1. In the oil refining business, the cost of inputs
(crude oil) and the price of outputs (refined products) are
both highly volatile, influenced by global, regional, and local
supply and demand changes. Refineries must find the sweet
spot against a backdrop of changing environmental regulation,
changing demand patterns and increased global competition
among refiners in order to be profitable.
2. Oil refining is a capital-intensive business. Planning, designing,
permitting and building a new medium-sized refinery is a 5-7 year process,
and costs $7-10 billion, not counting acquiring the land. The cost varies
depending on the location (which determines land and construction costs† ),
the type of crude to be processed and the range of outputs (both of the latter
affect the configuration and complexity of the refinery), the size of the plant
and local environmental regulations.
3. After the refinery is built, it is expensive to operate. Fixed
costs include personnel, maintenance, insurance, administration
and depreciation. Variable costs include crude feedstock,
chemicals and additives, catalysts, maintenance, utilities and
purchased energy (such as natural gas and electricity). To be
economically viable, the refinery must keep operating costs
such as energy, labour and maintenance to a minimum.
4. Like most other commodity processors (such as food, lumber and
metals), oil refiners are price takers: in setting their individual
prices, they adapt to market prices.
5. Since refineries have little or no influence over the price of
their input or their output, they must rely on operational
efficiency for their competitive edge. Because refining is caught
between the volatile market segments of cost and price, it is
exposed to significant risks.
6. “Crack” Spreads
The term “crack” comes from how a refinery makes money
by breaking (or ‘cracking’) the long chain of hydrocarbons
that make up crude oil into shorter-chain petroleum products.
The crack spread, therefore, is the difference between
crude oil prices and wholesale petroleum product prices
(mostly gasoline and distillate fuels). Like most manufacturers,
a refinery straddles the raw materials it buys and the finished
products it sells. In the case of oil refining, both prices
can fluctuate independently for short periods due to supply,
demand, transportation and other factors. Such short-term volatility
puts refiners at considerable risk when the price of one or the
other rises or falls, narrowing profit margins and squeezing
the crack spread. The crack spread is a good approximation
of the margin a refinery earns. Crack spreads are negative if
the price of refined products falls below that of crude oil.
A major determinant of a crack spread is the ratio of how
much crude oil is processed into different refined petroleum
products, because each type of crude more easily yields a
different product, and each product has a different value.
Some crude inherently produces more diesel or gasoline
due to its composition.
Refining is “low return, low growth,capital intensive, politically sensitive and environmentally uncertain.” A refinery will close
if it cannot sustain its profitability.
[The 3 Cs = Capital Intensive, Commodity Pricing and Cyclicality (volatile earnings).]