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