Appraising the local refinery option: Step 1 – Basic oil refinery economics

Introduction

Today’s column addresses several economic factors which are key to the oil refinery business. It continues the examination of economic challenges/concerns that are related to the economic viability of mini-oil refineries. For this purpose therefore, it is useful to recall the earlier observation that, no two oil refineries are the same. Each oil refinery, like each person, is unique.

Nevertheless, despite their individual uniqueness, all oil refineries share certain common economic characteristics. This commonality occurs because every oil refinery is engaged in processing crude oil, which (as was previously indicated) goes through four main processes; namely, 1) separation of the different types of crude oil hydrocarbons; 2) conversion of the separated hydrocarbons into higher-value products; 3) treatment of those products in order to remove contaminants and other unwanted elements (such as metals and sulphur); and 4) blending the various hydrocarbons streams in a manner designed to create the required products the refinery produces.

All traded refined products have to meet their established standards (whether domestic or international). Meeting such standards requires different levels of technological sophistication. And, in regard to this feature, I have already considered in some detail, related matters such as refinery capability, complexity, and configuration, at some length. I shall not repeat here, except to note such matters apply to all refineries, irrespective of their size. Mini-refineries, as the term indicates, occupy the smallest and least complex or sophisticated end of the spectrum of today’s oil refineries.

Price takers

Like all other commercial ventures, the success or failure of an oil refinery would depend principally on the differential between the cost of a refinery’s inputs, and the price at which it disposes of its output of petroleum-derived products. Competition among oil refineries relentlessly drives them to aim at producing higher and higher-value products, while simultaneously seeking to incur lower and lower input costs, than those obtaining at other competing refineries.

As would be anticipated, an oil refinery’s chief input cost is the crude oil it utilizes. Historically, the cost of that oil has been very volatile, even as the price of the products that the refinery produces have been sold in similarly volatile markets. As a rule, therefore, both input (crude oil) and output (refined products) are routinely traded in intensely competitive markets. And, as a consequence, oil refineries are considered by energy economists to be price takers in oil markets.

Capital intensive

In these weekly columns on the coming of first oil, readers would have already been made aware that, although mini-refineries cost less than their large counterparts (and sometimes far less, depending on their sizes), oil refining when compared to most other business is highly capital-intensive. Parenthetically, it should be noted that the investment costs of refineries do not only vary significantly by their sizes, but their location and regulatory environment can also affect their costs significantly.

A direct consequence of different sized oil refineries being similarly capital intensive is that, on average, their operational costs are high. As a result, once they are built, refineries are relatively costly to operate. Routinely, industry analysts define oil refineries costs as consisting of fixed costs (which include maintenance, depreciation, administration, personnel, and insurance); and variable costs (which would then include their crude oil inputs, required chemicals and additives for the refining process, utilities, and purchased energy). Therefore, one can reasonably expect that the profitability of oil refineries, and indeed their commercial viability (both large and small) would depend on keeping their operational costs, as the saying goes, well under control.

Market

Energy economists who have researched the demand and supply functions of oil refineries, share the consensus view that, typically, they have very little leverage over the oil price of either their outputs or inputs. Following from this, an oil refinery’s commercial survival would depend on its operational efficiency, which is usually measured by the ratio of its output to input. Improving its output-input ratio is considered to be dependent on 1) the refinery’s ability to upgrade the techniques applied; 2) refinery innovation; and 3) optimization, as oil refineries strive to get more output with fewer inputs. This observation leads to the notion of a refinery’s gross margin. This margin, as was noted previously, is the differential between the cost of the crude oil input and the price it receives from the sale of its output of refined products.

Further, because refineries operate in highly volatile markets for both their inputs and outputs, they are exposed to significant market risks and uncertainty; for which every refinery has to manage. This observation is made even more significant, given their capital intensive structure. Thus, in the present period of sluggish growth, accompanied with low margins, plus growing regulatory standards (following the global shift to low carbon development) refineries, by every reasonable measure, run considerable risks. Thus the closure of refineries noted in previous columns (more than 150 in the United States alone) in the three decades from the mid-1980s to the mid-2010s, together with the global reduction in refinery numbers since the end of the 1990s, reveal how rapid the re-configuration of the oil refining industry has been in recent decades.

The above paragraph should direct readers’ attention back to the previously discussed concept of crack spread. To recall, this is treated as the differential between crude oil prices on the world market and the (wholesale) petroleum product prices (for example, gasoline, heating oil, and distillate fuels). As expressed, the crack spread approximates the margin or profitability of a refinery. Thus, if for example, the prices of refined products fall below crude oil prices, the crack spread is negative.

Profitability

Further, following on the above, readers can readily arrive at the conclusion that, as was indicated last week, the profitability of an oil refinery, is heavily dependent on 1) the crude slate or the expected type/quality/ specifications of the crude oil supply available; 2) the product slate; 3) the configuration of the refinery, or its Complexity Index plus its capacity (barrels oil per day, bbl/d);  4) the location of the petroleum product markets in which it expects to sell; 5) the location of the crude slate; 6) the availability of government incentives; and 7) logistical and distributional concerns, which directly impinge on transportation, storage, and other such related matters.

Conclusion

Next week’s column continues this discussion on basic economic features of all oil refineries and after that it will begin to address several special economic considerations which apply to mini-oil refineries.

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