The dramatic swings in fortune over the past few years in the global petroleum refining business have placed many of the stocks of domestic refiners in the investment dog house. The period between 2004 and early 2008 saw oil demand marching higher with many commentators focusing the blame for gas price increases on the bottleneck in refinery supply. The world’s leading oil suppliers, the Saudis, as well as many in the Bush administration and US business community suggested that a large-scale build-out of American refinery capacity was essential for the maintenance of American petroleum product supplies. Then came 2008, when the crash of the oil market and the accompanying demand for petroleum products turned most refining margins negative. Between 2008 and 2009, the stocks of many domestic refiners such as Tesoro (TSO), Valero (VLO), and Western Refining (WNR) collapsed over 70% and have remained at depressed levels since.
The truth about domestic oil refining capacity, it seems, is that it is too plentiful for a nation where gasoline demand may have topped out in 2007 (according to some experts). In the long-term, a host of forces are conspiring to shift our nation’s consumption of refined petroleum products towards safer and more environmentally friendly fuels. Unfortunately for refiners, this shift may be sped up in the medium-term by higher vehicle fuel economy standards and the steadily increasing price of gas at the pump. The Obama administration announced a proposal to double auto fuel efficiency to 54.5 mpg by 2025 in November. Though the number of oil refineries in the US shrank from 300 in 1980 to about 125 in 2010, the total capacity volume has expanded by about 13%. Since late 2007, refinery utilization capacity in the US has been at depressed levels with few signs of a marked improvement. This has led some of the oil majors, such as ConocoPhillips and Sunoco, to exit the refining business altogether in order to focus on their upstream businesses. Industry experts tend to agree that the most likely path for the domestic refining business is consolidation.
The past year has provided some refiners with a golden opportunity. Transportation supply restrictions on Canadian oil moving to the Gulf Coast helped cause the spread between WTI and Brent crude to balloon, at times to over 20%. As WTI prices fell and Brent inched upward, some oil refiners in the Midwest and northern Gulf Coast regions benefited from significant margin expansion. While many of the refiners had access to light, sweet WTI, they could still sell their refined products at prices comparable to products refined from Brent crude, or similar crudes indexed to Brent prices. This was essentially transferring profits that would have gone into the pockets of Canadian oil producers to the income statements of American refiners. After the 2008 to 2010 period, this sudden (albeit short-term) boost helped shore up refiners’ balance sheets and push up their stock prices, though they continue to underperform the market since mid-2009. I argue that the improvements generated from this years’ rise in refiners’ crack spreads has opened the door to the M&A activity which will be necessary to consolidate the domestic oil refining business and adjust capacity to a level where refiners can make a consistent profit.
Take a look at Valero, the $11.6 billion refiner, wholesaler and retailer with operations in the Midwest, Gulf Coast, and Pacific regions. Valero’s share price has risen from a low of $15.57 in July of 2009 to a recent close of $20.77. It trades at a pitiful 5.31x LTM earnings. Over the past year, its coverage ratio has improved from 0.87 to 1.52 (I’m using Cash+Receivables/LT Debt here). Valero’s financial priorities are improving cash management, reducing debt and continuing to maintain CapEx in high return, high margin projects. Though I’m not an expert on the refining business, nor the companies I’ll discuss, I wanted to throw together a thought experiment on how VLO might improve its competitive position through M&A.
Here is my suggestion: VLO should sell-off its lower-margin assets in California (what VLO’s 10-K describes as the ‘West Coast’ region) to Tesoro, whose current operations are focused in California and Washington. Using the proceeds from this sale, as well as other potential financing options, Valero should seek to acquire Gulf Coast or Midwest assets, in the form of entire companies or refining assets of oil majors looking to exit the refining industry (I’ll examine different options for a Gulf Coast acquisition by VLO in a future article). The concentration of refining capacity of the different regions in the hands of fewer players should help prop up margins in the long-term and keep the independent refiner business model sustainable. I’ll explain my logic for the above two transactions below but the overarching reasoning is that Valero should make an effort to be the largest possible refiner in as concentrated an area as possible. Since 60% of Valero’s operating income in Q3 was derived from its Gulf Coast operations, I think it would be wise to focus on acquiring more capacity in that region.
To understand why selling California assets makes sense for Valero, you should know that the West Coast refined petroleum market is distinctly segmented off from the rest of the country. With the main refining hubs in the Los Angeles area, Bay Area, and the Seattle metropolitan area, very few pipeline connections allow the transportation of oil refined in the West to move east, nor do they facilitate oil refined in the East or Midwest to move to the Pacific coast. Essentially, the Western market has its own supply-demand dynamics from the rest of the country. Further, the California Air Resources Board is likely to place more aggressive fuel economy standards (and on a tighter timeline) than the rest of the country.
California may also be one of the first states to institute carbon taxes or a cap-and-trade system that is likely to punish oil refiners. Valero mentions these environmental regulation risks of its California operations in its SEC filings. Since Tesoro is already a sizable and concentrated player in the market, with 247,000 bpd throughput in two California facilities, 169,000 bpd throughput in Washington and Alaska, and 74,000 bpd throughput in Hawaii (all Q3 numbers). TSO also has 119,000 bpd in throughput in N. Dakota and Utah, though these operations are not so much a part of the ‘Pacific’ market as its other operations. Tesoro’s Golden Eagle refinery in Martinez, California, just north of Oakland has 166,000 bpd of refining capacity and sits just across the water from Valero’s Benicia refinery with 132,000 bpd capacity. The synergies could be interesting. So could the synergies when Tesoro’s 97,000 bpd Wilmington facility assumes control of Valero’s 132,000 bpd Wilmington facility. The feedstock and products for both sets of facilities tend to be similar. I’d estimate that Valero could get as much as $2,700 per bpd for these facilities, which is the price is purchased a Chevron’s assets in Wales for earlier this year. The implied purchase price would then be $815.4m, which Tesoro could fund in part through its $375m earmark for California CapEx spending in 2012. TSO has $1.1b in cash at the end of the third quarter and another $1b undrawn on its primary credit facility.
This $815m, along with Valero’s improved balance sheet flexibility, would go a ways towards financing the purchase of some Gulf Coast assets. When considering purchases, Valero should look to acquire higher margin operations to boost its $13.08 per throughput barrel margin in its Gulf Coast operations. By selling off its lower margin ($11.96 per throughput barrel) operations on the West Coast, Valero can focus on improving its market power in its higher margin areas. This thought experiment is largely theoretical, considering that Valero’s acquisition of Welsh assets earlier this year tends to support the idea that management is looking to expand geographically diversity. Ultimately, I see this strategy as unwise considering the refining industry’s capacity oversupply issues and the importance of maintain pricing power in such an environment. Look for my next article that will examine some of the potential Gulf Coast acquisitions Valero should consider. I'd encourage anyone with more knowledgeable insights on the refining industry (and M&A in particular) to comment.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.