Exploring Beyond Refining Complexity

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Morningstar submits:

By Allen Good

Fundamentally, little has changed since the spring when we last visited the U.S. refining industry. At that time, we cautioned that regardless of a potential bump in gasoline demand, refiners would still likely suffer from weak margins. Refiners did see an improvement in gasoline demand over the summer. Beginning in June, monthly average gasoline consumption increased year over year for the first time since September 2007. However, refiners still reported poor results, and stock prices continued to fall. Although gasoline demand will likely continue to register year-over-year monthly growth, it will likely do little to improve refining margins. The primary culprit behind refiners' poor performance this year remains weak distillate margins and narrow heavy crude oil differentials. Little improvement in either of these two fundamental drivers of refining performance is likely to occur in the near term.

Historically, evaluation of refiners began and ended with their complexity and size. The conditions of the last year may have broken that paradigm, at least for the short term. Under that framework, the large, highly complex refiners located in the Gulf Coast held the advantage. Not only did their size afford cost advantages, but they also had superior access to low-cost heavy crude. That advantage has somewhat dissipated in the last year with the narrowing of heavy crude oil differentials. Although the Gulf Coast facilities remain competitive because of their size and efficiencies, simply evaluating every refiner on the basis of its complexity or size may not necessarily be comprehensive. In the current operating environment, other factors may play an equally important role in achieving profitability.

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Waiting on an Economic Recovery

At the heart of refiners' troubles are the poor economic conditions. Both weak distillate margins and narrow heavy crude oil differentials are a function of the global recession of the last year. Distillate inventories have soared over their five-year averages as a slowing economy reduced demand for diesel. Due to refinery production cuts and the advent of the winter heating fuel season, distillate inventories have declined somewhat in the last few weeks but still remain high. The current 165.7 million barrels of supply represent 46.1 days of supply compared with 125.0 million barrels and 31.3 days of supply at the same time last year. Given the high inventory levels, distillate margins have collapsed from a year ago. Distillate margins in much of the country are only one fourth of what they were during the same time last year. Refiners have also lost the benefit of a strong export market that drove higher margins last year. Export opportunities created last year by European demand, Chinese stockpiling ahead of the Olympics, and South American power generation no longer exist. In order to return inventories to their historical ranges, a broad-based economic recovery and return of demand is likely needed.

Any improvement in heavy crude oil differentials will likely warrant similar circumstances. As the global recession took hold in the last year, OPEC cut production levels in order to support crude prices. The production cuts reduced the heavy oil supply on the global market. In addition, natural decline from Mexico and project delays in Canada further reduced heavy oil supplies available to the U.S. In recent years, U.S. refiners have added a substantial amount of coking capacity. As a result of greater demand and reduced supply, the discount normally given to heavy crude has shrunk. Current conditions are unlikely to change soon. Crude oil inventories in the U.S. and worldwide remain sufficient to meet current demand. Meanwhile, crude oil prices are within an attractive range for OPEC. Until global economic activity picks up, spurring demand and reducing inventories, crude oil prices will likely remain in a range that does not warrant additional OPEC production.

Inventory Imbalance

High distillate inventories are likely to plague all U.S. refiners, both independent and integrated, well into 2010. However, while it is worthwhile to pay attention to the inventory numbers we cited earlier, it is important to understand the detail behind the data. Inventories of gasoline and diesel may be above their average highs, but that inventory is not spread evenly across the U.S. The nature of the U.S. refined products market limits refined products distribution to the location of the refinery and the availability of pipelines. As a result, if demand falls nationwide, an imbalance can occur where inventories build in certain regions but remain within normal ranges in others.

This means refinery location takes on a new dimension in times of depressed demand. Depending on inventory levels in a given region, margins may be stronger than in the rest of the country. During third-quarter earnings, we saw some examples. Standing out among independent refiners was Tesoro ( TSO ), which reported third-quarter profits. Similarly, Chevron ( CVX ) and ConocoPhillips ( COP ) both reported profits for their U.S. refining segment. Both companies benefited from operating refining facilities located on the West Coast (PADD V). Although aggregate inventories remain high, PADD V inventories are much more in line with their historical ranges. As a result, gasoline margins in the region were stronger in the third quarter than a year earlier. This despite higher unemployment levels than the national average in the region's primary market of California.

In contrast, an inventory glut formed in the Gulf Coast (PADD III). This is not very surprising given almost half of U.S. refining capacity is located in PADD III. Consequently, Gulf Coast refining margins have been struck particularly hard. As a result, ExxonMobil ( XOM ) , whose refining capacity is concentrated in the Gulf Coast, reported a third-quarter loss for its U.S. refining segment.

Partially benefiting PADD V inventory levels were low capacity-utilization rates. To combat rising inventories, refiners began cutting operating capacity in hopes of improving margins. As the chart below shows, during the last two years, total U.S. refining capacity utilization has steadily trended downward as refiners sought to remove more capacity. However, the cuts in utilization have not been uniform across the country. As the chart below indicates, reductions in capacity utilization were concentrated in PADD I and more recently PADD 5. During the third quarter, capacity utilization on the West Coast was lower than the national average which likely contributed to the reduced inventory levels that benefited Tesoro and Chevron in the quarter. However, on the East Coast, where capacity utilization has generally been the lowest among all the regions, inventories continued to build.

The Importance of End Markets

The ineffectiveness of capacity cuts to improve East Coast margins further illustrates the importance of facility location and highlights another critical element that determines a refiner's success. The end markets a refiner serves can often determine the sustainability of its margins. East Coast refiners operate in a highly competitive market primarily a result of the availability of imports from foreign refineries. As the chart below indicates, the East Coast (PADD I) receives the most imports of any region in the U.S. Additionally, during the last two years imports declined only slightly as demand was falling. As a result, capacity cuts had little affect as inventories continued to build from imports. The region's weakness contributed to the decisions by Sunoco ( SUN ) and Valero ( VLO ) to each close a facility in PADD I.

The rest of the country faces only a limited threat from foreign imports but does have to compete with other domestic refiners. Often competition comes from large, low-cost refineries in the Gulf Coast. An extensive pipeline network connects the hub of U.S. refining to much of the rest of the country. Refiners that serve protected markets or markets with limited pipeline access can maintain margins in difficult conditions. This is often the case in the Mid-Continent and Rocky Mountain regions where pipeline access from the Gulf Coast is limited. In contrast, the pipeline capacity from the Gulf Coast to the East Coast is readily available putting further pressure on East Coast margins. By looking at third-quarter results again, we can see the benefit of protected markets. Holly ( HOC ), another independent refiner that delivered profits for the quarter, operates two small refineries that serve markets unreachable by Gulf Coast refiners.

Differentials Still Available

Suffering the most from the narrow heavy crude oil differentials might be the Gulf Coast refiners. Typically the largest and most complex, these refiners capitalized on their ability to upgrade cheap grades of crude into high-value products at a lower cost than other refiners. Their location on the Gulf afforded water access to several sources of cheap foreign crude. An extensive pipeline network was then utilized to send the low-cost production throughout the country. After years of investment to upgrade facilities to process heavy oil, Gulf Coast refiners find operating their coking operations uneconomical.

Other refiners, however, are finding crude differentials available. Once again, the location of a refinery plays a critical role. For example, Tesoro's third-quarter earnings reflected the success its 58,000-barrel-per-day North Dakota refinery had in capturing the discount available on crude from the Bakken Shale. Although not a heavy crude, oil from the Bakken Shale trades at a discount to account for transportation costs given inadequate takeaway capacity. Another example is Holly which is able to process a heavy black wax crude produced in close proximity to its 31,000-barrel-per-day Utah refinery. Both refiners were able to exploit their location to these unique crude sources and capture higher margins.

Longer term, heavy crude oil differentials are likely to widen back out, but Gulf Coast refiners may not retain their crude access advantage. Although OPEC sources may return to the market, China will likely represent a significant source of demand for those volumes. Historically Gulf Coast refiners have counted on heavy volumes from Mexico and Venezuela. However, Mexican volumes have fallen off substantially because of natural decline and are unlikely to return to historical levels. Future Venezuelan volumes remain unpredictable because of political issues. Future sources of heavy crude to the U.S. are likely to come from Canada. In this case, refiners in the Mid-Continent may be better positioned. Currently, pipeline infrastructure does not exist to deliver Canadian volumes to the Gulf Coast. Planned pipelines to the Gulf Coast likely won't be available until the end of 2012.

Still Not Attractive

Given the long-term trends of increased refining capacity abroad, adoption of higher fuel-efficient vehicles and ethanol-blending mandates, the future of U.S. refining appears grim. Current economic conditions are likely advancing the pace of refinery closures that would have occurred over the longer term. We believe the elements discussed above--refinery location, access to advantaged crude, and protected markets--will be decisive in deciding which refineries remain open as opposed to just complexity and size. Given the substantial headwinds of the industry, however, these factors are better used in determining which refineries will stay open as opposed to which are good investments. Even the profits that some refiners reported in the third quarter were well below the levels of two years ago. Any profits that may occur in 2010 will likely be anemic compared with those of earlier years. For refining to become attractive, we would have to believe a secular rebound in refining margins was going to occur. Right now, we believe valuations accurately reflect our thesis of continued weak margins.

If conditions do ultimately improve, large complex facilities on the Gulf Coast will likely return to prominence. Wide heavy crude differentials and high capacity-utilization rates should play to these refineries' strengths and lead to a return to profitability. This means a recovery would be relatively good for such names as Valero and ExxonMobil. However, there will still be a place for refiners, such as smaller refiners Holly and Frontier ( FTO ), with access to advantaged crudes and that serve protected markets. At the same time, refiners like Sunoco that operate in the highly competitive East Coast market may continue to struggle.

See also Back Door Biofuel Investment on seekingalpha.com

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.

This article appears in: Investing , Stocks



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