oil refining

When I completed my PhD in chemical engineering the typical job route at that point was to enter a research lab or go to an oil company. At the time I couldn't think of anything worse and ended up going to a management consulting company. This brings up the question of why on earth did I study chemical engineering but that's another story.

Well some things come full circle. I've spent a small part of my time on a side project for our fund looking at oil refiners. Turns out they are incredible fascinating. I'm talking about oil refiners here. The guys who take crude and turn it into something useful. Getting the crude oil out is a separate part of the oil industry.

Part of what makes it interesting is of course the huge changes in the price of gasoline recently. Part of this increase is due to an increase in the crude oil price per barrel which is an input into an oil refinery and part of it is the devaluation of the dollar.

While crude oil prices have gone up, the additional amount of value added by oil refiners has also gone up. And the reason for it is very interesting. This additional value refiners generate is typically referred to as a spread - the difference in the price of, say, gasoline and the price of crude oil.

As an aside (but it will actually be useful in the discussion of oil refining) the price you typically see quoted ("Oil hit $120 a barrel today") is a West Texas Intermediate (WTI) crude or Brent crude (named after the place the crude comes from). Collectively those two crudes make up 1% of all crude production. It's kind of weird that we use them as a benchmark for crude prices when most of the oil comes from the Middle East. As a rule those two crudes are the most expensive types of crude because of their attractive properties. There are in fact over 200 types of crude and they are categorized by the amount of sulfur in them (sweet or sour crude), a measure of how long the carbon chains are (heavy or light crude), and a host of other metrics.

Crude Oil

First, what is crude oil? A barrel of crude oil is a basically a pool of organic chemicals. Organic chemicals have a carbon backbone. Carbon likes to make 4 bonds with the atoms around it. The simplest carbon chain is 1 carbon with 4 hydrogens bonded to it - methane. Carbons can also bond to other things but in crude oil they are bonded to sulfur, nitrogen, and hydrogen. And of course they can bond to themselves. Either single bond (these molecules are called alkanes) or even a double bond (alkenes). Alkenes are generally referred to as unsaturated because they have less than the maximum number of hydrogen atoms attached to the carbon due to the double bonding. Carbon generally forms into linear chains but it can also form into cyclical molecules (aromatics) and branched molecules. Crude also contains salts.

The one thing to keep in mind is that crude oil is organic. We generally think of gasoline and kerosene and the plastic we make from the naphtha as synthetic. And they are to a certain extent. But they all come from decayed plant matter.

Oil Refining

An oil refinery will first take a barrel of crude and put it into a distillation column (and then a similar column under a vacuum). This will separate components that boil at different temperatures. They are very cool pieces of equipment and the theory behind it is brilliant but I won't get into that here.

In essence, very volatile stuff will come out the top of the column, thick sludgy stuff at the bottom, and something in between in the middle. The main classifications are gases like methane, ethane,.., a crappy version of gasoline or naphtha, diesel, kerosene (jet fuel), and some sludge generally referred to as fuel oil or bunker C. In reality there a huge number of classifications you could make. The gasoline that comes out is not modern grade gasoline but rather a component that is mixed with other 'reformates' to make modern gasoline.

Some refiners stop here. These are referred to as simple refiners. Complex refiners however go beyond simple plumbing and perform some chemistry on that crappy bunker C and also on the other outputs. 2 additional processing units can be applied - crackers and reformers.

Crackers, as the name suggests, crack the sludgy bunker C which contain long carbon chains into something a little more manageable. Let's say 20 carbon chains get reduced down to 8 chains which is an octane. Hmm..where have I heard that word before. Generally gasoline consists of molecules with 5 to 12 carbons. So all it is doing is taking sludgy stuff and turning it into volatile stuff whether that's kerosene, diesel, or gasoline. All 3 of these are premium products.

Reformers rearrange the bonds on a molecule. In this case they try to turn linear molecules into branched or cyclical molecules and they try to make double bonds (alkenes) from single bonds. Both of those things make a better performing gasoline (anti-knock, etc). In fact, the word gasoline or gasolene was probably created because of the alkene component.

Complex refiners also remove more salt, nitrogen, and sulfur from the outputs. The salts, sulfur, and nitrogen are generally undesirable (e.g., acid rain anyone?) and are removed at certain points in the processing chain.

Supply & Demand

So let's look at the actual market for this stuff. There's a couple of trends going on and other facts that impact the market.

1. Demand growth for lighter products is higher than demand for heavier products. Bunker C which can be used for dirty heating, electrical generation, and ship fuel doesn't grow that fast compared to gasoline, diesel, and kerosene. The growth in planes and cars is bigger than the growth in ships.
2. Automotive engines are increasingly requiring high performance fuel. Remember leaded gas? Tetra ethyl lead was added to improve the octane rating. When that was discovered to be a bad move we added MTBE which had the same effect. Guess what? Turns out that stuff screws up the water supply. Oops. So that's banned in some states and will probably be banned entirely.
3. In general, as emerging markets grow they shift their consumption from heavier, cheaper products to lighter, clean, more expensive products.
4. Most of the incremental crude oil coming online is from OPEC countries. While they make up the bulk of crude oil production their crude, in general, is crap. It's sour and it's heavy.
5. In order for a simple refiner to turn into a complex one (add reforming and cracking) it needs a certain amount of scale. If the plant is too small it is just not economical to become complex. These plants are shutting down removing capacity.
6. Money spent to increase complexity is money not spent on expansion
7. Refining was a terrible business in the 80s and 90s. After the oil crisis caused prices to skyrocket, demand dropped and there was a huge amount of overcapacity. A lot of refiners have shut down and new ones haven't been built in a developed country in 25 years. Even if a company wanted to build a new plant it can be difficult due to stringent regulations. In the US it is almost impossible. Instead refiners try to incrementally expand. It adds capacity but at a slower rate.
8. Recently demand has grown to the point where refineries are highly utilized. They are running all out.
9. Most of the most complex refineries are in the developed nations like the US. A lot of the US ones are based in Louisiana. Remember Hurricane Katrina?

What does this mean?

So let's put this together. There's been a relatively fixed or declining number of refineries in the world that have incrementally expanded slowly. Collectively these refineries can take 1 barrel of crude of a certain type and spit out a certain proportion of gasoline, diesel, kerosene, and bunker C. Demand for gasoline, diesel, and kerosene has grown faster than bunker C and gasoline regulations worldwide have made the specifications of these fuels harder to make, requiring more complex refineries. The incremental crude going into these refineries is dirtier (sour) and heavier (higher proportion of bunker C).

This means that refineries are making more money on the lighter products because supply is constrained. The spread has increased. But they are also losing money on any Bunker C output as that is in low demand. Bunker C is actually cheaper than crude. The spread is negative. This helps push up the price of the lighter products. This is because a simple refinery will demand a higher price on the lighter products to offset the loss on the Bunker C it will inevitably produce. Otherwise they would just shut down. Therefore complex refineries have done very well lately as they produce a lot of the lighter products and not much Bunker C. Here's a graph of spreads.

So will this ever change? Like all cyclical industries when companies make a lot of money on the product they make, they start to build more capacity. And that is occurring. Complex refineries are popping up in China and India and the Middle East. Eventually they will probably overbuild. Because while that is going on, oil prices have gone up which puts a crimp on demand. After the oil crisis of the 70s demand globally fell quite a bit leaving a lot of idle capacity. What I don't know is what oil production will look like. That is the bulk of your expense when you fill up gas. If that is truly constrained this coming decrease in refining spreads won't mean much to our wallet.