Last week's decision by Royal Dutch Shell PLC (RDSB.LN) and Saudi Arabia Oil Co. (SOI.YY) to "super-size" a Texas oil refinery opens the door to more expansions, but diverging petroleum-market trends complicate refiners' capacity choices.

The companies' announcement that they would double the size of their jointly owned refinery in Port Arthur follows an extended period of higher gasoline and diesel fuel prices supported, in part, by refinery production that's increasingly insufficient to meet rising demand. The expansion project's approval stands as an endorsement of the refining industry's strength, aided by new flows of crude closer to home. However, uncertainty about future fuel demand and pollution concerns will weigh on investment deliberations.

"It's clear with the profitability of refining, we'll see expansions, but will demand growth underpin that?" said Roger Read, an analyst with Natixis Bleichroeder, an investment bank. Natixis and/or its affiliates have received compensation for non-investment banking services from Shell in the last 12 months. "It's a move that's a little bit offensive but also a little bit defensive."

The idea to make the Motiva Enterprises LLC joint venture refinery the largest in the U.S., processing as much as 600,000 barrels a day of crude oil, was aired as a possibility for more than two years and followed some postponements and cancellations of projects by other refiners. While a "no" vote by Motiva's board--populated by Shell and Saudi Aramco officials--would have been downright chilling for the refining sector, its approval is a relatively passive vote of confidence.

Refiners must weigh the financial risk of multibillion-dollar upgrades with execution times of six to eight years against potential gains in profit. Going forward with the work can make the difference between an asset that's good for 50 years and one that's good for 30 years, Read said.

Alluring Canadian Crude

As the price of crude oil climbs past $80 a barrel, lower-cost but harder-to-refine oil becomes more attractive to refiners.

As part of the expansion, Motiva will be able to source heavy Canadian crude, more evidence that Canada's oil sands are growing in importance for U.S. refiners.

"The comfort level for expansions of this kind is improving by virtue of the fact that we'll have increased North American crude available," said John Parry, an analyst with John S. Herrold in Norwalk, Conn.

Canada, already the largest exporter of crude to the U.S., may see production from its Alberta oil sands tripling to 3 million barrels a day by 2015.

At the same time, many prospects for shipping crude south from Canada have been proposed. By mid-2010, it's expected that an additional 1.3 million barrels a day of pipeline capacity will be available from western Canada to the Midwest and Ontario. Further out in the future, pipelines are seen reaching Gulf Coast locations, including Port Arthur.

Apart from access to lower-priced Canadian crude, the Midwest and Gulf Coast product markets offer certain advantages that make them likely areas for expansion.

It's no surprise that the two largest expansions in the last few years--Motiva in Port Arthur and Marathon Oil Corp. in Garyville, La.--are occurring in the Gulf Coast.

"You can move product onshore and offshore and the region's regulations are more favorable for refiners," said Read.

The Gulf Coast's dense network of pipelines onshore and ready access to incoming and outgoing marine traffic affords flexibility for refiners looking to balance petroleum supply and demand to their best advantage.

In addition, the Gulf Coast tax environment is favorably disposed toward refining. Jefferson County, where Port Arthur is located, granted Motiva exemption from roughly $600 million in local taxes over the course of 20 years. Municipal and educational authorities also slashed Motiva's tax bill for the project.

Whither Gasoline Demand Growth?

Still, concerns linger for refiners.

"High gasoline prices have had some effect, more hybrid vehicles are coming into the market, and increased use of biofuels will eat into the growth rate," said Natixis' Read. When considering refinery investments coming on line after 2010, demand growth rates in the prior ten years are not a good guide, he added.

In addition, some expansion plans have met with opposition from environmental groups concerned about increases in pollution emissions that would accompany the refining of larger volumes of crude oil.

Challenges by environmentalists and public officials to BP PLC's (BP) plans to expand its refinery in Whiting, Ind., recently led the company to suggest it may cancel modification plans. If its pledge to mitigate chemical discharge into Lake Michigan results in a material impact to the project's viability, "we could be forced to cancel it," BP America Chairman and President Bob Malone said last month.

In addition, the Sierra Club, along with the National Resources Defense Council, has asked the Environmental Protection Agency to overturn a permit granted to ConocoPhillips (COP) to expand its Wood River refinery in Roxana, Ill. The Sierra Club has also stated its opposition to Marathon Oil Corp.'s (MRO) plan to expand its refinery in Detroit.

Copyright (c) 2007 Dow Jones & Company, Inc.