Keywords

Capacity utilisation, profitability, refinery, downstream, crude oil.

Introduction

The oil industry consists of several vertically oriented segments. These include crude oil exploration and extraction, refineries which distil crude oil into other products, pipeline distribution networks, terminals which store the finished product near major cities, and tanker trucks which transport products to retail outlets [7]. According to [4] three sectors namely Up-stream sector, Mid -stream sector and Downstream sector form the oil and gas industry. The downstream sector, which is the sector that relates with consumers and which is the focus of this paper involves the refining of the crude oil and /or raw natural gases obtained from the upstream sector as well as selling or distributing the products obtained. A number of products are derived from the refining crude oil; these include diesel oil, liquefied petroleum gas(LPG), asphalt, petroleum coke, gasoline, fertilizers, antifreeze, plastics, rubbers, pesticides, synthetic rubber, jet fuel among others[4].

As noted by [11] refinery margins are the oil industry’s key performance indicator of downstream profit. Notwithstanding the worldwide context that led to a decline in world demand in 2011, investments in new refinery capacities continued to be made, however the downward trend in the refinery usage rates helped perpetuate conditions under which refining margins could not increase [15]. It is worthy to note that in 2012, while margins for Dubai hydro cracking decreased in the Singapore region that for Brent and Light Louisiana Sweet cracking improved. Negative refinery margins invariably lead to loss in income.

The problem at stake is; are refineries profitable? What factors influence or affect profitability of downstream oil industry? What is the relationship between capacity utilisation rates and profits of downstream oil industry especially in developing countries? This is the problem or issue that this study investigated

Laterature Review

Nature Of Refinery Operations

Crude oil which is the basic raw material for refinery processing is of no importance in its natural state to consumers until it is converted, processed or transformed into petroleum products that can be used in the market place. This according to [13] is done at an oil refinery where heat, pressure, catalyst and chemicals are applied under widely varying process designs, operating conditions and chemical reactions through physical and chemical methods. As asserted by [24], the petroleum refining industry transforms crude oil into more than 2500 refined products, including liquid fuels (from motor gasoline to residual oil), by-product fuels and feed stocks (such as asphalt, lubricants, gases, coke), and primary petrochemicals (for instance, ethylene, toluene, xylene). The economic importance of refineries can be seen by the products it generates. Table 1 shows the general products generated from petroleum refining and their uses.

Table 1: Petroleum products and their uses.

Product General Uses
Gas Naptha Domestic cooking, heating, motor fuel
Solvents, feed to petrochemicals (for plastics, fibres)
Gasoline Motor fuel, small aviation
Jet/Kerosene Diesel Jet fuel, domestic heaters, solvents, petrochemicals
Motor fuels, agricultural vehicles, small boats, trains
Fuel Oil Electricity production, bunker fuel
Lubricating Oil Lubricants
Bitumen Road asphalt, roofing materials

Source: [23]

Profitability Of Refinery

Net profit which is also called Net Income [22] is the key profitability indicator used to assess the refinery sector [3].Profits or losses are the resultant difference between the cost of inputs and the price of outputs. In other words the difference between Total Revenue and Total cost is the profit or loss depending on whether the difference is positive or negative. To attain a competitive advantage, a business unit or enterprise must produce higher-value products using lower-cost inputs than competitors so that its price will be highly competitive. In the oil refining business, the cost of inputs (crude oil) and the price of outputs (refined products) are both highly volatile, influenced by changes in global, regional, and local supply and demand as asserted by [6].

It has been found by [12] that a greater percentage of refineries both in the advanced and developing economies are profitable at a netback above four dollars per barrel ($4/Bbl) and incur losses below three dollars per barrel ($3/Bbl). Netback is the difference in price between the cost of the crude oil and the price of the product. A study conducted by [23] revealed that the profitability of refineries is related to the difference between the value of the products made by the refinery, the cost of buying crude oil and other associated costs incurred in the transformation process of the crude oil. It must be noted that both studies by [12] on one hand and [23] on the other failed to talk about other determinants of profits in particular, the quality of the final products of the refinery. This is because it has been proven in business circles that price is a function of quality. So if [12] had taken quality of the products into account the story or findings would have been different. In effect therefore, profitability of refineries is a function of the price of the product (which is also a function of other factors including product quality) made by the refinery, the cost of purchasing the crude oil, and the cost of processing the crude oil. Since the downstream oil industry requires huge capital investment it needs to make enough or above normal profits to provide adequate dividend to shareholders and to allow for reinvestment to maintain reliable and safe operations. To remain competitive and possibly achieve competitive advantage in the industry, downstream oil industry should be able to heavily do reinvestment and hence finance improvement projects.

Since the price of Crude oil and refined products is influenced by the interplay of supply demand and also transportation pressures in different regional markets refineries must carefully take into account and balance a number of competing factors in determining what type of crude oil to process, what kind of equipment to invest in and what range of products to manufacture [14]. [14] continued to explain that like every business organisation a refinery’s main aim is to maximise the revenue derived from refined products and minimise the crude oil feedstock in order to maximise profit. Harvest Operations Corporation should bear in mind that prices of oil are set by international markets, outside the control of the particular refinery.

The price for each product multiplied by the product yield of the total barrel of crude gives the Gross Product Worth (GPW) which is also known as Gross Revenue of the refinery. The gross revenue minus the cost of the crude oil gives the Gross refining margin. A refinery’s gross margin is positively related to its degree of complexity, which presupposes that the higher the complexity the higher the gross margin [2]. The refinery’s variable margin is obtained by subtracting the variable refinery costs from the Gross margin, while the Net cash margin is the resultant figure after deducting the fixed refinery costs from the variable margin [23]. It needs to be noted and emphasized that since the net margin is the refinery’s source of income necessary to provide a return on its past investments and to provide funds for future investments the refinery must ensure that it is always positive.

1

Figure 1 illustrates how margins can be calculated to obtain net margins for refineries.

Source: [23]

Explanation of Figure 1 above:

1. Product yields * Product prices = Gross Revenue

2. Gross Revenue – Feedstock costs = Gross Margin

3. Gross Margin – Variable refinery costs = Variable Margin

4. Variable Margin –Fixed refinery costs = Net Cash Margin (which is the income for future investments)

Table 2 Downstream Net Incomes(Profit) of the Five Major Oil Companies in the World (millions of dollars).

Company/Year 2007 2008 2009 2010 2011
ExxonMobil 9573 8151 1781 3567 4459
Chevron 3202 3429 565 2478 3591
BP plc 2617 4176 4517 7239 5474
Royal Dutch Shell plc 6951 446 3054 4448 4274
ConocoPhillips 5923 2322 37 192 3751
Total 28566 18524 9917 17924 21549

Source: Oil Daily, Profit Profile Supplements, various dates and company earnings reports.

From Table 2, the total Net Income from the World’s five major oil companies reduced from 2007 to 2008, reduced further in 2009, increased in 2010 and increased again in 2011. The significant thing to note is that they never achieved the 2007 figure of $28,566m in the years 2008, 2009, 2010 and 2011. The implication as can be seen from the above is that the performance by some of the individual companies generally was not improving. This may be due to factors like the price of the products, cost of the crude oil, the cost refinery and capacity utilisation. If any of the factors above is unfavourable it can adversely affect profit or Net income.

Capacity utilisation and profit

The [19] defined the term capacity as the maximum rate of output that a plant is able to produce under a given set of assumed operating conditions. It is also defined by [25] as the upper limit or ceiling on the load that an operating unit can handle. Stevenson added that capacity needs include equipment, space, employee skills among others. Capacity is essential to good profitability. The determinants of capacity include facilities, product and service factors, process factors, human factors, policy factors, supply chain factors, and external factors [25].

Capacity utilisation is a measure of the extent to which the productive capacity of a business is being used. It can be defined as the percentage of total capacity (design capacity) that is actually being achieved in a given period. By formula capacity utilisation is given by: (Actual level of output divided by maximum possible output) multiply by 100 Capacity Utilisation = (Actual level of output / Maximum possible output) * 100

As asserted by [10] capacity utilisation is the proportion of available capacity that is utilised, which is measured by the ratio of actual output to capacity output. It is equal to the ratio of observed output to the capacity of the plant [8]. Thus, capacity utilisation refers to the ratio of actual output to the maximum or potential capacity output from a quasi- fixed inputs.

In theory, capacity utilisation is measured in 100% efficiency level, however, in practical sense, capacity utilisation may not exceed 90% maximum level especially in developing economies due to some challenges in the production process such as lack of proper labour monitoring and supervision, wastages in the process and machine breakdown [21]. In other words, each firm will choose its level of utilisation based on the principle of cost minimisation and then explores how such will determine its normal rate of utilisation [20]. Thus, the rate of capacity utilisation remains an important concept, though often neglected, in the production process because the presence of idle resources that can be readily engaged in production activities constitute a big problem in explaining fluctuations in firm output in Nigeria where under -utilisation of some productive equipment have become rampant in almost all productive firms. Capacity utilisation plays a crucial role in the evaluation of economic activity, contributing to explaining the behaviour of investment, productivity, profits and output [18]. In developing countries where capital is very scarce and in most cases under-utilised, capacity utilisation is very important to be considered [1].

Capacity utilisation rates at US refineries have been steadily rising and are now at their maximum sustainable levels. A report by [7] indicated that from 2000 to 2008, the average utilisation rate in US manufacturing industries was 77%, while in the refining industry it was 91%. [16] found that most refineries would have to run at least 60% capacity for them to be in operation. A research by [5] found that lower capacity utilisation directly affect the profitability of Bongaigaon refineries, implying that capacity utilisation determines or affects the output and hence profitability of refineries. [17] asserted that one main factor that determines profit margins of firms is capacity utilisation. Their study which concentrated in the manufacturing, mining, and utility industries found that firms operating in industries with higher capacity utilisation have higher profit margins. These findings are also true for aggregate level data, where aggregate profit margins and overall US capacity utilisation rates are positively correlated [17]. According to the authors because there were challenges in having access to firm-level data the study used industry level estimates. Their finding cannot be conclusive because it is possible that if they had used firm-level data different results would have emerged. Surprisingly, the study also found that firms operating in industries with high capacity utilisation and have high sales growth underperform compared with firms operating in industries with low capacity utilisation and / or have low sales growth.

Materials And Methods

The study used a quantitative research approach to analyse the realtionship between capacity utilisation rates of downstream oil companies and their respective profits. Quantitative approach according to [9] is appropriate when the problem at stake is identifying factors that influence an outcome, the utility of an intervention or understanding the best predictor of an outcome. Since the research analysed the relationship between capacity utilisation and profits, and also identified the factors that influence profitability of downstream oil industry, quantitative research approach was most appropriate and hence adopted. Five downstream oil companies in developing countries were randomly sampled, and analysed the relationship between the average of their capacity utilisation rates and their corresponding profits from 2001 to 2010. In other words all the capacity utilisation of the five downstream oil companies, and their respective profits in each of the years 2001 to 2010 were added together, and the averages were computed. The study thereafter analysed the relationship between the resultant capacity utilisation and the corresponding profit by running regression using SPSS 23.0 version.

Results

Regression output: relationship between capacity utilisation and profit

Model Summary

Model R R Square Adjusted R Square Std. Error of the Estimate
1 .550a .303 .215 206.000

Predictors: (Constant), Capacity

ANOVAa

Dsd Model Sum of Squares df Mean Square F Sig.
Regression 147245.942 1 147245.942 3.47 .100b
Residual 339486.458 8 42435.807
Total 486732.400 9

Dependent Variable: Profit

Predictors: (Constant), Capacity

Model Unstandardized Coefficients Standardized Coefficients t Sig.
1 B Std. Error Beta
(Constant) -2054.486 998.976 -2.057 0.074
Capacity 22.345 11.996 0.55 1.863 0.1

a. Dependent Variable: Profit

Discussion

The general equation of a regression line is Y = a + bX, Where Y = dependent variable, which in this case is the Profit; and X, independent variable, which in this case is capacity utilisation, “a” is the intercept, and “b” the slope which denotes the change in profit when there is a unit change in capacity utilisation.

From the regression results (Coefficients table), the relationship between capacity utilisation and profit can be written as Profit (Y) = -2054. 486 + 22. 345 Capacity Utilisation (X)

Minimum Capacity Utilisation Rate At Which The Refinery Will Remain Profitable

To predict the minimum capacity utilisation rate at which the refineries will remain profit, figures are put in the equation above. The following table (Table 3 shows that)

Capacity Utilisation Rate (X) Profit ($m) Y
100 179.64
99 157.3
98 134.95
97 112.61
96 90.26
95 67.92
94 45.57
93 23.23
92 0.88
91 21.47 (Loss of $21.47m)
90 43.81 i.e Loss of $43.81m)

Source: Field data, 2017

From the table above, the minimum capacity utilisation rate at which the refineries will remain profitable is 92%. This implies that any time the refineries operate below a capacity of 92% they will incur losses. Policies therefore must be put in place so that at least all refineries will operate at a minimum of 92%. This result is somehow consistent with the findings of [7] that minimum capacity utilisation of refineries in USA is 91%. It also confirms the findings of [17] that higher capacity utilisation yields higher profit. However it is not in agreement with the findings of [16] that most refineries have to run at a minimum of 60% capacity otherwise they will have to shut-down.

The regression equation (Y= -2054.86 + 22.345 X) also shows a unit change in capacity utilization will change profit by $22.345m. For example if capacity utilisation is increased by 1% profit will increased by $22.345m and vice versa.

Again, from the table titled model summary, the R square of 0.303 means that 30.3% of changes in profit is explained by changes in capacity utilisation. In other words, capacity utilisation explains 30.3% of changes in profit, which further implies that other factors account for 69.7%. Though there is a positive relationship between capacity utilisation and profit, its impact is low. It is even lower if Adjusted R square is considered. The adjusted R square of 0.215 implies that if all necessary adjustments are made, capacity utilisation explains only 21.5% of the changes in profit of refineries. This also means that other factors explains 78.5% of changes in profit.

It is therefore clear that changes in other factors cumulatively influence profit of refineries (downstream oil companies) more than capacity utilisation rates.

Conclusion And Recommendation

The study analysed the relationship between capacity utilisation and profit in the downstream oil industry in developing countries. The results clearly indicate that indeed capacity utilisation influences profit of downstream oil industry; however its influence is relatively small. Using the adjusted R square, capacity utilisation explains only 21.5% of changes in the profit margins of downstream oil industry in developing countries. This cannot be used to meaningfully formulate policies and make decisions regarding capacity utilisation and profit of downstream oil industry, because other factors apart from capacity utilisation cumulatively account for huge percentage (77.5%) of changes in profit of downstream oil industry. From the above results, downstream oil industry (refineries) in developing countries should be able to operate at a minimum of 92% capacity to make profit. This is extremely difficult bearing in mind that even most USA refineries run at 91% capacity [7], however if good policies are put in place this can be done. The downstream oil industry in developing country therefore need a new business model.

It is recommended that there should be reforms in the policies of the downstream oil industry in developing countries. Firms in the industry should restructure their internal processes to address a number of challenges. They should invest heavily in the oil business especially in infrastructure to improve their position on the supply curve; they should also minimise cost of operations, they should implement measures to curb corruption and mismanagement, and should also consciously look for and take advantage of the other factors that influence profitability of downstream oil industry apart from capacity utilisation.

It is also recommended that future research should be conducted in the following areas

a. The determinants of profitability in the downstream oil industry apart from capacity utilisation.

b. Challenges in the oil industry and measures to address them.