I made a trip to the San Francisco Bay Area this week for a talk with a local chapter of the American Association of Individual Investors (AAII) and a detailed tour of Chevron's (NYSE: CVX) refining facility in Richmond, Calif., led by one of the company's project engineers.

The refinery, located roughly 25 miles outside San Francisco, covers nearly 3,000 acres. In fact, Richmond is the largest refinery in the San Francisco Bay Area, with total throughput capacity of 240,000 barrels of oil per day and is Chevron's third-largest wholly owned facility. It's also among the oldest in the country--it opened more than a century ago, in 1902. My tour guide patiently and enthusiastically explained the complex web of pipelines and equipment.

Although I'm familiar with the basic refining process, I'd never toured a refinery of that size; the sheer scale of the operation is awe inspiring. It's a city unto itself, complete with its own fire department, water and sewage treatment facilities and a natural gas-fired power plant.

These aren't small facilities. Chevron's fire department is set up to aid the local Richmond department with handling fires throughout the city. And I found the water treatment facility particularly fascinating. Waste water collected from all over the refinery and surrounding lands is treated in several different ponds. One pond is equipped with bacteria that eat harmful chemicals that might remain in the water; the bacteria are kept active by constantly bubbling oxygen into the water.

And before any water is released into the environment, it's thoroughly tested. Interestingly, the company even passes the water through a pond filled with trout; as all trout fisherman know, these fish aren't particularly tolerant of poor water quality. The trout are frequently tested to ascertain if they're building up any contaminants in their systems.

The company's existing gas-fired power facility is capable of generating about 100 megawatts (MW) of power, not quite enough to make the refinery totally independent from the grid. But a new plant under construction as I toured the facility has a total output capacity of 150 MW. Even during periods of peak demand, Chevron should be totally independent from the grid. In fact, the company will have the ability to actually sell power from the plant for use outside the refinery. And the new power plant is a cogeneration facility that produces both power and steam used in a large number of refining operations.

The Refining Process

Refining is perhaps the most poorly understood segment of the energy business among investors. I've highlighted the basics of the business and some of the major factors that determine profitability on several occasions, including the Oct. 12, 2007 issue.

But getting out in the field always give you a better idea of exactly how these processes work and the type of machinery involved. As you might expect, for competitive reasons I wasn't able to take photographs while on the refinery tour; however, Chevron has provided me with some photos of their facilities, and I'll post some to At These Levels next week to better illustrate what some of the refinery equipment looks like.

Refining is basically the business of converting raw crude oil into useful refined products such as gasoline, jet and diesel fuel. Crude oil is essentially a soup of different types of hydrocarbon molecules, strings of hydrogen and carbon atoms. Much of the refining process consists of heating and cooling these molecules in a variety of processes.

The first step in the refining process is called distillation. Distillation towers are tall, cylindrical metal units located adjacent to furnaces. These furnaces are used to heat crude oil to extreme temperatures so the crude separates into molecules of different weights. Lighter molecules tend to rise up the distillation tower toward the top; lighter products might include butane and gasoline. Heavier molecules sink toward the bottom of the tower.

Distillation towers have trays located at different levels on the column. These trays collect molecules of a similar weight as they condense in the tower. This allows refiners to perform the basic separation of crude oil into useful products.

Simple distillation isn't enough--only about 40 percent of a typical barrel of oil can be directly converted into fuels using this process. Refiners want to boost the production of useful light molecules like gasoline and jet fuel, as these are the products in high demand. Many of the heavier molecules separated during distillation aren't suitable for use as fuel directly, but it's possible to convert them into lighter products using other processes.

Most involve heating heavier hydrocarbons in the presence of catalysts to break up those molecules into lighter products. Examples include catalytic cat cracking and hydrocracking.

Further processing of products is necessary to remove sulphur and nitrogen from the resulting crude oil. One of the biggest upgrades underway at the Chevron refinery was the installation of a massive new plant that will allow Chevron to remove sulphur from fuels more efficiently.

A Facelift

Perhaps the most interesting aspect of the tour was the massive construction project underway at the Richmond facility. Chevron is spending about $1 billion on the plant.

These projects will likely take three years to complete. Many of the refineries' basic processes are automated, and my tour guide told me that folks in my position often comment about how few people are visible working on equipment at the facility.

But, thanks to this multi-year construction project, the Richmond facility was abuzz with activity last week. Most of these upgrades involve the replacement of older, less efficient equipment that's been in service for decades.

I already mentioned the company's new gas-powered cogeneration plant and its new facility for managing the separation of sulphur from refined products. In addition, Praxair (NYSE: PX) is building a large new hydrogen production plant at the refinery.

The big industrial gas manufacturing firms typically own the plants they construct at refineries and sell the hydrogen they produce under long-term contracts. This is exactly the case at the Richmond facility: Praxair owns the plant in the middle of Chevron's refinery. This arrangement makes sense because hydrogen is a key part of several refining processes.

And the complexity of these upgrades is stunning. Since many of these new projects are connected to existing facilities, workers must find ways of installing new pipelines amid the existing spaghetti soup of 8,000 miles of pipe. The capital intensive nature of the refining business is apparent the second you set eyes on these facilities.

These upgrades can yield real benefits for profit margins. Not all crude oils are the same. Some, known as light crudes, contain a larger amount of light hydrocarbon molecules and are, therefore, easier to refine. Other crudes, known as sour crudes, contain high amounts of sulphur that must be removed during the refining process.

More advanced facilities for removing sulphur from crude oil can allow refiners to process crude oils that hold a higher sulphur content. Such crudes often trade at a lower price and are more readily available than light, sweet crudes. Refiners like Chevron, with the capability to refine higher-sulphur crudes, have the advantage of added flexibility in the sorts of feedstock used for their operations.

And refining is an energy-intensive business--refiners burn copious quantities of natural gas to produce the power and steam needed to refine oil. By replacing older, inefficient plants with more modern cogeneration facilities, refiners can cut their energy costs meaningfully.

From an investor's perspective, a few points are worth noting. First, the refining business is cyclical. Profit margins can change rapidly depending on the relative prices of crude oil and refined products. In recent months, thanks to weakened demand for gasoline, jet fuel and other refined products, margins have been relatively compressed. Most refineries are scaling back on their activity levels to avoid overproducing and creating a glut of products.

But this is a temporary demand phenomenon. Some refiners have put off or delayed planned upgrades due to weak market conditions; these improvements represent a massive up-front capital investment. And Chevron's plans to upgrade its Richmond facility were delayed due to some vocal local opposition and delays in getting permits for necessary construction projects. The company first proposed these upgrades more than three years ago.

Ultimately, US refiners will need to upgrade their facilities to meet demand and handle the processing of more complex heavy, sour grades of crude; easy-to-refine light, sweet crude is becoming increasingly scarce globally. To encourage the investment of massive up-front capital, refining margins will need to remain relatively high in coming years. The longer-term outlook for the industry is attractive.

Another investment angle to consider is the companies that supply services and equipment to the refiners. For example, industrial gas producers like Praxair and Air Products & Chemicals (NYSE: APD) should benefit from growing demand for hydrogen gas. Hydrogen is key to refining more complex grades of crude. In addition, their business model is relatively stable. As I noted earlier, these firms often construct and own facilities on or adjacent to their customer's operations, selling gas under long-term contracts.

Another group would be engineering and construction firms like Fluor (NYSE: FLR) and Shaw Group (NYSE: SGR). These companies are involved in building out key infrastructure and equipment used at oil refineries.

Keep an eye on At These Levels for photos of the Chevron refinery, and be sure to check on a regular basis for ongoing, up-to-the-minute commentary concerning the fast-moving markets, political developments and economic data; readers can also post comments and ask questions. Last week, for example, I explained one of my favorite strategies for making money and generating income in volatile markets, writing covered calls.

I'm also now on Twitter, a free service that's experienced a rapid growth in popularity over the past year. Twitter allows users to post short, quick commentaries on the fly. To hear my latest thoughts, go to http://www.twitter.com/, sign up for a free account and follow me--my Twitter username is Elliott_KCI.

Speaking Engagements

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