and increasing demand for oil have driven up utilization rates. However, new investment in refining capacity has not been quick to follow, as the memories of past overcapacity, high returns from investments in upstream activities, and environmental regulations on air quality and fuel standards have deterred new investment. The outstanding question among refiners is whether the current increase in margins heralds a "Golden Age or a Short Cycle?", as the Energy Information Agency asked in a recent presentation.

Regardless, refiners seem to be realizing that there is a shortage of refining capacity, especially for production of high value-added products, and therefore announcements of additional refining capacity are coming fast and furious. The particular focus in the U.S. is on adding capacity that can convert heavier, cheaper crude oil into higher-value added products (especially low-sulfur fuels). This is obviously more expensive than standard oil refining, but likely reflects the reality of the oil supply situation for refiners for at least the medium term.

Over the medium-term refiners can be fairly confident that margins will remain stable, as the IEA estimates that 30-40 new refineries are required just to meet increases in demand over the next decade.

[edit] Companies who stand to benefit

The refining industry is dominated by the integrated oil majors, as the list of the Top 20 oil refineries in the U.S. demonstrates.

However, for refinery pure-plays, an investor might look at Valero Energy, Sunoco, Western Refining, or Tesoro Petroleum. These companies have historically been valued like utilities (i.e., viewed as regulated entities with low P/E multiples and dismal earnings potential). However, this view has been evolving given the presence of refining shortages and the fundamental changes in the oil & gas industry.

As refinery infrastructure wears down and production demands continue to press on exasperated oil majors, companies such as Matrix Service Company (MTRX), which repairs and maintains refining, distribution, and pipeline facilities, should stand to benefit greatly.

Companies in the Oil & Gas Refining Industry (23)