Invest in an Oil Refinery Industry

The decision to invest in oil refining is a complex one, with manyfactors to consider. Government regulation, input prices, and outputprices all have a role to play in a long-term decision to invest in anincrease in capacity.In the United States especially, government regulation has played ahuge role in the profitability of oil refining. Many regulations havebeen introduced to improve air quality and prevent groundwaterpollution that have increased refining costs. A large number ofreformulated gasoline blends are required in many parts of the nation,which even vary over the course of the year based on seasonal changes. Environmental regulations and "not in my backyard" sentiments havealso made it extremely difficult to invest in additional refiningcapacity in the United States. In fact, no new refineries have beenbuilt since 1976.Recently, however, governments have shown considerable increasedinterest in promoting the development of new refineries. For example,the United States Congress is considering legislation to reduce theburden of environment regulations and to compensate oil companies fordelays resulting from unforeseen litigation and delays caused bygovernment authorities. Tax incentives relating to depreciation havealso been included in the Energy Bill.Input prices and availability play an important role because theycontribute significantly to the operating costs of a refinery. Highquality crude oil is increasingly harder to find. Middle Easternrefineries tend to have already refined oil once in less sophisticatedrefineries, leaving residual oil for many US refineries. This is amuch more difficult oil to process because it contains significantamounts of sulfur and heavy metals, and it must be heated in order toeven get it to flow into the refinery. These characteristics increaserefining costs.Output prices are also extremely important because they determine therefinery's revenue. As demand has increased for refined products,prices have risen, improving refinery margins. However, this has notalways been the case. A global excess of refining capacity resultedin many refineries being shut down. Many refineries in United Stateswere shut down in the early 1980s because they were unprofitable, anda second wave followed in the late 1980s and 1990s because ofcontinued poor profitability resulting from low gasoline prices. Oiland gas production has historically been far more profitable thanrefining and marketing, leading to a lack of interest in investing innew oil refining capacity.Given the considerable increase in refining margins in recent years,interest in investing in oil refining is increasing. Refineryutilization rates have increased significantly in recent years,increasing the risk of supply disruptions and keeping prices forrefined products high. Several existing refineries are planningsignificant expansions in the United States, and nontraditionalplayers, such as Virgin's Richard Branson, are considering enteringthe market. Branson believes the world needs as many as 20 new oilrefineries, which would indicate considerable room for expansion bymany players before margins would be adversely affected.When considering invest in oil refining, one must examine futuredemand, the availability and price of inputs, competitor activities,and future potential government regulations. Because an oil refineryis a long-term investment (typically requiring several years from thepreparation of engineering drawings to the start of operation, not tomention a multi-decade operating life), an investment climate thatlooks to be attractive for many years is critical. Global demandforecasts from the International Energy Agency suggest that as many as30-40 world scale refineries may be needed just by 2010 to preventconsiderable significant increases in prices of refined products. 50-70 world scale refineries would be needed to return refiningmargins to their historically lower levels. This suggests there isconsiderable room for error before excessive refinery investment wouldoccur globally, making such an investment more attractive.Reductions in sulfur appeared to be a major regulatory themeworldwide. In order to achieve this, demand for sweet crude oil willrise. Since Asian and European refineries have made less of aninvestment in sour crude refining capability than those in the UnitedStates, sweet crude will become even less available in the UnitedStates and even more expensive. A shortage of sweet crude and/or asecond rise in its price may make some marginal refineries in capableof producing low sulfur gasoline and diesel fuel, resulting in afurther decline in global refining capacity.Projected growth in China and India's demand for energy products playsa huge role in estimates of future demand. If the Goldman Sachsprojections for Indians owning 610 million automobiles, Chinese 514million automobiles, and Americans 233 million automobiles by 2050holds up, there will obviously be enormous demand for gasoline anddiesel fuels. Clearly, many more refineries would be required tosupply distillates to the world's drivers.It is always possible that the marketplace will overreact and too manyrefineries will be built or that a global economic slowdown will causethe growth projections to not pan out. Some speculations that globaloil production may be at or near its peak may also create insufficientsupplies of reasonably priced oil to allow a dramatic increase in thenumber of refineries. However, that could make existing refineriesmore valuable. Investors considering an investment in oil refiningmust incorporate data from many sources to formulate their ownforecasts of how supply and demand will interact with one another,along with the number of refineries, to determine refining margins. Many governments and private institutions make all kinds ofenergy-related forecasts that can be of considerable use, such asthose available in the sources below. I have collected severalresources you should find helpful in understanding the economics ofoil refining and how they may develop in the future.