(FORTUNE Magazine) – If Norman Rockwell were alive today and wanted to portray industrial America, he'd find the perfect backdrop at the Valero Energy plant on Corpus Christi's Refinery Row. There are no latte stands or Foosball tables here. Instead it's men and women working 12-hour shifts in blast-proof bunkers with 2 1/2-foot-thick walls and doors that each weigh a ton. When towering silos get clogged with the clay-like catalyst that helps turn crude oil into gasoline, the workers don't flip a switch or send in a robot. They blow the gunk out with blasting caps.

At a time when the new economy is flat on its back, maybe it's appropriate that old-economy fixtures like Refinery Row are again in style, churning out profits and enriching companies like Valero. Three years ago, says CEO Bill Greehey, "you probably would have had to pay people" to come to one of his Wall Street presentations. These days standing-room-only crowds welcome Greehey when he meets with investors in New York. Two brand-new Learjets are set to be delivered soon to Valero's airport hangar, where the floor is polished to a mirror-like sheen--just the way Mr. Greehey, as he's known around Valero, likes it.

After nearly 20 years of dismal returns, refinery shutdowns, and bankruptcies, the U.S. refining industry is enjoying a renaissance. "It's a whole new world," says Jim Gibbs, CEO of Frontier Oil, which hit an all-time high last month after Gibbs told Wall Street analysts to ratchet up their profit estimates for Frontier. Valero, meanwhile, earned more in the first half of 2001 than it did all of last year; its stock has doubled in the past 12 months, and analysts expect the company to make $726 million this year, vs. $339 million in 2000.

Even if you've never heard of Valero, there's a very good chance you've filled your tank with gas from one of its six refineries around the country. And if you haven't yet, that's likely to change later this year when the San Antonio company completes its acquisition of cross-town rival Ultramar Diamond Shamrock and becomes the nation's largest independent gasoline refiner. Although Greehey denies that the merger will make Valero/Ultramar what a Wall Street analyst calls the "OPEC of refining," the company will clearly command an outsized share of some major markets. For example, in California, where refiners are currently earning nearly $20 on every barrel of crude oil they process, Valero will produce nearly 20% of the gas.

Valero's buyout of Ultramar Diamond Shamrock isn't the only big story in refining. Earlier this year Phillips Petroleum offered $7 billion for another giant refiner, Tosco, in a move that signals Big Oil's renewed interest in what energy types call the "downstream," the refining and marketing end of the business. (The "upstream" is finding oil and getting it out of the ground.) At the same time, shares of smaller regional refiners like Frontier, Holly Corp., and Sunoco are among the stock market's few winners so far this year. "The industry is going to have a good run for the next ten years," says Frontier's Gibbs. "Business is good now, but you ain't seen nothing yet."

Although the refining sector is notorious for its boom-and-bust cycles--Gibbs has certainly seen his share--the industry's optimism may be justified this time. For starters, as anyone who drives knows, prices at the pump are on the rise again, after a brief dip early in the summer. And profit margins have proven remarkably buoyant over the past 18 months, propped up by tight supplies and limited refining capacity.

What's more, the refining industry's earnings are likely to remain high for a host of reasons. In fact, it's a good bet that the kind of price spikes Midwesterners saw at the pump this summer and last are going to be more frequent--regardless of what happens in the Middle East following the terrorist attack in America. And while execs readily admit that dramatic price jumps are bad for the industry's image among consumers, refiners clearly stand to benefit if supplies of gasoline remain tight.

Despite all these signs that there is real money to be made in refining again, some analysts remain skeptical about whether the profit gusher will continue. That's why Valero trades at less than five times projected 2001 earnings, while the S&P 500 boasts a P/E multiple of 22.

All of which brings us to the central paradox of this messy, old-economy industry: Refining margins are fat right now, and the plants are running flat-out, but no one wants to spend the billions of dollars necessary to build a new refinery because long-term returns are so hard to predict in this feast-or-famine business. The same uncertainty explains why owners of smaller, older facilities would rather shut them down than invest the hundreds of millions necessary to meet new EPA regulations.

Although refining powerhouses like Valero, Tosco, ExxonMobil, Chevron, and Sunoco are usually blamed when prices at the pump go up, the real causes are beyond the control of execs like Greehey. Probably the biggest single reason is the increase in the price of crude oil, from $12.50 a barrel in 1998 to $29 today, largely because of production cuts by OPEC and increased demand from Asian economies that bounced back after collapsing in 1998.

The terrorist attacks on the World Trade Center and the Pentagon only underscore the fragility of the gasoline market. Prices briefly spiked in some areas before federal and state authorities warned that there was no justification for higher costs at the pump, but any substantial increase in crude oil prices will certainly be felt before long. Over the next few years, however, what's likely to keep gas prices up isn't OPEC, the global political situation, or the environmental regulations on which the Bush Administration likes to pin the blame. It's us. Demand for gas in the U.S. has risen by roughly 2% annually over the past decade, spurred by the explosion in demand for gas-guzzling SUVs and light trucks. In fact, the typical American car is less fuel efficient than it was 15 years ago. Overall, gas consumption between 1985 and 2000 jumped by 23%, according to the federal Energy Information Administration.

At the same time, the number of operating refineries has plummeted, falling from 324 in 1981 to just over 150 by the beginning of 2001. Why have so many plants shut down? Believe it or not, the government subsidized the construction of refineries in the wake of the oil shocks of the 1970s, but by the early 1980s Americans were actually conserving gasoline--a combination that led to a big surplus in capacity. That made refining margins so slim that even no-risk government bonds offered a better return on investment than spending to modernize old plants or build new ones.

When Valero spent $2 billion to build the Corpus Christi refinery in the early 1980s, industry wags called it "Greehey's gamble." Amazingly, no one has attempted to build a big new plant since then. And while the Corpus Christi plant has proven to be a good bet--it will generate more than $400 million in profits this year--Greehey says that "if we announced today we were going to spend $3 billion to build a brand-new refinery, people would just laugh. Wall Street would kill you. The return on investment doesn't justify it." Of course, as Greehey adds, tougher environmental rules do increase the cost of building refineries, as does the likely opposition of anyone who lives within smelling distance of a proposed plant. But the main reason no one is opening refineries is that it simply doesn't pay to build them.

The capital investments that refiners did make in the past two decades have mostly gone toward compliance with environmental rules and boosting production at existing refineries. Indeed, refiners have been so ingenious at modifying and tweaking their aging cat crackers, crude units, and other heavy equipment that gas production has crept higher even as all those plants have shut down. But refineries have been pushed just about to their limit, with capacity running at 95% to 100%. "Something has to give, and that's what's happening now," says Greehey. "At some point you hit a brick wall."

Running flat-out doesn't leave much room for error--or accident. And if you want to see just how hard Greehey's "brick wall" has become, go 35 miles south of Chicago, to Lamont, Ill., the home of a Citgo refinery that normally processes 163,000 barrels of crude oil a day. In the wee hours of Aug. 14, a fire in a crude-processing unit rocked the plant and caused so much damage that Citgo says it will be early 2002 before the refinery is running again. The loss of that single plant helped push up gas prices in Chicago from $1.56 a gallon on Aug. 13 to $1.83 by mid-September.

Why not just ship gas from refineries in Texas or on the East Coast into fuel-starved Illinois? If only it were that simple. A crazy quilt of local, state, and federal requirements governing the composition of gasoline in local areas makes it impossible to move gas rapidly from one region to another. Although the rules are ostensibly designed to curb pollution (they have dramatically improved the air in big cities like Denver, New York, and L.A.), the makeup of gas is often driven by local political interests along with environmental zeal. In areas where the farm lobby is strong, grain-based ethanol is added to gas to meet federal emission rules. Elsewhere, in markets like California and New York, a petroleum-based compound is added to achieve the same result. It gets worse: St. Louis, Mo., uses one recipe while neighboring East St. Louis, in Illinois, uses another.

Altogether, refiners have to concoct roughly 50 types of gas for different markets, and these "boutique blends" make spot shortages and bottlenecks virtually inevitable. Throw in the usual logistical nightmares--tight pipeline capacity, slow-moving barges up the Mississippi, and ancient federal rules requiring refiners to hire U.S.-flagged ships between domestic ports--and you begin to understand why the loss of a single refinery can have such dramatic and costly consequences.

And if you think gasoline supplies are tight now, well, they're about to get much tighter. Expect refiners to keep shuttering older, dirtier facilities rather than spend billions to meet new EPA rules requiring them to cut the amount of sulfur in gasoline and diesel by more than 90%. Although the regulations are clearly beneficial--the new low-sulfur fuels will help reduce smog and other pollution--it's likely that more plants will be forced to close before the rules go into effect in three to four years. What's more, refiners that are spending heavily to comply, like Valero and Frontier, say the low-sulfur requirements are likely to reduce output still further.

Although refining executives love to complain about those burdensome EPA rules, they admit that the new sulfur requirements will benefit the bottom line. "It's not necessarily good for the consumer, but it's good for us," says Jim Gibbs of Frontier. "We'll probably make more money. Plants are going to close, capacity will drop, but for the survivors, returns will be way up." Even if those higher returns do make it worthwhile eventually to build new plants or to expand production substantially, things are going to stay tight for a while. "Refineries are incredibly complex, very large critters," adds Gibbs. "Just planning an expansion of a major unit takes four years."

Back on Refinery Row at the 272-acre Valero plant, 12-inch pipes rattle overhead like an elevated train, moving one million gallons of gasoline an hour into a bright-red tanker waiting at the dock. "We've got some designated smoking areas but this isn't one of them," refinery services manager Bobby Broadway says over the din, pointing out giant tanks filled to the brim with exotic, not to mention explosive, products like benzene, naphtha, methanol, and jet fuel. "We're either plumb full or running kind of low," he says, adding that every three days or so a fresh tanker with more than 500,000 barrels of crude arrives to feed the beast. The plant is literally churning out every last drop of gas that drivers can burn up. Greehey's gamble has clearly paid off.

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