Why The US Government Should Build More Oil Refineries

The Americans are in a complete frenzy. They might have to pay European prices for their gasoline soon and they don’t like it. They don’t like it at all. However, it’s all their own fault.

The price of gasoline is rising sharply and most people expect it to hit $4 a gallon very soon. Refineries are running at less than 95% capacity utilisation and gas stocks are falling. The latest data showed that gasoline stocks at the start of May were around 6% lower than at the same time last year.

The bottleneck has been in refining capacity. Indeed, there hasn’t been a new refinery built in the US since 1976. Many have been closed since then and those that have been left have been snapped up in a massive wave of consolidation - so a few, powerful players remain in the industry. The only way capacity has been increased is by efficiency savings at pre-existing plants.

With the US abuzz about the lack of refining capacity why doesn’t the county simply build more refineries? Isn’t it a bit of a no-brainer?

First of all we need to look at the cost of a new refinery. Thankfully, some recent newsflow can help us here.

On 15 May, India's Essar Global unveiled plans to build a 300,000-barrels-a-day refinery in Egypt. The cost was estimated at $3.4bn and it is expected it to come on stream in 2010.

Excellent, so we have a figure. However, this refinery is being built in Egypt. In the US, there are significantly more environmental regulations. The cost will be higher because of all of this red tape. So, let’s conservatively assume it takes $3.5bn and three years to bring a new refinery to full operation in the US. This is a significant barrier to entry.

Money, money, money

Who exactly is going to pay this $3.5bn? The integrated oil companies? The independent refiners? The government?

The main problem with the refinery part of the upstream oil process is that margins are lower than the other parts of upstream production. For example, Valero (VLO), which is a pure refinery and oil retail play has a trailing 12-month gross margin currently standing around 12%, according to Reuters’ data. For Tesoro (TSO) it is less than 10%. If we take an oil refiner such as BP, its trailing 12-month gross margin is more like 20%.

Quite frankly investing in refinery capacity is not attractive to integrated oils because it is a lower margin business than most of the rest of their other operations. Margins also tend to fluctuate significantly with the oil price. When margins are thin this is a risk.

I also believe that pure refinery companies like Valero and Tesoro will not want to invest in new refineries. It’s quite simple to see why – it’s down to basic economics. Increasing capacity in the system would increase the supply of oil to the market. This would, in turn, reduce the price of gasoline at the pump, which would hit refiners’ margins hard.

So, building a refinery would mean spending an enormous wad of cash - the result of which being that margins in your business shrank further. It is simply not in the interests of any oil company – be it integrated or a pure refiner - to build such a refinery.

So, that leaves the government. If anyone is going to do it would have to be them. However, state control is anathema in the US; it’s a little bit “Commie” isn’t it? Didn’t Joe McCarthy get all those reds under the bed and flush them all away years ago? Surely we can’t have any of those Commie-types in charge of vital oil refiners.

OH YES WE CAN….

Things get even crazier. Did you know that Hugo Chavez owns a significant amount of US refinery capacity? Yes, that’s right, the slightly mad one that hates America.

Venezuela’s state oil company owns Citgo Petroleum. Citgo is not only a gasoline retailer in the US, but it also owns SEVEN oil refineries across the country. Senator McCarthy is probably spinning in his grave.

However, Hugo Chavez has said that he ultimately planned to sell off these refineries and build more in Asia. So the Commies won’t be around for much longer. These refineries are likely to be bought by the current big players in the industry, tightening their stranglehold and ensuring no more refineries get built privately.

Now we have to look to the Middle East, where refinery capacity is set to explode.

The Middle East is expected to propel its refining capacity above that of Russia and the former Soviet republics. Aggressive refinery building is expected to boost capacity in the Middle East by a staggering 60%, according to a study published by oil consultancy Wood Mackenzie. This would result in the Persian Gulf being the main exporter of finished petroleum products in the entire world.

This is utterly, utterly crazy.

This means that the US would be even more dependent on the Middle East, going against its stated policy of become less reliant on foreign oil. Instead of importing crude, they will be importing refined oil products. I believe this is a retrograde move.

The only answer is for the US government to operate their own state-owned refineries – no matter how “un-American” this is. The Bush government has been able to find enough cash to spend on the war in Iraq. Indeed, the New York Times has put an estimate of $1.2trn on the war so far...that’s enough to build more than 350 refineries.

If I was an American I would be really concerned about the fact that all the cards in the refinery pack were being dealt in the Middle East. This cannot be good in the long run for the country’s energy policy. I do not believe any private or publicly-quoted oil company will build a new refinery in the US. It’s not in their interests. The government will have to do it.

So, come on you bunch of short-sighted doofuses, build a federal oil refinery. If you don’t, you’re saving up a whole load of problems for the future…

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