Energy is leading the market in 2021 after a miserable year where it lost 32.6%. The energy sector of the S&P 500, as measured by the Energy Select Sector SPDR Fund (XLE), is already up 39.8% through March 5, which dwarfs the S&P 500’s return of 0.33% so far this year.
Investors must ask: Why is the energy sector outperforming, how does the petroleum refining industry that drives it operate and can the momentum continue?
This comprehensive research report introduces the petroleum refining industry and breaks down its structure, firm conduct, performance and trends to watch going forward.
The petroleum refining industry encompasses the market involved in products derived from the refining of crude oil. These products span a wide range including gasoline, diesel, jet fuel, petrochemicals like benzene and toluene, and heavy products such as asphalt.
The refining process entails the processing of crude oil through heating and separating chemicals at different boiling points (fractionation) in a distillation column, and from there, the resulting products are either used directly or changed once more by heating up the individual chemicals to certain points to break down the molecules (cracking). This process allows for a barrel of crude to be turned into a wide variety of products that can be sold.
However, not all refineries are built equally, and some don’t have the technology to produce all the products listed above. Some, such as simple refineries, are geared toward producing gasoline, though the U.S. tends to have complex refineries that produce the majority of potential products.
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From a supply standpoint, refineries use crude oil that’s produced by drilling. For most of the industry’s history oil was produced from vertical wells, but in the past 15 years or so, new techniques like hydraulic fracturing (fracking) are freeing up oil from shale rocks, and horizontal drilling is allowing for more areas of oil pockets to be explored, thus increasing production of crude.
While products derived from crude have been used for thousands of years such as asphalt used to caulk ships, the refining of crude really got its start in 1859 after the successful commercial drilling for crude oil in Titusville, Pennsylvania. At the time, the only major product produced in the refineries was kerosene for lighting.
Standard Oil eventually came to dominate the refined products market from its founding in 1870 until it was broken up in 1911. Initially, the company was only involved in refining, but through vertically integrating by building its own pipelines and oil wells as well as using technological innovation to reduce waste and lower costs, Standard Oil was able to drive prices down to the point where competitors exited the market. In fact, at one point, the group controlled 90% of the kerosene refined product market.
This eventually attracted the attention of the Department of Justice, which successfully argued Standard Oil violated the Sherman Antitrust Act, leading to the group’s breakup in 1911. With the development of the internal combustion engine and the rise of the automobile in the late 1800s and early 1900s, new products became viable on the market, notably gasoline, breathing life into the industry.
During and after World War II, there was a push to build new refineries to meet growing demand from the war effort. After the war, the development of new technology such as polymerization allowed for the development of plastics, which took off in popularity. The period of building new refineries continued until the 1970s with the last major refinery built in 1977.
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The ’70s also saw the rise of OPEC, which came to dominate the crude oil industry until the late 2010s. The group engaged in supply cuts to drive up prices. Since then, environmental concerns and concerns about crude supply and prices have capped new major refineries in the U.S., with new capacity coming from expansions of existing sites, or from new small-scale refineries.
Looking ahead, new environmental regulations are presenting challenges for the industry, but products such as renewable diesel provide outlets for the industry to evolve. In addition, the rise of fracking is increasing U.S. crude production and driving prices down, which has helped profit margins in the industry over the past decade.
The petroleum refining space has a moderate degree of concentration with the top six firms controlling 85% of the market and top 4 holding 65%, as the chart using IBISWorld data shows, with the largest — Marathon Petroleum Corporation — holding 20.2% of the market.
This relatively split market share among a handful of players is reflected in the Herfindahl-Hirschman Index (HHI) index shown below, where an increase HHI reflects an increase in industry concentration while a decrease shows less concentration and more competition.
The petroleum refining market contains a wide array of products, with petrochemicals to fuels being the two main categories and many sub-products within it. However, this doesn’t mean that the market is highly differentiated since the individual products are produced with certain standards that result in a high degree of commoditization.
In addition, while refineries can make a wide range of products, they’re geared toward making gasoline and are not able to change output mixes by much.
With respect to elasticity of demand, gasoline, which is the most important product, is an inelastic product, meaning that changes in price don’t have as large of an impact on demand. That said, it’s important to know that it has been becoming relatively more elastic in recent decades in part due to substitutes for gasoline in the form of electric vehicles. Gasoline demand is also fairly seasonal, with demand picking up in the summer as people travel more followed by dips in the winter.
Other products, such as aromatic petrochemicals, tend to compete with each other on price leading to price elasticity, but they don’t make up a large component of volume or revenue. With respect to innovation, strides are being made in next-generation fuels, like renewable diesel and algae-derived fuels.
However, from a research and development (R&D) as a percent of gross-value-added basis, refined products are concerned to be a low R&D intensity industry with a score of 1.17%, according to the Organization for Economic Cooperation and Development.
The refining space is characterized as competitive, given that it’s an oligopoly. With respect to pricing, due to the commoditization from the products produced being standardized, it’s difficult to hike prices without excess demand or a lack of supply due to refinery outages, which would be a natural price hike. Imports make up 14.6% of domestic demand, according to IBISWorld, which puts a cap on price-hiking behavior.
Some may think that because of the concentrated nature of the industry, it would be easy to cut production or simply hike prices even while profitable. In reality, it’s very difficult to shut down production when in the short run it’s profitable, since the firm must cover the substantial upfront costs associated with building or buying a refinery and its equipment. The same high cost base to cover phenomena also means that if a competitor sees an opportunity to increase utilization (production), they will take it.
However, by having more products that can be produced from a refinery, firms can create optionality for themselves so they can indirectly cut production by switching output to products that are more profitable.
Firms in the space have roughly the same cost base with commoditized crude making up the most substantial component, so there are similar pricing movements coming between the players. That means that if crude prices go up, companies can reasonably pass costs along, knowing full well that the other companies must do the same without any particular company taking a lead.
As a result of these factors, barring idiosyncratic issues slowing production, there’s a landscape that resembles a competitive environment. With respect to merger behavior, there are very few mergers and acquisitions (M&A) between the major players within the refinery space with most acquisitions being purchases of individual refineries.
Due to environmental regulations and other factors, there hasn’t been a new major refinery since the 1970s. While there have been expansions within the past few years, little has been done on the oil refining side; natural gas for chemicals is the primary point of expansion.
The refinery space would best be categorized as a non-cooperative oligopoly since there’s a high degree of concentration among a few players split fairly evenly.
In addition, with respect to pricing, there’s no singular consistent price leader, and because of the product commoditization and the roughly similar cost base with an incentive to always be looking to boost utilization of existing capacity, there’s competitive pricing and production.
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There’s very little threat to existing firms from new entrants in the domestic market. As noted before, there are substantial capital expenditure costs involved with entering the refinery space. In addition, environmental regulations create structural costs in the industry. Case in point: There has been no major refinery built in the U.S. since 1977, according to the Energy Information Administration (EIA).
However, there’s a legitimate threat from overseas markets with independent Chinese operators that operate small simple refineries known as “teapots” entering the market in recent years. In fact, China has become a large exporter of refined products over the years, partly due to these independent firms.
Competition between existing players is fairly intense with the commoditization of products, the similarity of cost structure and the threat of imports.
However, the high barriers to entry because of substantial capital expenditure requirements and environmental regulations means that there are few companies and not much competition on a capacity standpoint. That means there’s not enough competition to build out capacity to the point where long-run profitability gets erased.
As alluded to before, from an upstream supply-side perspective, crude is fairly commoditized in the U.S. with many firms selling and no particular firm setting prices. However, OPEC does have a substantial impact on crude supply, and therefore prices, so refiners are still subject to the effects of their decisions.
From a downstream demand-side perspective, sales from a refinery are to any number of many wholesalers neither of which has outsized market share and eventually distribute to retailers or directly sell products to end consumers. As such, there’s not any party on the demand side with outsized influence to depress prices for refiners.
With respect to substitute products, consumers don’t really have any way of switching products such as fuels in the short run. Automobiles generally take specified fuels or plastics since they’re necessary and alternatives for plastics are generally less functional and more expensive.
That said, in the long run, there’s a threat on the fuel side from electric vehicles and a push for less plastic and more alternatives like glass or paper.
In California, such pushes have already resulted in refineries beginning to shut down, and West Coast refiners are looking to switch to alternatives like biodiesel. Similarly, in several Latin American municipalities, outright bans on plastics have been enacted.
Looking ahead, these threats are becoming more tangible, and eventually substitute products will become much more competitive.
Because of the nature of the refining sector — where most of the major companies are integrated firms with upstream segments — it’s difficult to differentiate refining side profit margin from the upstream side. However, there’s a proxy in the form of a crack-spread which looks at the ratio of a blend of products produced, like diesel and gasoline to crude oil inputs.
While it’s far from perfect, the crack-spread gives a good idea of what profitability looks like, and as the graph with EIA data below shows, it’s clear that from an economic perspective, there aren’t outsized long-run profits. This is in line with what would be expected from an oligopoly that competes; there are long-run profits, but they’re not outsized.
Due to standardization, there’s little product differentiation for a given commodity produced by a refinery. This results in a fairly competitive environment, as companies are unable to compete on product differentials.
However, companies that build more complex refineries can produce a wider array of products, which gives refiners the ability to cut production in one product and raise it in another as profitability dictates. With respect to innovation, as noted earlier there’s low effective R&D.
That said, looking into the future there’s innovation coming in the form of alternative fuels with renewable diesel appearing to be a viable candidate. In fact, Phillips 66 announced in August 2020 that it would convert its San Francisco refinery into a renewable diesel facility.
Unfortunately, this isn’t a growth space, since it’s a function of regulation resulting in a need to replace existing demand, so refiners are paying to convert facilities to satisfy existing demand.
In the U.S., the gasoline market is very mature and stagnant, with the graph of EIA data below showing that demand over the past 20 years has grown at a meager 0.4% annual compounding rate.
In the short run, as a recovery from the pandemic seems likely given the widespread distribution of safe and effective vaccines, gasoline demand will likely see a spike following a collapse in 2020. Fewer people traveled, commuted and went to school last year, but this increase will only get us to roughly 2019 levels in all likelihood.
Diesel demand, on the other hand, has greater ties to general economic growth and is expected to grow roughly 2-3% per year in the long run. From the chemical side, this will see growth roughly tied to the economy and export demand.
However, the prospect of exports to China are diminishing, as they’re beginning to build more chemical production capacity. As such, within a few years, demand will revert to general economic growth.
Christian Lebegue is a senior quantitative finance major. Contact Christian at firstname.lastname@example.org.
Disclaimer: I have no positions in any stocks mentioned and no plans to initiate any positions within the next 72 hours. Madison Business Review editor James Faris is a long-term investor in the Energy Select Sector SPDR Fund (XLE), which is an exchange-traded fund covering the energy sector of the S&P 500.
Additional disclosure: Investors are always reminded that before making any investment, they should do their own research on any name directly or indirectly mentioned in this article. Investors should also consider seeking advice from a broker or financial adviser before making any investment decisions. Any material in this article should be considered general information and shouldn’t be relied on as a formal investment recommendation.