Socro-Econ. Plan .Sci Vol. 19, No. I, PP. 35-40, 1985 GU384121/85 $3.00 + .

oO
Printed in the U.S.A. 0 1985 Pergamon Press Ltd.

MODELING OIL REFINERY OPERATIONS

NOEL D. URIt
Division of Antitrust, Bureau of Economics, Federal Trade Commission,
Washington, DC 20580, U.S.A.

(Received 29 May 1984)

Abstract-This paper develops a model to analyze the relative responsiveness of refined petroleum
product output to changes in the relative prices of these products. A scheme is devised and implemented
that shares out total production into motor gasoline, distillate fuel oil, kerojet fuel, and other refined
products. A multinomial logit specification is used whereby the share of each of these products is a
function of relative prices, a seasonal factor, and the relative amount of crude output to total product
output. Finally, the structural stability of the estimated relationships are tested for and the null hypothesis
of stability is not rejected.

INTRODUCIION products, which in turn are determined by the inter-

Modeling the activities of petroleum refineries with
regard to altering the mix of refined petroleum product
output has proven to be a most elusive proposition.
The structural and data problems inherent in such
analysis are difficult to resolve. It is imperative,
however, that a framework be developed to enable
such modeling efforts because of the overall impor-
tance of petroleum in a balanced energy network.
For example, refined petroleum product consumption
accounted for 42.6% of the total energy consumption
in 1983 in the United States.
Refinery operation is characterized by a phenom-
enon of being able to alter the relative amounts of
output of refined petroleum products (e.g. motor
gasoline, distillate fuel oil, residual fuel oil, kerosene,
propane, and kerojet fuel) given a barrel of crude oil
input, within technical limitations. There exists the
possibility of output substitution in the refining of
crude petroleum. In 1983, for example, the share of
total output attributable to each of the various refined
petroleum products continuously changed on a
month-to-month basis [I]. Thus, in PADD Region
III (this is defined below), for example, motor gasoline
accounted for between 40.2 and 45.5% of total 1983
refined petroleum product output.
Large output substitution elasticities of refined
petroleum products are basic to the question
defining the extent of the market for petroleum
products. That is, if refinery output shifted significantly
between, say, kerosene and distillate fuel in response
to changing relative prices, this would suggest that
the market definition would be much broader than
if no such shift was observed. See Stigler and Sherwin
[2] for more on this.
THE ECONOMIC ARGUMENT
Given the unregulated nature of the market for
petroleum products in the United States, the quantity
supplied is a function of the prices of the various
action of the demand for the products and costs (i.e.
marginal costs). Note that one cannot properly speak
of supply in the neoclassical microeconomic sense,
since supply exists only in that nonexistent theoretical
world of perfect competition.
Consider the operation of a petroleum refinery
from a simplified perspective. A refinery produces
output, as noted above, in the form of motor gasoline,
distillate fuel oil (i.e. home heating oil), residual fuel
oil, kerosene, kerojet fuel, etc. The typical refinery
can use a number of different types of crude oil. For
example, a typical refinery might be able to handle
both light sweet and light sour$ crude that comes
from, say, West Texas and Saudi Arabia [3].
It should be observed that the design of any specific
refinery will depend upon, among other things, the
specific characteristics of the crude oil to be processed
and the output mix desired, within limits. There are
different grades of crude oil and, as a result, there
will be differences in the yield obtained from them.
A light crude, for example, will yield a high percentage
of useful products by distillation, whereas a heavy
crude will produce significant amounts of crude-oil
material that must be sold as heavy fuel oil or else
processed further. As a result, there is some flexibility
in switching a refinery to alternative crude streams,
of although this is limited [4].
In the refining process, some of the available
crudes must be refined because of long-term minimum
volume commitments or because of requirements for
specialty products. These crudes are considered fixed,
and yield constant motor gasoline and distillate fuel
oil volumes. From the remaining crudes, and from
those crudes which are available in volumes greater
than their minimum volume commitment, are se-
lected those which can supply the required refined
products most economically. These are nominally
referred to as the incremental crudes. The refinery
problem becomes one of determining the minimum
incremental cost of, say, distillate fuel oil as a function
of incremental distillate fuel oil production, while

t The views expressed are those of the author and do not

necessarily represent the policies of the Federal Trade Com-
mission or the views of other Federal Trade Commission $Sour crude contains significant amounts of sulfur and
staff members. refineries must be capable of moving the sulfur.

35
36 N. D.
maintaining motor gasoline production and general
refinery operation at a fixed level. The mechanics of
solving this type of problem take us beyond the scope
of the current concern. (The interested reader is
referred to Garvin et al. [5] for its mathematical
solution.) The element that needs to be highlighted,
however, is that changing relative prices of refined
products that precipitate the desire to alter the output
mix can de facto change the relative shares of total
output from a refinery.
Given the technical flexibility that exists to change
the relative output share of refined petroleum prod-
ucts, the question to be empirically examined is
whether refineries actually do alter their behavior in
response to changing relative prices and, if they do,
what is the extent of this response.
AN ANALYTICAL FRAMEWORK
There are only a limited number of ways of
addressing the question of refinery output response
to changing relative prices of the various refined
products. One approach is to use a linear program-
ming framework along the lines, say, of the Refinery
Evaluation Modeling System (REMS) of the Depart-
ment of Energy [6]. This structure assumes that
demands for the various types of refined petroleum
products are given (i.e. quantities demanded are
exogenously determined). Subsequently, the quantities
demanded and an aggregate petroleum price deter-
mined. This allows one to relate price and output
and hence to determine the relative responsiveness
of output to variations in price. This approach does
not really give any insights into the question at hand,
however, since demand is assumed to be perfectly
inelastic in such a setting (which has been repeatedly
shown not to be the case [7]). This would suggest
that the level of output is determined solely by
demand while price is determined solely by the
position of the cost curves. This is too unrealistic.
An alternative approach in analyzing refinery out-
put flexibility is to use an econometric approach. To
date, unfortunately, this does not appear to have
been tried. An appropriate structure will be suggested
below.
A major issue that needs resolution in considering
a way to analyze refined petroleum product output
is how to insure that the components of refined
petroleum product output are exactly equal to total
output. That is, if we are examining changes in, say,
relative prices, and total output is predetermined,
how can we be certain that the aggregation across the
components precisely equals this total. To address
this apparent anomaly, a scheme must be designed
to share out total output based on some objective
criteria. These shares as a proportion of total output
will necessarily lie between zero and one. To guarantee
that aggregation holds, it is only necessary to require
that these shares across all refined petroleum products
sum to one.
Given that each of the shares is constrained by the
interval (0, l), a linear model specification is not
acceptable, due to the possibility that values may lie
outside of it. The obvious solution is to have a
transformation whereby for all possible values of the
explanatory variables, the share values will be in the
(0, 1) interval. One would also like the transformation
to maintain the property that increases in the value
URI
of the explanatory variables are associated with in-
creases (or decreases) in the value of the share. These
requirements suggest that use of a cumulative function
whose upper bound is one and whose lower bound
is zero will provide a suitable transformation.
There are a couple of such transformations that
would prove acceptable [8]. The one adopted here is
the logit specification because it has proven to be the
most mathematically tractable.
The logit model specification is based on the
function
&I = l/( 1 + exp (ai + C bifl,rl,,)) (1)
I
where S,, denotes the share of a given refined petro-
leum product produced in period t; x,, are the exog-
enous factors causing variations in output shares i in
period t; and ai, b,, , . . . , bin are coefficients to be
estimated.
The specification provided in eqn (1) can be esti-
mated directly by means of nonlinear least squares
or, after a suitable transformation of the dependent
variables S,,, by means of classical least squares. Such
estimation techniques, however, would not use all of
the information efficiently. Namely, the sum of the
shares is equal to one given that the available choices
are mutually exclusive (i.e. one gets motor gasoline
or distillate fuel oil, not both).
In what follows only four refined petroleum prod-
ucts are going to be considered. Consequently, when
limiting the logit model to the four-choice case, one
has
log $ = a2, + C b,x,
0 I 1
log : = ad1 + C b,xj
0 I I
where S, denotes the share of all refinery output
besides motor gasoline, distillate fuel oil, and kerojet
fuel, S2 denotes the share of motor gasoline output,
S3 denotes the share of distillate fuel oil output, and
S, denotes the share of kerojet fuel output; a*,, a3,,
a4,, bll, . . , bdh are coefficients to be estimated,
and x, are the exogenous factors causing variation in
the relative outputs of the refined products. The
subscript t, designating observations in each period,
has been deleted to simplify the notation. That this
is tantamount to the logit specification can easily be
seen by solving each of the equations as a simple
function of one specific share or by referring to
McFadden [9].
Each of these equations presumes that the logarithm
of the ratio of the share of one refined petroleum
product to one minus the share of that product
relative to a similar ratio for another refined petroleum
product is a linear function of the set of explanatory
factors. These values are dependent on the values
associated with the remaining equations only to the
extent that the system must be constrained so that
the sum of the individual shares is one.
 Modeling oil refinery operations
One is now in a position to estimate the parameters
~21, ~31, ~41, b2,, . . . , b4,,. If the set of explanatory
factors (i.e. xj) in each equation are not identical,
efficiency can be gained by using the iterative seem-
ingly unrelated technique of Zellner [lo]. This is just
a generalized least squares estimation procedure used
to reflect the correlation among the error terms
associated with each equation in the multinomial
model. The iterative Zellner technique is used here.
DATA
Before proceeding to a presentation of the estima-
tion results, a discussion of the data is in order. The
data employed in the estimation are monthly obser-
vations over the period 1981-1983. The year 1981
was used as the line of delineation since that is when
decontrol became effective, ostensibly permitting the
market mechanism to work, at least as far as refined
petroleum products are concerned.
Monthly refined petroleum product data were ob-
tained from the Department of Energy’s Petroleum
Supply Monthly [ 1 I]. Given the limited time period
for which data are available, practical econometric
consideration suggested that looking at a large number
of individual refined petroleum products (data are
collected on 18 separate items by the Department of
Energy) would present problems. Consequently, the
investigation was limited to just four products: motor
gasoline, distillate fuel oil (these two combined ac-
count for about 65% of refinery output), kerosene-jet
fuel type (which accounts for about 6% of refinery
output) and all other refined petroleum products.
The output data were collected on a Petroleum
Administration for Defense District (PADD) level
(see the Monthly Energy Review [ 1] for a character-
ization of the five PADD regions). This is the most
disaggregated basis publicly available for these data.
Regionally disaggregated data were selected over na-
tional aggregates since there are some differences in
refinery vintages by region and some differences in
the technical characteristics of the refineries in the
various regions.
The set of exogenous variables used in the esti-
mation consisted of the following:
(1) Prices. The price of motor gasoline relative to
the price of all other refined petroleum products (i.e.
of motor gasoline, distillate fuel oil, and kerojet fuel),
the price of distillate fuel oil relative to the price of
all other refined petroleum products, and the price
of kerojet fuel relative to the price of all unleaded
refined petroleum products. The price of other refined
products is simply measured as a weighted average.
All of the price data were taken from Platt ‘s Oil Price
Handbook [ 121.
(2) Seasonal variation. To capture the seasonal
variations in the output shares, crude oil input into
the refining process is used. This variable really is a
proxy for changing refined product requirements (i.e.
more motor gasoline in the summer and more distil-
late fuel oil in the winter) over the year. The data
are taken from the Petroleum Supply Monthly. Note
that this method of reflecting seasonal variation was
adopted in difference to using dummy variables since
the latter method would use up eleven degrees of
freedom. This was judged unacceptable given the
limited number of observations to begin with.
37
(3) Technical characteristics. As discussed above,
not all crude oils yield the same output mix, nor the
same volume of total output of refined products. As
crude input increases, given that there is a quality
change in the crude and hence more or less refined
products produced, relative output shares will change.
This affect is reflected by including a variable defined
as the ratio of crude input to total refined product
output. These basic data were taken from the Petro-
leum Supply Monthly.
Other variables were considered in preliminary
analyses and proved to be statistically insignificant.
In particular, a weather variable (measured by heating
degree days), the relative price of imported refined
petroleum products, and electric utility generation
(residual fuel oil is a significant boiler fuel) all failed
to demonstrate any impact on the output shares of
the products.
What one is left with now is a mechanism for
analyzing refined petroleum product output shares
based on relative prices, technical refinery character-
istics, and crude oil input (as a proxy for seasonal
variation). Empirical estimates of the impact of these
factors on changing shares is the subject of the
following section.
EMPIRICAL RESULTS
Using the data and the estimating technique pre-
viously discussed, the empirical results were obtained.
Preliminary analyses suggested that the imposition of
symmetry constraints might be appropriate (that is,
b, = b,, on the relative price terms). To test this
hypothesis, a Quandt test is employed. The test
consists of computing the determinants of the unre-
stricted and restricted disturbance covariance matrices.
The logarithm of this times minus the number of
observations used in the estimation has a chi-square
distribution with degrees of freedom equal to the
number of independent restrictions being imposed
[ 12l.t The test was performed for each of the regions
considered with the null hypothesis being that sym-
metry holds. In all instances, the null hypothesis
could not be rejected. That is, it is not possible to
statistically reject the contention that a relative in-
crease in the price of refined petroleum product j will
affect the logarithm of the relative product share i to
the same extent that a relative price increase in the
price of refined petroleum product i will affect the
logarithm of the relative product share j.
The estimation results for each of the PADD
regions are given in Tables l-5. The standard errors
of the estimates are in parentheses. All of the reported
estimated coefficients are statistically significant at
the 95% level or better. The Durbin-Watson statistics
are either inconclusive or suggest the absence of serial
correlation.
In interpreting the results, note that they relate to
the change in the share of refined petroleum product
output of either motor gasoline, distillate fuel oil, or
t This result is valid only for maximum likelihood esti-
mates. Kmenta and Gilbert [ 141, however, have shown that
iteration of the Zellner estimation procedure until conver-
gence (as is done here) results in maximum likelihood
estimates.
 38 N. D. URI

Table I. PADD 1 refinery share equation estimates”)

Explanatory Variables c2)

~2(3) D. W.c4)
Equation Constant Pmg’Po pd’po pkj’po Crude/Total Output Crude

log ( s2 ) -6.9229 1.5933 (5) (5) 3.8799 0.0167 0.6722 1.57

- (0.9177) (0.7551) (1.2328) (0.0014)
Sl
log ( s3 ) 0.1719 (5) 0.5111 0.3310 -0.7564 0.0171 0.7154 1.75
(0.0308) (0.2155) (0.1518) (0.3138) (0.0028)
G

log ( s4 ) -2.4013 (5) 0.3310 1.4729 -0.0404 (5) 0.7078 1.79

(0.7120) 0.1518) (0.6449) (o.ooao)
G

(1) Standard errors of estimates in parentheses.

(2) Pk. : price of kerojet, Pw : price of motor gasoline, P : price of other nfined petroleum products,
crdde : crude oil input to refinery, and total output = ?otal refinery petroleum output.
(3) Coefficient of determination.
(4) Durbin-Watson statistic.
(5) Not statistically significant.

kerojet fuel relative to all other refined petroleum
products. It is consistently the case that month-to-
month variations in the relative prices of the own
fuels are significant in explaining relative variations
in the relative amounts produced of the various
refined petroleum products. Of equal or more signif-
icance is the relative shift between refined products
in response to changing relative fuel prices. Thus, for
example, in region PADD 3, an increase in the
relative price of kerojet fuel will result in a reduction
in the relative share of distillate fuel oil output.
In this latter regard, just what is the mechanism
through which this substitution can take place? Take
kerojet fuel as an illustration. Kerojet production can
be manipulated in the refining process via a number
of alternatives. One way is to divert kerojet quality
kerosene from other uses (e.g. kerosene blended with
heavier gas oil to produce distillate fuel oil). Another
way is for refiners to technically adjust the refining
process by changing the boiling point ranges on the
distillation towers to increase or decrease the per-
centage of crude oil extracted as kerosene (at the
expense of other light refined products such as either
motor gasoline or distillate fuel oil). Finally, it is
possible to change crude oil types to those with a
higher percentage of kerosene or for which the kero-
sene is kerojet quality.
There are two other inferences to be drawn from
these results. First, as the ratio of crude input to total
output increases, there is a general indication that
the relative share of motor gasoline increases at the
expenses of distillate fuel oil and kerojet fuel. This is

Table 2. PADD 2 refinery share equation estimates”’

Explanrrtory Variables (2)

g2(3) D. W.(‘I)
Equation constant Pmg’Po pd’po pkj’po Crude/Total Output Crude

log ( S2 ) -6.1965 0.9005 -0.4051 1.1442 3.7031 0.0104 0.6524 1.62

-
(2.4393) (0.4589) (0.2023) (0.5811) (1.921) (0.0044)
Sl

log ( “3 1 0.3676 -0.4051 0.5119 (5) -0.4153 0.0129 0.6937 1.99

(0.0526) (0.2033) (0.1420) (0.1700) (0.0063)
Sl

log ( S4 ) -2.3297 1.1442 (5) 1.7197 -0.0397 (5) 0.6845 2.20

(0.7770) (0.5811) (0.4994) (0.0075)
<

(1) Standard errors of estimates in parentheses.

(2) Pk. = price of kerojet, Pw = price of motor gasoline, P : price of other refined petrolem products,
CFa de = crude oil input to refinery, and total output : ?otal refinery petroletan output.

(3) Coefficient of determination.

(4) Lurbin-Watson statistic.
(5) Not statistically significant.
 Modeling oil refinery operations 39

Table 3. PADD 3 refinery share equation estimates”’

Eicplanatory Variables (*I

$(3) D. W.(4)
Equation constant Pmg'Po pd'po pkj'po Crude/Total Output Crude

log (2 ) -2.5924 0.8130 -1.5168 -1.5237 1.6474 3.0163 0.7862 1.55

(0.6233) (0.3847) (0.5847) (0.4640) (0.6235) (0.0059)
s1

log ( S3 ) 0.4086 -1.5168 0.7838 -0.3944 -0.9271 0.0476 0.8115 1.91

(0.0732) (0.5847) (0.3734) (0.1510) (0.4298) (0.0059)
G

log ( S4 ) -2.9126 -1.5237 -0.3944 1.9371 -0.6713 (5) 0.7527 1.93

- (0.9373) (0.4640) (0.1510) (0.6678) (0.0987)
Sl

(1) Standard errors of estimates in parentheses.

(2) Pk. z price of kernjet,Pm = price of motor gasoline,P : price of other refined petroleumproducts,
crdde = crude oil input,to refinery,and total output : total refinerypetrolem output.
(3) Coefficientsof determination.
(4) Durbin-Watsonstatistic.
(5) Not statisticallysignificant.

consistent with the results of Copp [ 151. Second, both other refined petroleum share. This latter term is
the relative production of motor gasoline and the equal to one over one plus the sum of the exponentials
relative production of distillate fuel oil are sensitive on the right-hand-side of each of the eqns (2a)-(2c).
to seasonal variations. This is hardly a surprising Needless to say, such an expression is quite complex
result [ 161. and not subject to easy interpretation. Thus, share
A final useful result would be obtained if estimates elasticities are not readily available.
of the actual share elasticities were available. This
would provide information on the percentage changes TESTING FOR STABILITY
in the various refined petroleum product shares in A final concern in the analysis is with the structural
response to changes in the various explanatory factors. stability of the estimated relationships in the sense
Unfortunately, as specified, there are no ready mach- that the estimated coefficients on the explanatory
inations available to allow for deriving such estimates variables have remained constant over time. The test
in an easily interpretable form. Thus, for example, is carried out using the test statistic reported in Uri
to obtain a refined petroleum product share for motor [ 171, where the test statistic equals the difference
gasoline, one needs to take the exponential of the between the sum of squared residuals of the entire
right-hand-side of eqn (2b) and multiply it by the all sample less the cumulative sum of the squared resid-

Table 4. PADD 4 refinery share equation estimates”’

ExplanatoryVariables (2)
$(3) D. W.c4)
Equation Constant Plllg’PO 'd"o pkj'po Crude/TotalOutput Crude

log ( s2 ) -3.0426 0.9328 (5) -1.3212 1.8353 0.0428 0.6151 1.87

(0.4320) (0.51731 (0.9255) (0.0206)
<

log ("3 I 0.1278 (5) 0.3158 (5) -0.6352 -0.0397 0.5924 1.97
(0.0423) (0.1356) (0.2206) (0.0129)
%

log ( s4 ) -1.9122 -1.3212 (5) 0.5697 -0.3606 (5) 0.6544 1.96

(0.3812) (0.5173) (0.1951) (0.1784)
s1

(1) Standarderrom of estimatesin parentheses.

(2) Pk. = price of kerojet, Pw = price of motor gasoline,P = price of other refined petroleumproducts,
crdde : crude oil input to refinery,and total output : ?otal refinerypetrolem output.
(3) Coefficientof determination.
(4) Durbin-Watsonstatistic.
(5) Not statisticallysignificant.
 40 N. D. URI

Table 5. PADD 5 refinery share equation estimates”)

ExplanatoryVariables 12f
~2(3) D. W.t4)
Equation Constant Pnlg'Po pd'po pkj'po Crude/TotalOutput Crude

log csz ) -2.5749 1.0646 (5) -0.9337 0.1525 0.0218 0.6982 1.82
(a.83841 (0.3702) (0.4105) (0.0716) f0.0117)
s1

log (s3 1 0.2701 (5) 0.3465 -0.1447 0.3466 0.0556 0.7599 2.14
(0.0548) (0.1528) (0.0625) (0.1528) (0.0052)
Sl

log (2 ) -2.7998 0.9337 -0.1447 0.9455 -0.2381 (5) 0.7505 2.05

(0.7646) (0.4105) (0.0625) (0.3023) 10.0761)
$1

(11 Standarderrom of estimatesin parentheses.

(2) - price of motor gasoline,P : price of other refined petroleumproducts,
"J = price of kerojet, P
cr de = crude oil input t?&finery, and total output = ?otal refinerypetroleumoutput.
(3) Coefficientof determination.

(4) Durbin-Watsonstatistic.

151 Not statisticallysignificant.

uals over the non-overlapping segments divided by tested for and the null hypothesis of stability is not
the cumulative sum of squared residuals of the non- rejected.
overlapping segments. The null hypothesis that a
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