The Future of U.S. Refining

Refining is easily the least glamorous aspect of the oil and gas business. And yet, this is where the next smart play is for energy investors. An increase in energy production in North America, combined with geopolitical turmoil, is likely to ensure profitability for the U.S. refining industry for the near future.

U.S. refining situation
Perhaps the most notable U.S. energy trend outside of the shale gas boom this year has been the massive splitting and selling off of refining operations. Many integrated companies opted to shed their refining operations to focus on exploration and production. Let's recap:

  • Murphy Oil (NYSE: MUR) divests its refining business and sells assets to Valero (NYSE: VLO) and Calumet Specialty Products (Nasdaq: CLMT) .

  • Marathon Oil (NYSE: MRO) splits in two, and the refining part becomes Marathon Petroleum (NYSE: MPC) .

  • BP (NYSE: BP) aims to sell one refinery in California and one in Texas by 2013 as part of an asset purge initiative to raise money to pay for costs incurred from last summer's oil spill.

  • ConocoPhillips (NYSE: COP) plans to spin off its refining business, calling the new entity Phillips 66. It is also trying to sell its East Coast refineries.

  • Sunoco (NYSE: SUN) simply gives up. The company is desperately trying to sell its refineries on the East Coast, going as far as to simply shut them down to save money.

Pretty grim picture, right? But most of the industry doom and gloom stems from the current refining situation on the East Coast. These refineries tend to be older and less sophisticated, only able to handle certain types of crudes that can be refined much cheaper in places like the Gulf of Mexico and the Midwest.

The industry outside of the East Coast is poised to pop:

  • Fool analyst Jim Mueller makes a great argument for considering Western Refining (NYSE: WNR) right now.

  • Tesoro (NYSE: TSO) had a terrific third quarter this year. Refinery utilization is at 92%, net income surged, and the company reduced debt.

  • HollyFrontier (NYSE: HFC) refines crude that comes from its own backyard in Oklahoma, which is why it's more successful than refineries on the East Coast that refine crude shipped from Africa.

Canada's oil sands
Speaking of imports, when the U.S. government decided to remain undecided on TransCanada's (NYSE: TRP) Keystone XL pipeline, environmentalists cheered, and oil and gas supporters groaned. But let's not kid ourselves; if there is money to be made, people are going to find a way to make it. Since that time, I've read numerous alternative plans to get Canada's oil into the U.S. and pushed out to U.S. refineries.

One option entails using tankers to transport crude to refineries on Lake Superior, where it's estimated that there's 2 million barrels a day of refining capacity available. Another possible option involves widening existing pipelines and reversing the flow of the essentially empty Capline pipeline that flows north from Louisiana to Chicago.

The point is that Canada's oil will make its way into the U.S. one way or the other, and that's good news for U.S. refineries.

Europe's ban on imports
The EU has already banned oil imports from Syria and is toying with the idea of banning Iranian imports as well. Though there seems to be a consensus on banning imports from Iran at some point, it may not happen anytime soon. Iran is one of Europe's top three suppliers, and those nations would struggle to find a replacement supply because countries like Saudi Arabia and Russia prefer to sell oil to Asia, where the price is higher.

If a ban on Iran does happen, though, European refiners will have to pay more for crude, driving down profits, pushing up costs to consumers, potentially shutting down refineries, and ultimately wreaking havoc across the Atlantic. It will, however, benefit U.S. refiners that will be able to export their refined products overseas. If that seems far-fetched, consider that European refiners are already having trouble. European refining margins were negative in July and again in September; many refineries are operating at a loss.

U.S. domestic oil and gas production
Let's say, hypothetically, that the scenarios presented above don't actually happen -- Canada doesn't send us crude, and Europe doesn't demand our refined petroleum products after all -- U.S. refining will still increase in the coming years. Why? Because it's estimated that by developing its unconventional energy plays, by 2020 the U.S. will likely be the top oil- and gas-producing country in the world.

Even if you're skeptical of the hype and don't buy into the No. 1 ranking, there is no denying that domestic energy production is surging. You can see the evidence in the explosive growth in American oil and gas plays like the Bakken shale, the Mississippi lime, and the Marcellus shale -- not to mention the tremendous potential of plays like the Niobrara and Utica shales. The increase in domestic oil and gas production will keep capacity numbers high at U.S. refineries.

Foolish takeaway
If the price of oil stays high around the globe -- due to geopolitical risk factors abroad or what have you -- the price of gasoline will remain high as well, ensuring that refiners will be able to maintain high margins and profitability on their products.

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