Wednesday, March 31, 2004

The Dismal Segment
Just as economics is the "dismal science", petroleum refining is the dismal segment of the oil business. I started my career as a refinery process engineer, and it took me years to outgrow the pessimism that my two years there instilled in me. After all, if you are a refinery executive, on your best day the facility is running flawlessly, making some money and churning out product, but it's all downhill from there. It's the rare plant manager who hasn't been awakened at 3:00 AM by a phone call informing him of a serious problem or accident, and refinery accidents tend to be spectacularly attention-getting.

Business Week recently carried an excellent article on the current state of the US refining business and its contribution to high gasoline prices. The short version of the story is that refining capacity has been overextended through a combination of high demand, complex and conflicting regional gasoline specifications, and the impact of environmental regulations on the facilities themselves. It sounds bleak, but it is also generating healthy profits in a part of the business that until a few years ago was a perpetual "dog."

In the past, the normal cycle for the refining industry was that any period of high margins would be followed by heavy investment in new capacity. Rather than new refineries, of which I believe only one has been built in the US since 1971, this usually meant adding or expanding "cracking units", expensive hardware that turns low value byproducts into high value gasoline and diesel fuel. After each wave of capacity addition, gasoline production would increase and--surprise--prices and margins would drop, just as you'd expect in a competitive business. I doubt there were many US refineries that achieved better than a 5 or 6% return on average capital employed in the 1990s, when you could earn that much investing in T-bills.

What appears to be happening now, contrary to the recurring suspicions of collusion mentioned in the article, is the end result of environmental and permitting regulators having achieved their implicit goal of limiting refinery expansions. In the process, they have saved the refinery owners from themselves in a way they could never have done on their own, by breaking the cycle of unprofitable capacity additions.

So when you pull into the gas station and grumble at the high prices, in addition to cursing OPEC, you might make a mental note that you are at last paying a premium for the cleaner gasoline that has helped to improve air quality in many of our metropolitan areas. If you live in Southern California and are old enough to remember Second-Stage Smog Alerts (23 of them in 1978 and not one since 1988), you know exactly what I mean.

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