Energy Production Committee

Understanding the Petroleum Industry

Price Overview | Demand | Supply | Trade and Imports | Refining | Stocks
What's Hot: Demand | Supply | Trade and Imports | Refining | Stocks

Refining

• World refining capacity peaked in 1981 at 81.5 million B/D. Following the collapse in demand in the early 1980’s, capacity shrank to 73 million B/D. It has not yet fully recovered. In 1997, it was still only just over 79 million B/D.

• The global distribution of refinery capacity reflects the pattern of demand rather than that of supply. For example, in 1997, the Middle East had 4% of the world’s refinery capacity, 6% of its demand and 30% of its supply. The comparable percentages in Asia were 23%, 27% and 10%.
• Refineries are sited close to consumers, rather than close to the wellhead source of crude oil, for a variety of economic reasons, including:
  • the economies of scale of large ships,
  • the low level of losses during refining,
  • the benefits of being able to tailor the output to the market’s increasingly fragmented and somewhat unpredictable needs,
  • the propensity for governments to protect domestic refining from the full blast of competition.
• Asia, in its role of primary driver of demand growth over the last decade, therefore acted like a magnet for refinery capacity over this period, just as it did for trade. Nearly 5 million B/D of capacity has been added in Asia since 1990, more than the net growth in capacity in the world as a whole.
• In contrast, the mature markets of North America and Europe saw refinery capacity shrink slightly over this same period. But the decline was a pale shadow of what happened to them a decade earlier. In the late 1970’s, refiners aggressively invested in capacity on the basis that the strong demand growth would continue. When the reverse happened in the first half of the 1980’s, thanks to the second price shock, the impact of the demand drop fell swiftly and severely on refiners: over 1/5 of all the refinery capacity in the two regions was lost in just 5 years, with Europe bearing the brunt.
• Reflecting the trend in demand, refineries today can produce a much higher proportion of higher valued, lighter products, like transportation fuels. They can also produce cleaner fuels. Thus, what global refining has lost in terms of volume, it has more than made up for in terms of complexity (see What's Hot). This complexity has cost tens of billions of dollars. Hence, the capital intensity of the refining industry had reached well over $3,000 per barrel of daily capacity in the U.S by 1995, more than five times its 1975 level. Yet, refiners have generally been unable to earn an adequate return on the additional investment. For example, EIA data show that the average Return on Equity (ROI) for independent refiners in the U.S. was significantly below that for the S&P 400 between 1986 and 1996.
• Contrary to expectations, specialty products (see What's Hot) have been part of the profitability problem. There was a widespread view that the mandatory nature of the billions of dollars of investment needed to enable refineries to produce specialty fuels, like RFG, would lead to their being profitable. In almost all instances, this has not been the case. Except on the special gasoline mandated by the California Air Resources Board (CARB gasoline), companies have been able to recover little more than their operating costs. However, this exception carries a warning for regulators. It suggests that the more specialized the product they mandate, the higher its relative price and the greater the risk of a breakdown in its supply.
• Due to the profitability squeeze, there is still a shake-out going on in refining in the mature markets of the industrialized world, and the target is improved efficiency. North America and Europe are leading the way; Japan, only recently freed from rigid regulations, has barely begun. The efficiency gains that have been achieved have not necessarily led to higher profitability. The whole industry is pursuing the same objective, so the cost-basis for prices is falling too.
• One facet of the efficiency drive has been a continued progression toward fewer, larger refineries that are operated more intensively (see What's Hot). Older, smaller, simpler refineries are still being closed, but their loss is being offset by new or expanded or debottlenecked units at existing sites, so companies can capture the very marked economies of scale that exist in refining. Unit costs have then been cut further by raising utilization rates. These reached a remarkable 94% in the industrialized countries in 1997, almost a 20 percentage point increase in a decade.
• The other facet is mergers, acquisitions and joint ventures (JV) (see What's Hot), the inevitable next step after companies have exhausted the options for cutting their own costs directly. The refinery sector landscape has been changed dramatically over the last few years by this corporate restructuring. In the U.S. in particular, there has been a rapid increase in concentration, although not to a point that threatens competition.
• World refinery runs are seasonal, but less so than demand; stocks, particularly of products, act as a buffer between the two. Nonetheless, the global refining system must shift its production in favor of heating fuels in the winter. Hence, gasoline prices are typically much stronger relative to distillate prices in the summer than in the winter. The gasoline-oriented U.S. refining system therefore tends to make a greater proportion of its profits in the summer, while the distillate-oriented European system does better in the winter.

• The U.S. has the largest and by far the most complex refining system in the world, reflecting its being the world’s largest consumer of both oil and transportation fuels (see Graph). However, only Africa has a lower average capacity per refinery than the U.S. level of 94 thousand B/D. The pressing need to minimize unit costs and refining’s pronounced economies of scale strongly suggest that the number of refineries in the U.S. will continue to decline, while those that remain will continue to expand their capacity through debottlenecking.

Graph: U.S. Refining, Runs, Capacity, Number, 1973-97

• One simple, commonly-used measure of refinery complexity is processing capability, which compares upgrading capacity to distillation capacity (see What's Hot). This has continued to increase in the U.S. even though it is 2½ times higher than in the rest of the world. One motivation for this increase has been the obvious one of raising light product yields, particularly of diesel and jet fuel, at expense fuel oil, so as to reflect the trends in demand. However, an equally important motivation has been to be able to run poorer quality crudes, i.e. crudes that are heavier and contain more sulfur and metals, because such crudes are cheaper. Both have been helped by companies finding it to be relatively cheap to debottleneck upgrading units if they do it in combination with the mandatory investment required by clean fuel legislation.
• In the last ten years alone, the average gravity of the crude being run by U.S. refiners has dropped by almost 1 degree API and the sulfur they contain has risen by 20%. Thus, U.S. refiners are producing a higher proportion of light products and meeting higher quality standards on them, even though the crudes they are taking into their refineries have got more fuel oil and more pollutants in them.
• The greatest expansion has been in one of the most aggressive, and therefore highest cost, upgrading options, coking. U.S. coking capacity has increased by 40% in the last 6 years, mostly in the Gulf Coast area, and mostly through joint ventures involving Venezuela or Mexico (see What's Hot), two of the world’s largest suppliers of poor quality crudes. This additional coking capacity has reduced U.S. residual fuel oil production to such low levels that even the Gulf Coast, the top refining center in the country, has occasionally had to import what is usually the dog of all products, high sulfur residual fuel oil.
• The tug-of-war between gasoline and distillate (see What's Hot) has been particularly hard on refining profitability in the U.S. because of the strong gasoline orientation of refiners here. Gasoline comprises more than half the output of the U.S. refining system; elsewhere, it only accounts for 20%. Thus, every 1 c/gal reduction in the price of gasoline brought about by the tug-of-war has 2½ times more impact on a U.S. refiner’s bottom line than on that of his overseas competition.
• The U.S. meets the vast majority of its own refined products needs. However, the degree of self sufficiency varies quite markedly between the regions, due to a mix of history, economics and politics. These differences make the differentials between crude and products, and between the products themselves, wider in some regions and narrower in others.

• The East Coast is at one extreme, refining only 1/3 of what it consumes - a legacy of the 1960’s, when local opposition drove refinery construction to the Caribbean or the Gulf Coast.
• The Midwest’s refining deficit has evolved more recently, as simple, small, local refineries have been forced to close, because of a steady decline in the high quality crude oil production that originally justified their construction.
• The Rocky Mountain refineries evolved, like those in the Midwest, courtesy of abundant local supplies. Declining production was pushing the region toward the same refining-deficit fate until surging Canadian supplies, and new pipeline capacity that makes the Rockies their most economic destination, gave the local refiners a new lease on life.
• On the West Coast, an approximate balance between refinery capacity and local product demand is virtually guaranteed, because of the unusually high cost of moving products either in or out.
• The Gulf Coast is at the other extreme, refining almost twice its own needs and using the surplus mainly to support the East Coast and Midwest markets. The drive toward refining efficiency has accelerated the trend toward increasing Gulf Coast dominance. Half the U.S. refining capacity is now in this one region.

• The refining sector also shows significant regional differences with respect to the quality of the crudes they run. These differences particularly impact the margin needed to cover a refiner’s costs. For example, reflecting Alaskan and Californian production, West Coast refiners run crudes that are 5-7 degrees API heavier on average than those run elsewhere in the U.S. This has forced West Coast refiners to invest especially heavily in upgrading, raising their fixed costs. The tightest standards in the country for product qualities and for refinery emissions raise them even further.

For more info, go to What's Hot in Refining

• The Trend to Complexity
• The Distillate/Gasoline Tug-of-War, from the Refining Side
• Specialty Products and Market Fragmentation, from the Refining Side
• Larger and More Intensively Operated
• Alliances, Mergers and Joint Ventures
• Mexican and Venezuelan Joint Ventures

To see graphs, go to Refining Graphs

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