Wednesday 18 April 2018

Is an oil refinery a good business to own for the long term?

Is a refinery a good business to own for the long term? 

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.  P
lanning, 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. 



Summary: 

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).]

http://www.canadianfuels.ca/website/media/PDF/Publications/Economics-fundamentals-of-Refining-December-2013-Final-English.pdf

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