Refining Business Drivers
Refining Lesson Overview
The Business Drivers Lesson consists of the following topics:
- Refinery Complexity
- Refinery Complexity and Product Yields
- Crack Spread
- Refining Margins
- Refining Margin Calculations
- Global Refining Margins
- Refinery Profitability
- Refinery Return on Investment
- Regulation Trends
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[Related: What is Refining?]
Refinery Complexity
Refinery size usually is measured in terms of distillation capacity. Common units for capacity are:
- BCD – Barrels per Calendar Day, based on 360 days per year, allowing downtime for maintenance, and
- BSD – Barrels per Stream Day, i.e. the nameplate or maximum capacity of the refinery.
In addition to throughput, refineries have another dimension, called refinery complexity factor. This concept was developed by W.L. Nelson in the 1960s.
With the Nelson Complexity Index (NCI),refineries are classified based on their processing complexity, varying from simple (hydroskimmers) to very complex conversion refineries. Simple refineries employ limited processing technology and produce a product slate similar to the component make-up of the crudes they run. Very complex refineries utilize extensive processing technology and produce more gasoline and middle distillates.
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Originally, Nelson developed the complexity index to quantify the relative cost of components that make up a refinery. It is a pure cost index that provides a relative measure of the construction costs of a particular refinery based on its crude and upgrading capacity.
Refineries that simply distill crude oil (called “topping refineries”) are considered to have a “complexity factor” of 1.0. As more processes are added to a refinery (e.g. conversion units for cracking) the complexity factor increases.
The “deep conversion” refinery, with numerous and varying process units, has the highest complexity factor of all, at 9.0 or higher. The complexity factor is independent of the throughput of a refinery, but multiple units of the same process increase complexity.
Clearly as a refinery’s complexity increases, it becomes increasingly costly to build and operate. On the other hand, complex refineries are capable of producing a higher percentage of high value products, such as gasoline.
(The above discussion is based on work performed by Nelson & Farrar.)
Refinery Complexity Factors
Nelson assigned a factor of 1 to the distillation unit. All other processing units are rated in terms of their cost relative to this unit.
The Nelson index compares the costs of various upgrading units – such as a Catalytic (hydro) cracking unit or a Catalytic reformer – to the cost of a crude distillation unit. Note that the Catalytic (hydro) cracker has a complexity of 6, and the complexity of other conversion units varies widely.
Key References:
Refining Report Complexity Index Indicates Refinery Capability, OGJ, Sept. 19, 2005.
Study Updates Refinery Investment Cost Curves, OGJ, April, 2007.
Refinery Complexity and Product Yields
The impact of complexity on gasoline yield is dramatic, as shown in the diagram.
The barrels of products produced compared with the barrels of crude oil consumed (shown as “% yield”) in a simple refinery is significantly different than in a very complex conversion. As can be seen, a simple refinery has 20% yield of gasoline and a conversion refinery has 50% yield. The other product yields are also indicated.
Also note in a conversion refinery there is a yield “gain” because more products are produced from the crude.
Note how gasoline yield in a conversion refinery (50%) is more than double that of a simple refinery (20%).
Learn more about our updated online refining course here!
Refining Margins and the Crack Spread
A key indicator of refinery margins (and ultimately profitability) is called the “crack spread”. The crack spread is the difference between petroleum product prices and the crude price.
A common version of this indicator is the 3-21- crack spread, which assumes 3 barrels of crude oil can be used to produce 2 barrels of gasoline and 1 barrel of distillate (diesel or fuel oil):
The calculation for the 3-2-1 Crack Spread in ($/Bbl) is below:
[(2 x Gasoline Price) + (1 x Distillate Price) – (3 x Crude Oil Price)]/3
Note that spread does not take into consideration all product revenues and excludes refining costs other than the cost of crude oil. Thus it is just an indicator of refinery profitability.
Crack spreads are be different for each market region and are highly dependent on crude sources and refinery location.
Gross refining margin (discussed on the next pages) is similar to a crack spread, but it takes into consideration all product revenues and all raw material input costs.
The profitability of the refining function is driven primarily by margins. In the case of refiners, a gross margin is the difference between the prices of the refined products that were realized at the refinery gate or “rack” and the feedstock/input costs (i.e., primarily costs for crude oil).
Numerous market, political, and regulatory factors affect crude oil and refined product prices that result in price volatility.
- Price volatility dramatically affects product revenues – affecting refiners’ margins
- Changes in the price of crude oil can have significant impacts on the profitability of refining companies since changes in crude oil prices are not always immediately reflected in refined product sales prices
Margins for refiners are typically very volatile. The key components in the crude and product calculations are driven by very different supply, demand, and market factors, including broader geopolitical and economic conditions, as well as more-localized factors related to accidents, outages, and/or weather.
It is important to note that refining margins are not necessarily correlated with the cyclical profitability of the upstream Exploration and Production functions.
- When crude prices increase, the market may or may not allow product prices to move up as quickly as crude prices – “squeezing” the margin.
- When crude prices fall, there can be a lag in product price deceases – causing margins to increase.
Refining Margin Calculations
The refiners margin calculation requires two concepts to be understood: Crude Oil Landed Cost and Product Netback Value.
In the refiners margin calculation product prices and crude costs are normalized and measured at the refinery “gate”… a term for the crude receipts and product tanks that are ready for sale.
Product Netback Value
To calculate this item, the product yield from the crude oil in the specific refinery configuration is needed. All product prices used to value the refinery’s product output must be “netted back” to the refinery gate. For example, If a refinery is in the US Gulf Coast and the products are sold along the Colonial pipeline in Atlanta, the Atlanta product prices need to have the Colonial Pipeline charges deducted to get the price at the refinery gate.
Crude Oil Landed Cost
Crude oil prices are usually quoted at the loading port at the point of origin or at a meter transfer point in a pipeline for domestic sourced material. To get the “landed crude cost” at the refinery gate, transportation charges, duty payments, shipping losses and insurance need to be added to the quoted cost at the loading port.
The Gross Refining Margin is the difference between the Netback Product Value and the Landed Crude Cost.
More on Netback Product Value
Refiner margins are very difficult to determine on a product-by-product basis. This is typical in a continuous process manufacturing environment where crude and operating costs must be allocated to each product on some rational basis, since it is difficult to have all costs specifically identified to the individual streams of products produced.
However, refiners make an attempt at this allocation as we discuss below.
Product Mix (or Yield) Value
Item A:
Starting with product prices – All product prices used to value the refinery’s product output must be “netted back” to the refinery gate. For example, if a refinery is in the US Gulf Coast and the products are sold along the Colonial pipeline in Atlanta, the Atlanta product prices need to have the Colonial Pipeline charges deducted to get the price at the refinery gate in the Gulf Coast.
A refinery in Singapore, exporting products to Hong Kong needs to have the marine freight and any other duties or charges taken out to get the Hong Kong product “netted back” to the Singapore refinery gate.
Item B:
The next step in refinery profitability is to know or calculate the product yield (in volume %) from the crude oil run in the specific refinery configuration.
Item C:
The product mix value is calculate by multiplying Item A by Item B for each product…remembering that Item B is a percentage.
The calculated values are added to get the Product Mix value in cents per gallon and multiplied by 42 to get $ per barrel.
Landed Crude Cost
Now looking at crude…
Crude Oil Landed Cost Calculation
Crude oil prices are usually quoted at the loading port at the point of origin or at a meter transfer point in a pipeline for domestic sourced material. To get the “landed crude cost” at the refinery gate, transportation charges, duty payments, shipping losses and insurance need to be added to the quoted cost at the loading port.
In this example of an imported set of crude oils. The cost for the crude at the loading (FOB- Freight on Board) port is used as a basis. Then the freight, duties, insurance & loss are added to the cost – as well as a credit charge for capital tied up while the crude is “on the water.”
Crude costs generally account for 65 percent to 70 percent of total refinery costs.
- Refiners either purchase crude from third parties or, in the case of integrated companies, produce crude from their own production properties.
- Crude oil quality is another key variable. Heavy, high-sulfur crudes can cost up to one-third less than lighter, better crudes. However, because high-sulfur crudes require more processing, refineries that buy primarily cheap crudes incur more fuel costs and fixed expenses for maintenance and labor.
Refinery Gross Margin
In summary, the landed cost of the crude is subtracted from the netback product mix value value (Calculated on the previous page) to result in the refinery gross margin (or refinery profitability).
Another commonly used margin is called the refinery ”semi-variable margin.” Here the variable refinery operating costs are also subtracted in the margin calculation.
There are numerous ways to calculated refinery margin throughout the industry.
Global Refining Margins
A key driver of refiners margin is the differences in global supply/demand fundamentals.
The graph from BP shows that the refining industry has generally experienced strengthened refining margins in each of the main refining regions over the last two to three years. Note the margins are not gross margins but are calculated on a “semi-variable” basis, i.e. the margin after all variable costs and fixed energy costs. Note also that the margins vary on the type (or complexity) of the refinery.
United States refining margins often outperformed those of European and Southeast Asian refiners, but margins in all regions are well above the levels of the previous three to five years. One reason for this divergence is the fact that gasoline supplies in the US have been very tight causing high prices.
Another key reason for the strengthening of margins is global refinery utilization rate. Given the current economic environment and limited spare capacity in the global refining system, utilization rates have been in the 90 percent range in the early 2000’s.
The question for the refiner is whether these high margins are a paradigm shift or whether we will revert to the (much lower) historic levels.
Refinery Profitability
Refineries with different types of processing units can produce very similar products but with different costs. Refinery costs generally fall into one of three categories:
Refinery maintenance and other fixed operating costs – Costs that are largely independent of refinery throughput but which are both regionally and locally site-specific. These are generally manpower, maintenance, overhead, insurance and taxes.
Refinery processing costs that are variable costs – Costs that are throughput-dependent and include catalysts, chemicals, utilities, power, and refinery fuel. However, since the last usually is produced on site and may be refinery gas or fuel oil, it is usually considered as part of the refinery overhead costs. Some so-called variable costs such as catalysts, chemicals, and fuel are not strictly throughput-dependent, but are assumed to be for most general calculations. Variable costs are higher when a refinery runs a heavy-sour crude oil.
Overhead and other types of indirect costs – Costs that generally relate to overhead costs that cannot be directly allocated to products produced. These costs generally do not vary directly with production levels and therefore are primary fixed costs. Examples of these types of costs are depreciation and working capital.
The level of refinery operating costs will depend on many factors and will be directly related to the complexity and the size of the refinery. For example, variable costs can be greatly influenced by purchased utilities costs, which will depend on local pricing policies. Catalysts costs will be influenced by the type of feedstocks processed. Local and regional labor rates will greatly affect fixed costs. The size of the refinery will also affect the fixed per-barrel costs. Modern centralized controls rooms, for example, result in fewer personnel needed to operate the refineries.
Fixed Costs of Refining
Fixed costs — Costs that are largely independent of refinery throughput but which are both regionally and locally site-specific.
The fixed cost categories are defined in the pie chart. The costs are defined at a point in time because of the impact of labor and inflation on the key items.
Refining Return on Investment (ROI)
A positive gross refinery margin does not always mean that a crude oil can be profitably run in a particular market. In order to understand the full implication of processing a crude, a capital recovery cost must be included.
A capital recovery cost is that cost needed to justify new investment and is based on:
- The investment cost for the refinery
- A return on investment or hurdle rate return needed to justify replacement or new investment
The hurdle rate return on refining investment varies by a company’s assessment of the risk associated with the investment. It can range between 10- 15% per annum (after tax).
Regulation Trends in Refining
All segments of the oil and gas industry are subject to significant regulation in all parts of the world. Refining is one of the most regulated segments, with rules covering refinery emissions and requirements for cleaner gasoline and diesel.
US focus on regulation began with removal of lead from gasoline began in the 1970’s in response to passage of the 1970 Clean Air Act. The Clean Air Act also targeted other air pollutants: carbon monoxide, nitrogen oxide, volatile organic compounds, sulfur dioxide and directly emitted particulate matter (soot).
Starting in the 1990’s US refineries were designed to deliver a full range of gasoline fuels that help reduce vehicle emissions. Special reformulated gasoline mixtures are designed for specific areas of the country where the levels of various pollutants are high. There are now over 60 grades of gasoline blended for various parts of the US.
US Refineries are currently working to reduce sulfur in gasoline and diesel fuel, and incorporate a federal mandate to include ethanol in motor fuels.
The industry is currently and actively lobbying governments around the world to develop a standard way of measuring CO2 emissions from refineries, so that they have a clear understanding of the capital requirement to meet new CO2 emission standards.
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I would like to thank you for the brilliant interactive Oil 101 materials. I did use it to prepare for the recruitment process in Royal Dutch Shell, and I managed to take a new role in the oil and gas industry:)