Crude or Refined? Rationality of Downstream Investment for OPEC Members
47 Pages Posted: 13 Feb 2018
Date Written: February 1, 2018
Should oil-producing countries aggressively move toward downstream and invest in the oil refinery industry? This is a crucial development policy question for such economies. We critically review the rationale for a vertical integration strategy (i.e. downstream investment) within an oil-rich economy. We show that the average markup in the refining sector is significantly smaller than the profits in the upstream; thus, not much economic value-added can be expected through the vertical integration. We also find that while crude oil process contains unit-roots (i.e. random-walk), refining margins are stationary (i.e. mean-reverting). Thus, from a hedging prospective the more stable and mean-reverting refining margins can provide a revenue cushion when crude oil prices are low. Our theoretical model also shows that, among several other factors, the relative magnitude of refined demand to crude oil supply shocks plays a significant role in determining the optimal degree of integration. The analysis can inform energy sector investment decisions as well as export diversification policies of oil producing countries.
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