Industry Profiles: Petroleum Refining

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Industry Profiles: Petroleum Refining

Overview

While oil companies remain some of the largest companies—and in a few cases the most profitable—in the world, the industry has faced a number of challenges in recent years, including low prices in the late 1990s (due to a large supply and slack demand), and costly environmental restrictions to curtail the industry's harmful effects on the earth's natural resources. Amidst these conditions a rising level of consolidation marked the industry, as companies joined forces in an increasingly challenging business climate. For example, British Petroleum acquired Amoco Corp. in 1998, followed by Atlantic Richfield Co. (ARCO). In 1999 Mobil and Exxon joined in what, at the time, was the largest merger on record, forming Exxon Mobil Corp. Finally, in 2001 Chevron acquired Texaco, forming ChevronTexaco.

After consistently low prices into the late 1990s, when crude oil prices reached $11.97 per barrel in 1998 and $17.51 in 1999, prices rose more than 57 percent to $27.52 in 2000. That year, North American refineries collectively produced an average of 14.3 million barrels of refined petroleum products each day. This level was expected to remain flat in 2001. From 1990 to 1997 U.S. production grew by about 10 percent, while capacity rose by just two-tenths of a percent. This improvement indicates the industry's renewed emphasis on cost efficiency, as it's usually less profitable to operate a refinery below capacity. U.S. refinery production in 1997 stood at 93 percent of the industry's installed capacity of 15.705 million barrels per day, up from an 84-percent utilization rate in 1990. After rising to almost 96 percent in 1998, utilization rates remained steady at approximately 93 percent in the late 1990s and early 2000s, when estimated capacity had increased to 16.52 million barrels per day. In 2000, North American countries supplied almost one-fifth of the world's oil, ahead of European countries, which supplied about nine percent.

It's not so much volume growth as depressed prices that have adversely impacted the industry. In 1990 wholesale prices of gasoline, by far refineries' largest end product, averaged 78.6 cents per gallon. After falling as low as 59.9 cents in 1994, by 1997 prices had rebounded to 70.0 cents per gallon. But when inflation is factored out, 70.0 cents in 1997 would equal just 57.8 cents in 1990 dollars, amounting to a real decrease in gasoline prices of more than 26 percent over the eight years. After 1997, wholesale gasoline prices (including inflation) fell sharply again in 1998, reaching 52.6 cents per gallon. However, by 1999 and 2000 prices were rising, reaching levels of 64.5 cents and 87.9 cents, respectively.

The industry is dominated by a handful of huge oil conglomerates, sometimes known as the "majors," that are involved in crude oil production as well as refining, distribution, and retail sale of petroleum products. Below them is a second tier of independent refiners, some of which are quite large in their own right. The leading U.S. oil companies include Exxon Mobil Corp. and Chevron-Texaco.

History of the Industry

The use of semi-refined fossil fuels dates back several millennia before the common era. From ancient Mesopotamia, 6,000-year-old inscriptions include descriptions of oil and asphalt use as waterproofing materials. Egyptians embalmed their dead in asphalt, and Romans wrote by the light of oil lamps and drove chariots with wheels lubricated by crudely refined greases.

The invention of the kerosene lamp by Dr. Abraham Gesner of Pittsburgh prompted the formation of the Pennsylvania Rock Oil Company in 1854. During this time Americans sought alternative lamp fuels in response to a shortage of whale oil. Dr. Gesner extracted his "improved illuminating oil" from coal, but his methodology proved invaluable to petroleum refining's founding father, Benjamin Silliman, Jr., who wrote a treatise on the chemistry of petroleum in 1855 and then promptly figured out how to distill it. Steam was introduced into the distillation process in 1858. In 1860 the first semi-continuous refining system, operating in a battery of stills, was patented by D.S. Stombs andJulius Brace of Virginia. Luther Atwood cracked petroleum later that year, and Jean Lenoir then produced a three horsepower motor, which ran on benzene. The first full-fledged refinery began production in 1861 near Titusville, Pennsylvania, adjacent to the site where Edwin Drake and W.A. Smith had discovered the first producing oil field in the country at Oil Creek. The refinery churned out little except kerosene; contemporaneous demand for lubricating oils and greases wasn't high enough to keep anyone in business, and petroleum as a transport fuel was still several decades away.

Julius Hock's invention of the noncompression petroleum engine in Vienna in 1869 perhaps marked the beginning of the modern refining process, as engine fuel would become the primary vehicle for petroleum markets worldwide. "Horseless carriages"—powered by burning hay, steam, or electricity until Frank and Charles Duryea built the first gasoline-powered automobile in 1892—eventually became the channel through which refined petroleum captured public attention. The internal combustion engine, invented early in the twentieth century, and then Henry Ford's production of the Model T, suddenly brought petroleum to a pinnacle of economic significance.

In the early part of the twentieth century new technology was developed in petroleum-driven locomotion; automobiles, airplanes, and military vehicles proliferated as petroleum exploration and refining outpaced itself annually. Intense demand for petroleum products during World War I led to production facilities that would continue to produce innovations even after the war; solutions to agricultural, industrial, and transportation problems came with each new piece of understanding about the capabilities of a barrel of crude. Even food supply was drastically affected, as gasoline powered tractors enabled farmers to increase their productivity, and asphalt surfaces on highways allowed diesel-powered trucks to speed goods to market.

World War II also prompted an upsurge in refining capacity, yielding subsequent massive peacetime productivity. American consumers during the 1950s demanded large, stylish automobiles, warm houses, and air travel. For nearly three decades, Americans found uses for more refined petroleum. The "more is more" credo became refining's byline; a constant, steadily increasing demand for new products was met by the constant, steadily increasing supply of new crude oil supplies. Unfettered by environmental controls or financial limits, refiners expanded and enjoyed a long, golden age of prosperity.

Then, in 1973, a political crisis in the Middle East spurred a severe recession and highlighted the extent to which the United States had become dependent of foreign oil supplies. Furthermore, the fall of the shah of Iran in 1979 precipitated a series of supply interruptions and price increases. Overcompensating for the shortages brought on by Iran's domestic turbulence, refiners misjudged the oil demand for the early 1980s. While worldwide refining capacity increased tenfold between 1938 and 1981, "more is more" no longer held true, and in the 1980s refiners faced a loose market with substantial excesses in place.

Refiners entered the 1990s burdened by unpredictable supply and demand factors and the potential business consequences of the burgeoning environmental movement. Such issues as recycling, the hole in the ozone layer, and water pollution became an increasingly more importantt part of the U.S. legislativ agenda. Consequently, the business strategy of refiners shifted to finding cleaner-burning, more efficient fuels for smaller cars, as well as finding more environmentally friendly ways in which those fuels could be created.

Significant Events Affecting the Industry

One legislative package designed to address environmental pollution has had a significant impact on the industry. The Clean Air Act Amendments of 1990 required that the United States' 39 smoggiest cities substitute oxygenated gasoline for winter use beginning in November 1992. By 1995, the country's nine smoggiest cities—Baltimore, Chicago, Hartford, Houston, Los Angeles, Milwaukee, New York, Philadelphia, and San Diego—were to have implemented its Phase I specifications. Phase I stipulated that oxygenates (MTBE) be substituted for aromatics (which don't burn completely) in octane enhancers, essentially prescribing complete reformulation of automotive gasoline.

This new gasoline was required to have a minimum oxygen content of 2 percent by weight, a maximum of 1 percent benzene by volume, a maximum aromatics content of 25 percent, and no heavy metals. It could not cause an increase in nitrogen oxide emissions and must create less tailpipe emissions of volatile organic compounds and toxic air pollutants (relative to a baseline of 1990 summertime gasoline). The cost to refiners of implementing substitutions and reformulations prescribed in Phase I was estimated to run $3 to $5 billion.

Furthermore, the California Air Resources Board (CARB) instituted standards exceeding those of the Clean Air Act, requiring them to be met by 1996. Some analysts predicted the CARB standards would eventually replace Clean Air standards nationwide.

Costs of compliance prompted a spate of refinery closures in the early 1990s, including five smaller company sites in 1992, representing a total of 145,000 b/cd capacity lost. More streamlining was required of major companies, particularly Chevron. Chevron drastically scaled back operations at its Port Arthur, Texas, refinery (140,000 b/cd lost) and cut its Richmond, California, refinery capacity by 40,000 b/cd.

By the early 2000s, environmental concerns had developed over the use of MTBE (which is a possible carcinogen, according to the U.S. Environmental Protection Agency). One way that MTBE posed an environment threat was the contamination of groundwater supplies. The government was exploring alternatives to using MTBE, including the use of ethanol. Additionally, many states passed legislation restricting or banning its use in the near future. Meanwhile, several oil companies claimed that they were capable of meeting environmental standards without using government-mandated substitutes like MTBE. One consequence of different regions using different formulations of gasoline in order to meet environmental requirements is that the dynamics of supply and demand become more complicated. If the government requires a rapid change to MTBE alternatives, it is possible that smaller oil companies will be forced out of business. This could lead to a smaller supply of gasoline, and thus higher prices.

Key Competitors

The largest integrated oil company in the world (and thus the United States) by sales revenue is Exxon Mobil Corp. The massive oil conglomerate also holds the distinction of being the United States' second-largest corporation in terms of annual sales, behind Wal-Mart Stores. In 2001 it weighed in with $191.6 billion in sales. That year it posted a healthy profit of $15.3 billion, an eight-percent margin. Exxon Mobil, which employs 97,900 workers throughout the world, was formed through the 1999 merger of Exxon and The Mobil Corp. Mobil was formed in 1934 with the merger of Standard Oil Company of New Jersey and Anglo-American Oil Company Ltd. Exxon struggled to shake the fallout resulting from the Exxon Valdez disaster and other public relations debacles early in the 1990s. In the Valdez incident, an Exxon shipping vessel ran aground and caused a 11 million-gallon oil spill in Prince William Sound, Alaska, on March 24, 1989. The disaster caused significant environmental and economic harm to the region. The company also suffered from negative attention surrounding an early 1990s marketing campaign involving a tiger, which was criticized for being insensitive to animal rights.

Posting $104.4 billion in 2001 sales, of which $3.3 billion was net profit, ChevronTexaco Corp. gleans most of its revenue from petroleum operations. The San Francisco-based conglomerate originated from the 1911 break-up of the Standard Oil trust as Standard Oil Company (California), better known to some as Socal. In 1984 the company was renamed Chevron to correspond with its retail brand. In addition to its oil drilling, piping, and refining operations, Chevron operates more than 25,000 retail service stations bearing its name.

Industry Projections

According to data from DRI-WEFA reported in Standard & Poor's, from 2000 to 2005 crude oil prices are expected to fall about five percent each year and then grow at annual rates of approximately four percent. Contributing to these gains will be refined production originating from new crude oil reserves, which companies are constantly seeking to expand their businesses. In the early 2000s, major new exploration projects were underway at Exxon Mobil in the Gulf of Mexico, Asia, western Africa, and the Caspian Sea.

Global Presence

The major U.S. oil companies have operations spread throughout the world, and most own exploration and drilling properties on several continents. They also obtain significant shares of their annual sales from foreign markets, some of which are considered much more attractive than the United States because their demand for petroleum products is growing much more rapidly. Exxon Mobil, for example, only pulls in 39 percent of its net earnings from the United States.

Employment in the Industry

U.S. refinery employment has been edging downward for decades. In 2000 it stood at 80,690 people, which was down from 93,000 persons in 1998 and 120,000 in the late 1980s. Production workers in the industry earned an average of $21.63 per hour in 2000.