INTERNATIONAL: Refining bottlenecks drive up oil price

Analysis

There has been a fundamental disagreement between Washington and OPEC (particularly Riyadh) over the source of higher oil prices:

• The Bush administration emphasises shortages of crude, urging OPEC to increase production.
• OPEC argues that the problem lies with US refining.

The reality is that both are affecting the price of oil, but that investment in refining facilities has been lacking for too long.

Refining. Difficulty within the refining industry arises from the underlying cost structure of a refinery. The industry is extremely capital intensive -- attracting very large economies of scale -- and characterised by very high fixed costs and low variable costs:

1. Fixed costs. High fixed costs require maximum capacity operation. Lower throughput increases average fixed costs exponentially, seriously damaging profitability. Hence there is an incentive to operate over capacity. The market therefore has a natural tendency to over-supply, since all refiners maximise their individual utility by operating at or above capacity. This forces down margins and pushes refineries into loss. For example, between 1995 and 2005 refinery margins in the US Gulf Coast for processing Brent Crude have averaged only 10 cents per barrel and in North-west Europe the equivalent margin has averaged 1.84 dollars. This margin only relates to variable costs: capital costs and a return on investment must also be covered by operations.
2. Variable costs. Despite widespread losses, low variable costs mean refineries do not close, providing that variable costs are met (ie refinery margins are positive). Continued operation makes some contribution to fixed costs. Failure to close is reinforced in the OECD because of the high cost of closure arising from environmental clean up requirements. Thus the refinery sector in the past has lacked an automatic market balancing mechanisms to restore profitability (ie loss of capacity).
3. Poor profitability. Between 1999-2003 while the major integrated oil companies earned roughly 20% on average capital employed in the upstream, refining and marketing earned less than 10% -- the bulk of which comes from marketing (ie buying cheap and selling dear) -- rather than refining. Therefore, it is hardly surprising that investment in refining has been lacking.

Increasing supplies. The industry is faced with the challenge of increasing gasoline supplies and supplies of lower sulphur products. Their failure to do so contributes to higher prices:

1. Upgrading capacity. The major problem with the refining industry lies in 'upgrading capacity' -- upgrading oil from sour to sweeter crudes -- rather than 'primary distillation capacity' -- the first process in refining, whereby a barrel of crude is 'cooked' to split it into the various products:

   • In 2003, only 5% of oil product demand in the United States was for heavy fuel oil, while 50% was for gasoline and naphtha.
   • In Europe the figures were 11% for heavy fuel oil and 30% gasoline and naphtha.

   However, refining a barrel of Arab Heavy in a primary distillation unit produces 53% fuel oil and only 15% gasoline and naphtha. Thus refiners must re-process the heavier ends of the barrel to produce more light products. This 'upgrading' requires extremely expensive investment in equipment.

   Globally, most upgrading units are operating at full capacity, implying potential shortages of gasoline. In the United States this is aggravated by the fact that the US Clean Air Act of 1990 has encouraged a plethora of gasoline specifications, fragmenting the US gasoline market and inhibiting market arbitrage to mitigate pressure on the price for certain gasolines (see UNITED STATES: Gas shortages, volatile prices, set to - July 20, 2001).

2. Sulphur requirements. The supply problem is further aggravated by the fact that most governments around the world are tightening sulphur specifications on diesel. Thus, costly desulphurisation equipment is required to produce the lower sulphur products.

3. Lighter & sweeter crudes. The only other way to increase gasoline supplies and supplies of lower sulphur products, absent investment in upgrading and desulphurisation, is for refiners to use lighter and sweeter crude. However, the increases in crude oil from OPEC seen over the last year are heavy sour crudes. Such increases do not respond to market demands. Thus, the price of light sweet crudes, when compared with sour crudes, has risen due to these shortages in upgrading capacity:

   • The differential between West Texas Intermediate (light sweet crude) and Dubai (medium sour crude) in 2002 was 2.30 dollars per barrel.
   • In 2004 it was 7.78 dollars, and in the first quarter of 2005 reached 8.56 dollars.

   The two benchmark crudes on NYMEX and the IPE are both light sweet crudes. Thus, greater OPEC output will have little or no effect on the headline prices of crude oil.

Outlook. Washington's recent interest in building new refineries on unused military bases will do nothing to rein in the headline prices of oil, as the problem is not a shortage of primary distillation capacity but a shortage in upgrading capacity. Increasing OPEC output will not help either, and there are signs that OPEC is concerned its efforts to reduce headline prices could cause a surplus of heavy source crudes. If over done, this could cause a speculator-driven price collapse.

The obvious solution is greater investment in upgrading current refineries, although this would not be a quick fix given the lead times on such projects. Furthermore, tight upgrading capacity has greatly improved refinery margins, and it is difficult to see why oil companies would invest to change this situation.