The Case: Petro Refinery

Petro Refinery LLC is a Kazakhstan-based oil refinery. Its main focus is on providing refined petroleum products to markets in China, the United States, and several European Union countries.

The president of Petro Refinery hosts weekly meetings with select team members. This week he is prepping his colleagues and two outside consultants, both recent Ross Executive MBA grads, for anupcoming evaluation of the refinery operations. The goal is to maximize the firm's financial performance.

Dimitri (President): Hello everybody, thank you for coming. I would like to introduce you all to Jennifer and Miguel -- consultants who will help us look for areas of improvement in our business. Both of the consultants have experience with process optimization. Jennifer has years of experience in the energy sector, and Miguel comes to us from the automotive sector.

My assistant will be sending out several documents. First document will provide a brief overview of the refinery business. Second document covers the crude refining process. Third document covers ourfirm's current production possibilities and costs. Those who are familiar with the details of the refiningbusiness can ignore the first two documents and focus on the third.

For our next weekly meeting, please work with the consultants to come up with suggestions on how our financial position can be optimized. In your analysis, please assume that the prices we pay for crude oil will stay the same. Furthermore, assume distributors will pay us the same rates for each gallon we sell them. Please carefully review the production possibilities and costs document for more details, along with Tables A, B, and C.

Refinery Business Overview

A refinery is basically a factory. Just as a paper mill turns lumber into paper, a refinery takes crude oil and turns it into useful petroleum products such as diesel.

Different crude oil input produces different volumes of petroleum products. Crude oil is classified by density (light, medium, or heavy). If the input is a barrel of light crude, more products such as gasoline will be produced. If the input is a barrel of medium or heavy crude, more products such as diesel will be produced. The most modern refineries can turn more than half of every barrel of light crude oil into gasoline.

Refineries require substantial initial capital investment. Few new oil refineries have been developed over the past 20 years. In many parts of the world, including in Central Asia, there is an effort to upgrade and modernize older refineries. This is in fact what Petro Refinery LLC started doing with its refinery a number of years back.

It is important to note that when it comes to oil refining, if the input is equivalent to a 42-gallon barrel of crude, the output is roughly 45 gallons of petroleum products. (See Table A.) This is due to the overall density changes that occur during the refining process.

Crude Oil Processing

All refineries perform three basic steps -- distillation, conversion, and blending.

Distillation

Modern distillation involves channeling crude through hot furnaces. The resulting vapors and liquids then move into distillation towers. Inside the towers, the vapors and liquids separate according to weight and boiling point.

2|Page

Conversion

In the conversion stage, cracking and rearranging of molecules results in transforming lower-value input into higher-value output. This is where liquids and vapors from the distillation towers are transformed into intermediate components that eventually become finished products.

Blending

The last stages of the refinery process fine-tune the products produced in the conversion stage. This is where different types of diesel and gasoline are configured based on customer specifications.

Production Possibilities and Costs at Petro Refinery LLC

Petro Refinery LLC purchases light and heavy crude oil and refines it into gasoline, diesel, and various other products. The petroleum products are then sold in gallons. For the next week, the refinery expects to be paid $3.50 per gallon of gasoline sold to distributors, $3 per gallon of diesel, and $2 per gallon for all other refined petroleum products.

The firm's refinery operations are grouped into three standard steps: distillation, conversion, andblending.

Capacity in each department is calculated by measuring the equipment hours needed per refining each 1,000barrels of crude. The firm's output possibilities are based on equipment hours available, in combinationwith equipment hours required, in each step of the refining process. As an example, Petro RefineryLLC's weekly refining capacity is sufficient to process either 800,000 barrels of light crude or 800,000barrels of heavy crude if devoted fully to either crude type. However, Petro Refinery LLC usually processes both light and heavy crude in any given week. For example, if 500,000 barrels of light crude are processed, there would still be sufficient availability of refining equipment for also processing 360,000 barrels of heavy crude.

Data on the equipment hours required for refining light or heavy crude at each step of the way can be found in Table B.

The Petro Refinery production schedule for the prior several months resulted in a weekly processing of 700,000 barrels of light crude and 120,000 barrels of heavy crude. The weekly output was 15,800,000 gallons of gasoline, 8,800,000 gallons of diesel, and 12,300,000 gallons of other petroleum products. At these levels of production, the blending facilities were operating at full capacity. However, the distillation and conversion facilities were not maximizing capacity potential.

-----------------

Table A Crude Input and Output Input Sweet light crude Heavy crude Price $88/barrel $74/barrel Output per barrel (in gallons) Gasoline 20 15 Diesel 10 15 Other (jet fuel, heavy fuel oil, LPG gases, etc.) 15 15Table B Refining equipment demand per 1,000 barrels Input Sweet light crude Heavy crude Equipment hour available per week Distillation 2 hours 2 hours 3,000 Conversion 2 hours 3 hours 2,400 Blending 2.5 hours 3 hours 2,400 Table C Overhead and labor costs Fixed overhead Variable overhead Labor Distillation $2,000,000/week $2/barrel $0.5/barrel Conversion 3,000,000/week 3/ barrel 1.5/barrel Blending 2,000,000/week 2.5/barrel 1Ibarrel ASSIGNMENT QUESTIONS 1. How much money has Petro Refinery LLC been making per week under its current production policy of processing 700,000 barrels of light and 120,000 barrels of heavy crude after subtracting the labor costs, the variable overhead costs, and the weekly fixed overhead costs? 2. The demand forecast for next week indicates that Petro Refinery LLC need to process 650,000 barrels of light and 350,000 barrels of heavy crude. Determine the light crude-heavy crude processing combination in barrels for next week that will maximize the profit using: A. The traditional method B. The bottleneck method 3. Which method in Question 2 results in higher profit and why? 4. Suppose blending is available for an extra 250 hours per week. How would that affect your findings in Question 2? 5. Suppose the price of heavy crude increases by $6/barrel (with light remaining the same). How would that affect your findings in Question 2