Keeping in mind the complex nature of the U.S Refinery Industry, we have tried to analyze the industry's key catalysts in a simple way. In follow up articles we will present detailed company analysis.
The Oil & Gas Industry is divided into three segments, Exploration and Production (E&P) (Upstream), Pipeline and Processing (Midstream) and Refining and Marketing (R&M) (Downstream).
Crude oil produced by E&P is sent through pipelines/tankers/ships to refineries, where crude oil is processed and different petroleum products are made, which are then sold through marketing to the end client, directly or through other means.
Refining crude oil results in output being higher than the input. The increased volume of petroleum products produced is called processing gain. The U.S. processing gain averaged around 6.2% from 1996-2010, which is a 42 gallon barrel of crude oil being converted into approximately 45 gallons of refined products.
Crude oils can be differentiated upon their API gravity (density) and sulfur content. Low API gravity (lighter) crude oil produces a higher proportion of profitable products such as diesel, gasoline and jet fuel, which can be refined with simple distillation. High gravity crude oils produce a lower share of profitable products through simple distillation and needs further refining to produce the required amount of profitable products.
High sulfur content is considered an undesirable characteristic in crude oils due to both processing and product quality.
A barrel of crude oil is converted into Motor Gasoline, Diesel, Jet Fuel, and Other Products.
Apart from crude oil, refineries use other inputs to produce petroleum products. The additional inputs include Natural Gas Liquids ((NYSE:NGL)), lease condensates, and crude oil products that are partially refined.
The marketing segment sells refined petroleum products to relevant consumers through retail outlets of the company and distributors.
Numerous factors influence the profit margins for refineries, including the type of crude oil processed (sweet/sour heavy/light), delivery method, location, and crude oil prices. Refining is a margin business, and higher absolute prices tend to weaken demand and make it harder to pass on increases in their costs, but refiners have no control over the price of oil, so they focus on finding crude oil (heavier) trading at a discount, and will yield the products they need to meet their sales commitments in the short term. In the long term, it involves investing so as to enable them to refine these heavier crudes, if allowed by regulators.
Complex refineries have flexibility in the choice of crude oil utilized as feedstock and can benefit from the use of lower priced crude feedstock (heavy crude oil), which normally sells at a discount to light crude oil.
Gasoline prices fluctuate in line with crude oil prices, and complex refineries that can switch to lower priced crude feedstock will witness better profit margins. However, simple refineries, that cannot refine these heavy crude oils will witness their margins squeeze in time of rising light crude oil prices.
North American Oil Production on Rise
Oil production in North America has been on the rise in the past few years due to the shale oil boom and the sand oil. The Bakken shale underlying North Dakota has time and again been named among the top contributors to the increased production of light oil in the U.S.
On the other hand, the Canadian sand oil have witnessed increased output of the heavy oil, which is finding its way to the U.S. and the output is expected to increase 50% in the next three years.
There are expectations that the U.S. may achieve energy independence by 2035 due to the abundant supply of oil and gas in North America as a result of the shale boom, and reduce the import of crude oil from the Middle East significantly, if not completely.
Refineries Shifting Toward Heavy Crude Oil Over The Past Few Years
Global production of oil is gradually moving towards heavier, sourer crudes because the easily available deposits of light, sweet crude are being tapped out, has forced refineries to evolve and switch towards refining the heavy crude oils.
A refinery designed to handle light, sweet light crude oil cannot switch to heavy, sour sand oil without severely upgrading itself. U.S. refineries have invested billions in upgrades over the last decade to enable them to process heavy crude oil.
Concerns For Refineries On The Gulf Coast
Refineries along the Gulf Coast need heavy oil, since they have been switching to the heavy crude oil. Since they couldn't easily switch from light to heavy crude oil, they can't switch from heavy back to light crude oil.
The heavy crude oil is available in abundance due to the Canadian sand oil. However, the problem being faced is due to the lack of infrastructure, as the heavy crude oil is being sent to the oil hub at Cushing, Oklahoma from the Canadian sand oil, it is not being transported to the refineries on the Gulf Coast due to a last of infrastructure (pipelines).
The laid down pipeline infrastructure runs from the Gulf Coast towards the North and was used to send refined products. To resolve this, some of the pipelines like the Seaway pipeline are being reversed to carry the heavy oil from the North to the Gulf Coast.
Bakken Shale Oil Opportunity For Refiners In The North
The oil produced from the Bakken shale is mid-weight and fairly sweet, and the refineries in the region are equipped to refine the production from the promising shale.
Crude Oil Price Differential
Due to the supply glut at Cushing, Oklahoma, the WTI has been trading at a discount to the Brent in the recent past.
The heavy crude oil (sand oil) trades at a discount to the WTI. Hence, at a significant discount to the Brent.
World Refining Capacity
A significant production of the crude oil in the world is sent to the U.S. (Gulf Coast) for refining, the finished refined products are then exported to respective destination.
Refining Margins of U.S. Refineries
Due to the crude oil price differential and the differentials between inland and coastal crude oils, refiners depending on crude oil from North America are expected to enjoy higher refinery margins. Some of the potential beneficiaries include HollyFrontier Corporation (HFC), Valero Energy Corporation (VLO) and Marathon Petroleum Corporation (MPC).
These refineries are concentrated on the Gulf Coast and the Midwest, making it a beneficiary of the oil production from the Bakken Shale, and the pipeline reversal being done to transport the discounted sand oil to the Gulf Coast.