Selling Crude Oil Versus Investing in Oil Refining: an Efficiency Analysis

This paper attempts to establish the efficiency of investing in crude oil refinery from an opportunity cost standpoint, in particular in relation to direct sales of crude oil. To model the investment decision, the author has analyzed the complex system of tax and customs tariff regulations in Russian Federation, as well as capital and operational expenditures of Russian vertically-integrated oil and gas companies. Instead of focusing exclusively on specified payback periods this study compares the net present value of two alternative projects, namely direct crude oil sales and a refinery construction for the subsequent sale of refined products. Much attention is paid to refining margins. Instead of using a deterministic forecast of crude oil and refined products prices, it is proposed to simulate their behavior using Monte-Carlo simulation and the long-term relationships between crude oil prices and the prices of the main types of products. Long-term relationships are determined using econometric analysis of time series with regime shifts. The results obtained demonstrate that vertical integration effectively improves profitability of an oil company: less than 20% of scenarios result in a loss of potential profits when opting for an oil refinery instead of direct crude oil sales. The model developed in the paper may be used to analyze the efficiency of constructing the different types of oil refineries by varying capital expenditures and other parameters in the model.