As many may know, the oil refining business is mostly a low-margin operation, despite the all-familiar headline news on higher gasoline prices at times, supposedly something favorable to refiners. Refining profitability can be roughly measured by something called crack spread, a margin that refiners can add on top of their crude costs. Current crack spread for gasoline is under $19 a barrel when compared to West Texas Intermediate. Since one barrel equals 42 gallons, a crack spread of $19 translates to about 45 cents per gallon of gasoline in potential refining profits. Actual earnings, however, will be less after deducting all refining costs.
Rising crude prices benefit oil producers but often cost refiners more for the same gallons of gasoline produced. The extra cost may or may not be fully absorbed by changes in the price of gasoline, potentially further lowering refining margins. Assuming $100 a barrel for crude, it would be $2.38 in base crude cost for a gallon of gasoline. After adding all refining costs including expenses on transporting crude and other logistics, plus allowing certain pricing room for retail markup, there seems to be little margin of profits left for refiners. Given the tough business fundamentals in the oil refining business and the potential difficulty of making strides on financial performance, can refiners still be good investments?
Just like how investing works with businesses in every sector and industry, it depends on individual companies. There are always some companies that can get creative with cost cutting or revenue generating to expand their margins of profits. Innovation of any kinds is what can lead to value creation and make a business a worthy investment. While refiners overall have lower gross margins, especially as compared to those of crude producers, some are still able to do better than others. For example, Phillips 66's (PSX) gross margin almost doubles that for Valero Energy (VLO) on a trailing-twelve-month basis, as the two companies operate very differently in the same refining business.
One area in which Phillips 66 is different from Valero has everything to do with how crude oil is transported to refinery sites. While Phillips 66 can self-transport crude to its refineries using its own oil pipelines, Valero, having no pipeline operations, arranges for the crude delivered to its refineries by either crude suppliers or third parties of crude transporters. These two different business approaches not only can result in different cost structures used to account for crude transporting costs, but may also lead to different crude base prices reached with crude suppliers. Transporting cost and crude price, if not appropriately managed, can contribute to the increase of the overall costs of gasoline production.
When self-transporting crude using its own pipeline infrastructure, to apply transporting cost, Phillips 66 needs only to capture its pipeline investments over time and incur a pre-assigned, non-cash capital depreciation one accounting cycle at a time. This way, the cost of transporting crude is both flexible and likely cheaper in the long run. On the other hand, Valero, relying on others to transport crude for it, will have to accept whatever market quotes are at the time it needs the transporting service, making its transporting cost potentially more expensive and not self-manageable. The cost of transporting crude to refinery sites is an indispensable part of the total expenses that refiners must grapple with to stay competitive in the thin-margin refining business.
Having the ability to self-transport crude to refinery sites may also give a refiner a potential advantage when it comes to settling on crude price with crude suppliers. Because a lack of transporting capacity by crude suppliers and third-party oil pipeline operators can depress crude prices as quoted on the market, refiners that can take the responsibility of transporting crude upon themselves can edge out crude suppliers to demand more favorable settlement prices by relieving crude suppliers from the duties of transporting crude. There seem to be a positive relationship between available crude transporting capacity and potential crude price movement.
Such a relationship is evident in the recent news about the proposed opening of the southern part of Keystone XL and the crude price's immediate moving up after the announcement. Similar to the reason why a lack of crude transporting capacity can depress crude price, additional Keystone pipelines can help reduce crude inventory buildup at Cushing, Oklahoma, NYMEX's crude futures deliver point for WTI, and thus support crude prices, once the pipelines start transporting crude to various refineries near and along the Gulf Coast. It's clear for refiners that having the ability to self-transport crude to where it will be refined can avoid hefty transporting costs, as well as potentially bringing down crude settlement price, which in turn reduces total gasoline production costs and leads to better refining margins.
Given the limited pricing power that refiners normally have in the gasoline market, with pipeline operations, Phillips 66 can leverage its crude transporting ability as a means to affect the cost side of its operations. It is true that Phillips 66 inherited the oil pipeline business when it was spun off from ConocoPhillips (COP). But adding some pipeline operations seems to really make sense for the oil refining business when refiners haven't found other ways to help increase their margins.