Long-Term Market Reactions to Oil

The Wall Street Journal ran a very interesting article on Tuesday regarding how the nature of gasoline refining has changed in the past 20-30 years. Due to lack of expansion of refining capacity, and growing demand, availability is tight, so margins have finally risen from their historic lows.

What I find most fascinating is how the article describes not just that refineries are being built, and large ones at that, but where they are going up.

India.

A man named Mukesh Ambani, chairman of India's largest private company, Reliance Industries, Ltd., "is building the world's largest refinery complex" on India's northwest coast, near Pakistan.

The article contains a few important facts which help us understand how the provision of various elements of the gasoline supply chain are changing, and why.

Years ago, one of my close friends was a now-retired senior oil executive at Exxon International. He was a lifer, having begun to climb the corporate ladder there right out of college as a petroleum engineer. Tony used to tell me how little Exxon had made on the refining of crude over the years. This, he said, had shaped Lee Raymond's views on running the company.

Now, the Journal reports, refining margins are around $20/barrel of oil. That's on barrels which are bobbing up and down in the $70 range, meaning a 28.5% gross margin. Not bad for an industrial commodity, both coming and going. Further, the larger refining margins mean that it is now very feasible for refiners to price shipping the crude to, and the gasoline from, their refineries. Thus, the Indian connection.

Finally, an eye-opening little piece of information. In 2000, America imported less than 8% its gasoline. By last year, that number had risen to 11%. It is now at 13%. A 63% rise in the volume of gasoline imported by the US in six years.

Thus, Mr. Ambani's bet. But, he's not alone. Worried about American oil companies not building a new onshore refinery from scratch in 30 years? Maybe you shouldn't be. Mr. Ambani's partner in the latest refinery venture is- Chevron, the merged entity that was one Chevron and Texaco. The article also mentions, as part of the wave of planned refineries worldwide, that Exxon, ConocoPhillips, and Total, SA, are all in talks with Saudi Aramco to build new refineries as well.

As the article points out, these offshore refineries will solve two vexing problems for US gasoline supply. One is geographical concentration. By taking advantage of relatively inexpensive shipping costs, as a percentage of the new refining margins, these new refineries will spread the risks of weather, specifically hurricanes, knocking out large amounts of US refining capacity, or distribution facilities. Further, they are being designed to refine high-sulfur oil. As the classic "light sweet" crude becomes less of the oil supply globally, on a percentage basis, these new refineries will provide more gasoline from currently harder-to-refine crude sources.

Finally, there is the matter of...ah....how does one put this delicately.....refinery construction and its impacts on the local environment. Americans don't want another smelly, belching industrial refinery located near where they consume all that gasoline. But, being the economic creatures that we are, we are more than happy to pay Indians to allow those belching refineries to be located, built and operated on their less-discriminating shores.

In a way, although most people don't consider process industries quite like they do finished goods industries, it's just like what happened with steel and other basic metals operations. Third- or second-world countries are more than happy to get the jobs that are created when you have to erect and operate the world's largest oil refining complex. And they will gladly offer their less-stringent environmental quality constraints in the bargain.

Mr. Ambani is assembling a workforce of 150,000 people to erect the new refinery by December, 2008. According to the article, "two years ahead of many projects that others are planning." Read that to mean, "able to reap the full measure of gains by being the first guys on the block to refine high-sulfur crude into American-bound gasoline at still-bloated margins."

God bless 'em, the Indians went our way, rather than tilting toward the Russian socialists after all! They know a huge profit when they see it, and they go for the jugular.

And, in a beautifully seamless piece of "best practices" engineering, Ambani's team is simply unrolling the very same blueprints for their first mega-refinery on the site, and building it again right next door! How brilliant is that? Everyone who's ever done home construction or renovation knows all too well that much of the cost and time of those projects come from customer indecision and changes in the plans while building is underway. The Journal pieces cites the expected cost/barrel of the refining capacity being constructed by Mr. Ambani to be $10,300, or "about a third lower than the estimated cost of building the two big refineries planned for Saudi Arabia" with Exxon, Total and ConocoPhillips. So, not only do the Indians offer their environment to the cause of global gasoline supply, but their cheaper, though more productive, labor as well. And think of what all those labor dollars in India will be buying- more finished goods! Talk about a virtuous circle.

To top all of this great news off, Mr. Ambani and his 29% partner, Chevron, already have factored in the effects of the rush to supply American's with more gasoline by the decade's end. Between the various new refinery projects on the drawing board, and the expectations of US gasoline demand growth to slow after the next few years, due to ethanol and hybrid cars, the partnership expects the profit opportunities in the American market to change in a few years.

By building this super-refinery in India, they are well positioned to supply China and.....India!

Thank God, Adam Smith's invisible hand is at work, as is Joseph Schumpeter's view of creative destruction. As the US onshore petroleum refining business becomes too expensive and constrained to effectively compete globally, those US companies engaged in the business move their operations overseas, to where it's economical to build and operate new, better-designed refineries for today's oil supply. It isn't going to be just your shirts, shoes or computers that are built with components and subassemblies shipped around the world anymore. Soon, the gasoline in your car's tank will have been around the world to get to you, too.

Oh, and one last point. No US senators, congressmen, or cabinet secretaries were involved in the provision of this new gasoline supply. Leave it to the market, and you'll get a better solution every time.