Independent Refiners: Too Much Risk and Uncertainty

There’s too much risk and uncertainty to allocate capital to refining assets.

The independent refiners have had a tough go of it since mid-2007, with many declining by 70% to 90%. Most balance sheets are clean (Frontier Oil (FTO), Holly Corp (HOC)) while some have large debt loads due to acquisitions (Western Refining (WNR)).

Trough valuations (1999 and 2002) give a wide range of where refiners are likely to trade and some have traded as low as $42/complexity barrel during arguably weaker economic downturns and well below current valuations.

HOC currently trades at $313/complexity barrel, adjusting for cash and stake in Holly Energy Partners and is proforma for ’09 expansion projects. FTO trades at $698/complexity barrel adjusted for cash and debt.

It’s All About the Crack

Crack spreads, or the gross margin from refining crude into its constituent products, have been dismally low in Q4 and our expectations are that they won’t improve for some time.

Last week, BP noted Q4 margins were the worst since Q1 led by the Gulf Coast and Mid-West, where margins were $2.30/bbl and $2.20/bbl, respectively, quarter to date. Most refiners need $4.00+/bbl to breakeven.

The lack of margin, mostly on the gasoline side of the equation where the gulf coast spot gasoline crack has averaged -$2.73/bbl for Q4 to date, is the result of deteriorating consumer demand. Gasoline demand is down some 3-4% y/y and with no near term catalyst. Include the impact of increased ethanol blending and gasoline demand is lower still.

Consumer demand for gasoline has been evolving for the better part of three years as at the pump prices accounted for a growing portion of personal income, exceeding 2.5% since ’05 and more than 3% for most of ‘08. Adding to that a contracting economy and an increasing unemployment rate - some estimates are calling for greater than 10% up from the current 6.7% - suggests we have some time before gasoline demand stabilizes.

Further, we have little confidence that international demand, i.e. China, will hold, putting a strain on distillate demand and eroding the only segment of the products market with margin. Winter demand should keep prices for distillates at an elevated level during Q1 ’09, but what happens after that is anybody’s guess; however, we expect prices to decline due to increased distillate production, India, and declining international demand.

Better entry points are ahead.

Disclosure: no positions

Comments

[bosun.j:]

Well there ya go then! No need to upgrade and improve refining capacity while demand is low. No need to shut down one cracking unit while keeping the others on line. Can't have that can we? No siree, how will they be able to justify high heating oil and diesel prices when oil goes back up?

2008 Dec 30 08:20 AM

[NOWHEREMAN:]

Good comment Bosun.

This is the best of times to build these puppies but instead of building, capacity is being shut in. Idiots

2008 Dec 30 08:25 AM

[Tom Armistead:]

I am long the somewhat similar Tesoro (TSO) based on the idea that refinery stocks are trading at prices well below the replacement cost of their assets. TSO has done a lot of work to improve optionality around inputs and outputs, primarily by increasing complexity.

I attribute the worst of the difficulties for refineries to inventory problems: they got caught long gasoline in a declining market.

Difficult economic times bring out man's inherent tendancy to resort to conflict. That tendancy will manifest itself most strongly in the oil rich areas of the world, so that complex refineries in the US wil earn premium prices for working with heavy and sour oils.

Perhaps the best entry points are behind us.

2008 Dec 30 10:51 AM

[BrotherMaynard:]

If you read larry summers' piece in the wapo yesterday, you'll find that he hints about creating new jobs in the renewable sector. I have a feeling any favorable legislation going forward is going to be heavily geared toward this, as it actually sounds more like it is being designed strictly for job creation. I'm not saying i agree, but it doesn't look like building refineries is going to be a high priority for this bunch.

2008 Dec 30 12:02 PM

[31October:]

This is good news - maybe good will come from the pain when supply is restricted:

Maybe Americans will wonder how the oil companies stay profitable regardless of natural supply/demand, why unrelated defense and oil companies share the same directors, why congressmen who make $170k/year live in $10M homes, and why those congressmen's in-laws are on those same completely unrelated boards.

Or maybe I'll just accept reality and buy some BP & XOM.

Jan 22 04:29 PM