U.S. Refining Sector

Source: API 5/1/2006, Location: North America

Crude oil needs to be refined in order to produce the gasoline and other products demanded by consumers. Refining a barrel of crude oil involves a series of complex processes. The first stage for all refineries focuses on the initial distillation in which the barrel of crude oil is heated and broken down into its component parts. Subsequent processes, often referred to as “conversion,” focus on transforming lowervalued products into higher-valued products by either removing impurities, such as sulfur, or further transforming lower-valued products, such as bunker fuel suited for ships, into higher-valued products, such as gasoline for automobiles. It is the size and scope of these various “conversion” processes that typically distinguish differences in refineries. As a result, different refineries will prefer different types of crude oil.

U.S. refining capacity stands at approximately 17 million barrels per day. At the beginning of 2005, this capacity was spread across 55 refinery companies operating 144 refineries. These companies include vertically integrated operations (i.e., companies involved in the production of crude oil), as well as independent refiners (i.e., those with little or no crude production capabilities). Operations, reflecting both the economics of the industry as well as each company’s particular business strategy, range in scale from millions of barrels per day down to thousands of barrels per day. No refiner, however, owns more than 13 percent of total U.S. refining capacity.

The current composition of the U.S. refining sector highlights the considerable transformation realized by this segment of the industry. These changes have been driven in large part by the long-term decline in economic returns realized by the U.S. domestic refining sector. Figure 10 illustrates this decline through gross refining margins, a common proxy for trends in profitability. As shown by the figure, the trend in profitability has, until the past few years, been consistently moving downward.

As a consequence, the U.S. market has seen a decline in the ownership of refining capacity on the part of major U.S. oil companies. During the 1990s, the major U.S. oil companies reduced their ownership of refinery capacity from 72 percent to 60 percent of total U.S. capacity, while the “fast-growing independent refiners” increased their refinery capacity from 8 percent to 23 percent of total U.S. capacity.13 The largest independent refiners now rival major oil companies in their capabilities to meet the nation’s growing needs for cleaner transportation fuels. In addition, competition from imports is increasing, as more than 10 percent of U.S. daily consumption of petroleum products now comes from outside the United States. These changes, taken together, reflect the competition faced by domestic refiners in their efforts to meet U.S. demand for petroleum products.

How Has the Refining Sector Been Affected by Today’s Crude Market?
The growth in demand for petroleum products has affected the refining sector and this, in turn, has significantly affected the global crude oil market. As expected, the utilization rate of the world’s refineries increased significantly during the 2000-2004 period. In the United States, utilization rates exceeded 90 percent even as the capacity to refine crude continued to expand over the period. Once the required downtime to perform routine maintenance is taken into account, refinery utilization rates are extremely high. Moreover, as the demand for petroleum products increased, so too did the demand for conversion capacity noted above, i.e., capacity capable of producing relatively more valuable products from heavier crude oils. These changes reflected not only the increasing demand for higher-value products, such as gasoline and diesel fuel, but ongoing changes in fuel specifications, as well, which increase demand for such conversion capacity.

The reduction in spare refining capacity, in turn, has affected the international crude oil market. As noted above, there are many different types of crude oil, e.g., West Texas Intermediate, West Texas Sour, Arab Heavy, Bonny Light, to name just a few. While there are many characteristics to any given crude, the two most common distinctions relate to its viscosity, i.e., how “light” or “heavy” a crude is, and the amount of impurities contained within the oil, of which sulfur is the most commonly identified. These characteristics indicate the amount of processing required to convert the crude oil into saleable petroleum products.

Generally speaking, lighter crudes require less processing to produce a relatively more valuable slate of petroleum products, such as gasoline, diesel, and jet fuel, than heavier crudes. The more sulfur contained in a crude oil, the more “sour” it is said to be and the more processing required before resulting petroleum products can be sold into the marketplace. Thus, “sour” crudes require more processing than “sweet” crudes. As spare refining capacity has diminished, particularly the capacity to turn heavy, more sour crude oil into high-valued products, the refining sector has placed a relatively higher value on lighter, sweeter (“light sweet”) crudes than on heavier, more sour (“heavy sour”) crudes. This is because light sweet crudes require less processing to produce a given volume of higher-valued products.

Refining margins currently reflect these changes. Holding aside any temporary impacts resulting from Hurricanes Katrina and Rita, those refiners that can produce more valuable products from the heavier, more sour crudes have tended to earn higher margins relative to those refiners who have not yet invested in this equipment. Of course, the former refiners typically have faced higher costs due to the additional equipment required to process heavy, sour crudes, but these costs have tended to be outweighed by the relative differences in prices of heavy sour and light sweet crudes. This outcome can be properly interpreted as the market providing an economic incentive for additional investment to process those heavier, more sour crudes.

Refined Petroleum Product Markets
Conceptually, the market for refined petroleum products is very similar to the crude oil market in that there is widespread buying, selling, and trading of products in both the physical market (e.g., spot market) and the futures market. And just as with crude oil, there are significant international flows of refined products. The United States, for example, imports approximately 3.5 million and exports approximately one million barrels per day of refined products.

Trade in petroleum products reflects the international market’s efforts to match what is produced (supply) with what consumers prefer (demand). In the United States, for example, the majority of exports tend to involve products for which there is little or no domestic demand. This would include commodities produced as by-products of the refining process and that are no longer consumed domestically, such as petroleum coke; products for which there is little seasonal demand, such as heating oil sent to the Southern Hemisphere during our summer season; and products for which there is no domestic market due to environmental specifications, such as residual fuel and gasoline that fails regional fuel specifications. Imports, in contrast, reflect domestic demand for products such as gasoline and winter heating oil, i.e., products demanded by U.S. consumers that cannot otherwise be met by domestic refiners. In sum, these flows highlight the fact that the United States is in the position of having to compete on international markets to satisfy demand for those products most desired by U.S. consumers.

In addition, petroleum products and futures are also traded on organized exchanges, such as NYMEX and the Chicago Mercantile Exchange, just like crude oil. Thus, the interactions of traders on organized exchanges establish transparent prices for petroleum products, as well as crude oil. Petroleum product deliveries in particular areas will often be at prices based on those determined on an organized exchange, with adjustments for differences in location and the precise type of petroleum product being traded.

As noted above, crude oil is the single largest input cost associated with the manufacturing of petroleum products. Consequently, changes in crude oil prices have a significant effect on petroleum product prices and changes in expectations about future crude oil prices can lead to changes in both current and future prices of gasoline and other petroleum products through the building up or drawing down of inventory. However, prices for petroleum products can also change due to supply-and-demand factors unrelated to the crude market. Such factors would include, for example, an unexpected hurricane that interferes with refinery operations, or colder-than-normal weather in the Northern Hemisphere, or environmental mandates and regulatory requirements. These events can cause the price paid for product to be delivered today or months from now to rise or fall independent of crude oil price changes.

As with the crude oil market, there exists a dynamic relationship between current prices and prices for petroleum products to be delivered in the future. A change in the price of gasoline or heating oil to be delivered some months in the future can lead to a similar change in the futures price paid for product to be delivered next month. That, in turn, can have implications for prices of products throughout the chain of distribution. A change in “futures” prices, for example, can affect the prices being paid today on the spot market. As discussed above, these price changes provide market participants with signals about whether they should be building up or drawing down inventories, thereby affecting the supply of product currently on the market. Thus, the change in the spot price could, in turn, lead to a similar change in the wholesale or “rack” price paid for gasoline by retailers and, in turn, in the prices paid by motorists at the pump.

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