Greater investment in oil refineries is needed to bring down the price of oil, Organization of the Petroleum Exporting Countries President (OPEC) and Kuwaiti Oil Minister Sheikh Ahmed Al-Fahd Al-Sabah said last weekend.
For over 30 years, the refining sector has suffered from poor profitability, which has lead to insufficient investment in upgrading capacity. This has constrained the ability of refineries to produce enough gasoline, with serious effects upon crude oil prices.
There has been a fundamental disagreement between Washington and OPEC over the source of higher oil prices. The Bush administration emphasizes shortages of crude, urging OPEC to increase production. OPEC argues that the problem lies with U.S. refining. The reality is that both issues are affecting the price of oil, but investment in refining facilities has been lacking for too long.
Difficulty within the refining industry arises from the underlying cost structure of a refinery. The industry is extremely capital intensive and is characterized by very high fixed costs and low variable costs.
High fixed costs require maximum-capacity operation. Lower throughput increases average fixed costs exponentially, which seriously damages profitability. Hence there is an incentive to operate over capacity. The market thus has a natural tendency to oversupply, since all refiners maximize their individual utility by operating at or above capacity. This forces down margins and pushes refineries into loss.
Low variable costs mean refineries do not close, despite widespread losses, providing that variable costs are met. Continued operation makes some contribution to fixed costs.
Between 1999 and 2003, the major integrated oil companies earned roughly 20% on average capital employed in the upstream, but refining and marketing companies earned less than 10%. Therefore, it is hardly surprising that investment in refining has been lacking.
The industry is faced with the challenge of increasing gasoline supplies and supplies of lower sulphur products. Their failure to do so contributes to higher prices. The major problem with the refining industry is its need to upgrading capacity--upgrading oil from sour to sweeter crudes--rather than primary distillation capacity--the first process in refining, whereby a barrel of crude is "cooked" to split it into the various products.
The supply problem is further aggravated by the fact that most governments around the world are tightening sulphur specifications on diesel. Therefore, costly desulphurization equipment is required to produce the lower sulphur products.
The only other way to increase gasoline supplies and supplies of lower sulphur products, absent investment in upgrading and desulphurization, is for refiners to use lighter and sweeter crude. However, the increases in crude oil production from OPEC seen over the last year are of heavy, sour crudes. Therefore, the price of light, sweet crudes, when compared with sour crudes, has risen due to shortages in upgrading capacity.
Washington's recent interest in building new refineries on unused military bases will do nothing to rein in the headline prices of oil, as the problem is not a shortage of primary distillation capacity, but a shortage in upgrading capacity. Increasing OPEC output will not help either, and there are signs that OPEC is concerned that its efforts to reduce headline prices could cause a surplus of heavy crudes. If overdone, this could cause a speculator-driven price collapse.
Problems in refining go a long way to explain the relatively high price of certain oil products. The obvious solution is greater investment in upgrading current refineries, though this would not be a quick fix because of the long lead times on such projects. Furthermore, tight upgrading capacity has greatly improved refinery margins, and it is difficult to see why oil companies would invest to change this situation.