Oil Refiners as Proxy for Demand

Refining margins have been absolutely decimated, especially for refiners of heavy, sour crude like Valero Energy (VLO) and Tesoro Petroleum (TSO). This is taking a toll on profits in the oil and gas sector, with both oil majors highly leveraged to downstream operations like ConocoPhillips (COP) and independent refining outfits showing steep falloffs in operating margins. I see this as a proxy for the underlying economic demand in the U.S. economy.

Refiners

Refining is a cyclical business and this same pattern has been repeated for decades. When times are good, refining margins are high. But, margins crash down at a moment’s notice, leaving some flat-footed and generating the waves of oil-sector busts of yesteryear. The desire of large firms to move away from Refining and Marketing reflects their desire to be insulated from these swings.

Independent refiners like Tosco, Valero, Premcor, Tesoro, and Giant grew up because of this vacuum left by the majors. Because the world’s refineries are leveraged to light sweet crudes like West Texas Intermediate (WTI), heavy and sour crudes like Maya and Alaska North Slope normally sell for large discounts on the spot market. This generated a demand for complex refining capacity capable of processing these crude varieties and offers the independents a natural area of competitive advantage.

Refiners as a proxy

However, this cycle has been especially severe for refiners leveraged to heavy, sour crudes, with WTI-Sour Crude margins averaging $1.34 a barrel for all of 2009. Valero, the largest independent refiner had never had layoffs until now. Below is the beginning paragraphs of today’s VLO press release.

Valero Energy Corporation (NYSE: VLO) announced today that the company is continuing to take action to improve its profitability by rationalizing underperforming operations. As a result, the company’s subsidiary, The Premcor Refining Group Inc., intends to shut down the coker and gasifier complex at the Delaware City refinery. The coker is expected to be idle at least until the outlook for coking economics improves, while the closure of the gasifier complex is for an indefinite period. The company also noted that the plant-wide shutdown of the Valero Aruba refinery is now expected to be for an extended period, and, as announced earlier this year, the shutdown of a coker and a fluid catalytic cracking unit at the Corpus Christi refinery continues, and that cokers at certain of its refineries would run at reduced rates until coking margins improve.

The company expects that these decisions will reduce headcount at the Delaware City refinery by at least 150 employees and 100 contract workers. Valero has notified its employees and contractors along with the appropriate regulatory agencies and union officials. At the Aruba refinery, the company expects that more than 700 contract workers will be released in September.

I imagine this was a hard decision for Valero, a company that was #3 on the list of best companies to work for in America as recently as 2006 and prides itself on taking care of its employees. It is now #91. But, this is the reality of the refining business in 2009 and it doesn’t speak well to underlying demand in the U.S. economy.

Back in July of 2008, before oil prices collapsed, I saw the reduction in refining margins as a telling sign of weak demand. The fact that margins remain weak despite incipient signs of recovery suggests that underlying U.S. consumer demand remains weak. In the last business cycle, margins did not improve materially until 2004 when the employment market picked up and underlying demand growth improved.

Comments

[BrotherMaynard:]

refining is a brutal biz right now...end demand for refined products is in the tank (historically speaking) yet input costs have doubled over the past 6 months. can't think of a sound economic reason for this to happen. i suspect financialization has something to do with driving up prices, despite demand being historically low, and supplies being historically high. in addition, it doesn't take much to corner the brent/wti physical markets as there aren't but a few hundred thousands bbls per day being pumped of each.

Sep 08 04:21 PM

[untrusting ...:]

Good article. Helpful insights. Thanks.

Sep 09 12:59 AM

[J. Bruun:]

Hi Edward,

Thank you for the article.

How does this translate into trading recommendations? When is it time to go long if you fundamentally believe that over then next year or two we will be far out of this long recession? What I'm thinking is that when the 2012 LEAPS come for e.g. VLO it will be time to buy out of the money calls.

Jan

Sep 09 08:50 AM

[Edward Harr...:]

Generally, I am bullish on the oil patch because I believe excess liquidity will go into asset prices, especially commodity markets. That's bullish for Upstream companies. But, if prices rise quickly that squeezes refiner margins. So, I couldn't say i think VLO or TSO are going to benefit.

I do believe we have a glut of sour heavy crude over sweet light and that means the fundamentals will eventually re-assert themselves in the refiners direction (not SUN because they are not leveraged to complex refining).

The key word is eventually, of course, because refiners likely won't run-up until then.


On Sep 09 08:50 AM J. Bruun wrote:

> Hi Edward,
>
> Thank you for the article.
>
> How does this translate into trading recommendations? When is it
> time to go long if you fundamentally believe that over then next
> year or two we will be far out of this long recession? What I'm thinking
> is that when the 2012 LEAPS come for e.g. VLO it will be time to
> buy out of the money calls.
>
> Jan

Sep 09 09:56 AM

[Ricard:]

I'm sold on your argument. Your subsequent comment seems to have held out during the past 4 years, so I'm sold on that as well. Refiners are not a commodity play - quite the opposite.

Sep 09 10:37 AM

[Dollarhane:]

I think one thing that should be covered and looked at is gasoline inventories and demand. One needs these to decrease to enable margins to improve. This is a very gradual process and is a reason for it taking until 2004 for margins to increase in the last downturn.

Although refiners are getting hurt now, I do not th

ink that it is going to get much worse. Night is darkest before dawn and even though VLO and TSO are lagging in corporate profits right now - I think they will see brighter days ahead coming into the middle of 2010.

Sep 09 01:18 PM

[blackjack:]

shutting-in temp. and shutting down perm. eventually will have a beneficial bearing, even tho remote and e. coast oriented...cutting costs will upbraid fin. structure and sooner than later, will show up..now is the time to accumulate TSO and VLO ahead of a better spring '10.

Sep 09 01:21 PM