What Is an Oil Refinery?

An oil refinery is an industrial plant that transforms, or refines crude oil into various usable petroleum products such as diesel, gasoline, and heating oils. Oil refineries essentially serve as the second stage in the crude oil production process following the actual extraction of crude oi up-streaml, and refinery services are considered to be a down-stream segment of the oil & gas industry.

The first step in the refining process is distillation, where crude oil is heated at extreme temperatures to separate the different hydrocarbons.

Key Takeaways

  • An oil refinery is a facility that takes crude oil and distills it into various useful petroleum products such as gasoline, kerosene, or jet fuel.
  • Refining is classified as a downstream operation of the oil & gas industry, although many integrated oil companies will operate both extraction and refining services.
  • Refineries and oil traders look to the crack spread - the relative different in production cost and market price - of different petroleum products in the derivatives market, to hedge their exposure to crude oil prices.

Understanding Oil Refineries

Oil refineries serve an important role in the production of transportation and other fuels. The crude oil components, once separated, can be sold to different industries for a broad range of purposes. Lubricants can be sold to industrial plants immediately after distillation, but other products require more refining before reaching the final user. Major refineries have the capacity to process hundreds of thousand barrels of crude oil daily.

In the industry, the refining process is commonly called the "downstream" sector, while raw crude oil production is known as the "upstream" sector. The term downstream is associated with the concept that oil is sent down the product value chain to an oil refinery to be processed into fuel. The downstream stage also includes the actual sale of petroleum products to other businesses, governments or private individuals.

According to the U.S. Energy Information Administration (EIA), on average, U.S. refineries produce, from a 42-gallon barrel of crude oil, about 20 gallons of motor gasoline, 12 gallons of distillate fuel, most of which is sold as diesel fuel, and 4 gallons of jet fuel. More than a dozen other petroleum products are also produced in refineries. Petroleum refineries produce liquids the petrochemical industry uses to make a variety of chemicals and plastics.

Pertroleum products made from a barrel of crude oil

Cracking Crude Oil

An oil refinery runs 24 hours a day, 365 days a year and requires a large number of employees. Refineries come offline or stop working for a few weeks each year to undergo seasonal maintenance and other repair work. The EIA regularly publishes lists of planned refinery outages in the United States. A refinery can occupy as much land as several hundred football fields. Famous oil refining companies include the Koch Pipeline Company, and many others.

Crack or crack spread is a trading strategy used in energy futures to establish a refining margin. Crack is one primary indicator of oil refining companies' earnings. Crack allows refining companies to hedge against the risks associated with crude oil and those associated with petroleum products. By simultaneously purchasing crude oil futures and selling petroleum product futures, a trader is attempting to establish an artificial position in the refinement of oil created through a spread.

The Nelson Complexity Index (NCI) is a measure of the sophistication of an oil refinery, where more complex refineries are able to produce lighter, more heavily refined and valuable products from a barrel of oil.

The proportions of petroleum products a refinery produces from crude oil can also affect crack spreads. Some of these products include asphalt, aviation fuel, diesel, gasoline, and kerosene. In some cases, the proportion produced varies based on demand from the local market. 

The mix of products also depends on the kind of crude oil processed. Heavier crude oils are more difficult to refine into lighter products like gasoline. Refineries that use simpler refining processes may be restricted in their ability to produce products from heavy crude oil.

Refinery Services

Oil refining is a purely downstream function, although many of the companies doing it have midstream and even upstream production. This integrated approach to oil production allows companies like Exxon (XOM), Shell (RDS.A), and Chevron (CVX) to take oil from exploration all the way to sale. The refining side of the business is actually hurt by high prices, because our demand for many petroleum products, including gas, is price sensitive. However, when oil prices drop, selling value-added products becomes more profitable.

There are some purer refining plays, like Marathon Petroleum Corporation (MPC), CVR Energy Inc, (CVI) and Valero Energy Corp (VLO). These companies enjoy lower energy prices, and benefit from stronger U.S. production because crude can’t be exported; only the refined products can be. This means that refiners have the whole of the shale oil supply to work with, and their input costs have dropped with the new supply.

One area service companies and refiners agree on is creating more pipeline capacity and transport. Refiners want more pipeline to keep down the cost of transporting oil by truck or rail. Service companies want more pipeline because they make money in the design and laying stages, and get a steady income from maintenance and testing.

Oil Refinery Safety

Oil refineries can be dangerous places to work at times. For example, in 2005 there was an accident at BP's Texas City oil refinery. According to the U.S. Chemical Safety Board, a series of explosions occurred during the restarting of a hydrocarbon isomerization unit. Fifteen workers were killed and 180 others were injured. The explosions occurred when a distillation tower flooded with hydrocarbons and was over-pressurized, causing a geyser-like release from the vent stack.