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Crude Lessons About Oil


All crude oil is not created equal. No one knows that better than the world's refiners. The markets generally track a type of oil referred to as "light, sweet" crude. But while this fast-flowing, low-sulfur variety is in tight supply and goes for roughly $50 a barrel, there's a veritable ocean of thicker, lower-quality crude being pumped out by Saudi Arabia, Mexico, and others that currently sells for as little as $35 a barrel.

The problem is that the world can't just switch from one to the other. "Heavy, sour" oil is more complex and costly to convert into useful products such as gasoline and heating oil. And much of the world's refining capacity, particularly in Asia, simply can't process it. "There's no shortage of crude oil today," says Thomas D. O'Malley, chairman of Premcor Inc. (PCO), a refiner based in Old Greenwich, Conn. "There is a shortage of light sweet."

The result is that the price of oil -- and of products made from it -- is higher and more volatile than it might be if there were more capacity for handling the heavy, sour stuff. In the meantime, refiners that specialize in the cheaper grades -- such as Valero Energy, Premcor, and Frontier Oil (FTO) -- are reaping rich rewards. Valero Energy Corp. (VLO) figures that lower-cost oil, together with higher refining volumes, helped boost its third-quarter income by $480 million. "It's a way we can increase our profits, but it doesn't cost consumers a penny more," says Valero spokeswoman Mary Rose Brown.

These higher profit margins are beginning to cause refiners to switch over existing capacity to handle the growing flow of lower-cost crude. New oil coming to the market from such places as Saudi Arabia, Russia, and Canada is increasingly of this type. But upgrading existing refineries to handle low-grade crudes can cost hundreds of millions of dollars per facility and take several years. That's a tough sell in a historically low-margin, cyclical industry. Timothy M. Donohue, a principal at Booz Allen Hamilton Inc., figures the $8 to $10 per barrel discount for heavy crude would have to remain for up to seven years to justify a large-scale shift.

REFINED REFINERIES

Independent refiners such as Valero are willing to take risks. Unlike big integrated oil companies, such as Exxon Mobil Corp. (XON), which control about one-third of U.S. refining capacity, independents don't have their own oil supplies. So while Valero already depends on heavy and sour grades for 70% of the oil it refines, the company wants to handle more. Last year the San Antonio-based company spent $340 million upgrading its Texas City refinery near Houston to allow it to handle greater volumes of the low-cost oil, thereby reducing the cost of its feedstocks, says Senior Vice-President Gene Edwards. Premcor is following suit by upping its capacity for low-grade crude by 30% with a $250 million investment in its Port Arthur (Tex.) plant.

Increasing refiners' ability to handle heavy, sour crude, while important, won't dramatically boost industrywide output. For that, industry experts say, what's needed is investment in brand- new refining capacity -- and few major additions are in the works. Even refiners' healthy profits of late don't justify the multibillion dollar costs of a new refinery, says analyst Jeffrey A. Dietert of Houston-based investment bank Simmons & Co. International. "In the long run," says William Hauschildt, vice-president of refining operations for ChevronTexaco Corp. (CVX), "refining hasn't matched the return on capital employed compared to other industries."

As a result, analysts expect refining capacity to stay tight -- and margins healthy -- for the next few years. Analyst Jacques Rousseau of Friedman, Billings, Ramsey & Co. (FBR) predicts that total U.S. refining capacity will grow by only 0.5% a year from 2004 through 2006. Meanwhile, U.S. demand for gas and other refined products will grow by 1% to 1.5% per year. Imports will take up the slack, but overseas refining capacity is expected to grow more slowly than demand, too. No matter how you look at it, heavy, sour crude won't offer consumers sweet relief from rising oil prices anytime soon.

By Wendy Zellner in Dallas


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