Refining My Knowledge of the Refineries

 |  Includes: HFC, SUN, VLO
by: William Trent, CFA

I have frequently heard that oil inventories aren't very important because refining capacity is the gating factor for most products. According to a recent MSNBC article:

There hasn’t been a new refinery built in the U.S. since 1976, the result of extremely tight environmental restrictions, not-in-my-back-yard community opposition, and the high cost of new construction. Used refineries currently sell for about 30 to 50 percent of the cost of building a new one, so it’s cheaper to buy an old refinery and upgrade it. Or squeeze a little more gasoline out of the refineries you already own.

Expansion of refining capacity is also made more difficult because oil refineries are a lot more complicated to build and operate than your average widget factory. For starters the raw material — crude oil — has many different properties, from thickness to sulfur content, so not all refineries can blend just any barrel of crude.

You would think that in this type of environment, the refineries would be able to charge whatever they like. But recent PPI datasuggests otherwise.

PPI for petroleum refineries

After a prolonged period of significant price gains, the year/year change in refinery pricing power dipped into negative territory early in the year and has been relatively flat since. Are the glory days over or is this a temporary lull? For help answering this question I turned to the recent conference calls from three of the larger companies that get most of their business from refining and marketing: Sunoco (NYSE:SUN), Valero (NYSE:VLO) and Holly (HOC).

First, speaking to refining margins, as we did last quarter, if you look at slides 6 to 9, we have included some detail of the realized refining margin versus our reported market benchmark for each of our geographic refining regions. Rather than walk through each slide in too much detail, let me make a few summary comments.

In the Northeast, our realized gross margin for the quarter was $12.32 a barrel, which was up about $0.75 a barrel from last year’s very strong second quarter, and was also about $0.73 a barrel better than our standard 6321 benchmark. On the input side, realized crude costs in the second quarter were $1.66 a barrel higher than our Dated Brent plus $1.25 a barrel benchmark. So still reflective of a very expensive market for light sweet crude in the Atlantic basin, but improved from the first quarter of this year...

If I can turn now to the MidContinent region, where industry downtime had a more significant market impact, our realized gross margin in the second quarter was $22.14 a barrel, up over $7 a barrel from the second quarter of last year but about $6 a barrel lower than our standard WTI based 321 benchmark. Again, on the crude side, actual crude costs were $2.17 a barrel above the WTI plus $0.75 a barrel marker, as WTI continued to be a weak relative benchmark.

Additionally, the price of Canadian syncrude, which accounts for about half of our crude slate at Toledo, traded at an increased premium to WTI during the quarter, due largely to upgrade or maintenance and other downtime among Canadian producers.

On the product side in the MidContinent, our realization was almost $4 a barrel below the benchmark. This correlation, also seen in last year’s second quarter, is fairly typical of periods when gasoline crack spreads are very strong. This is primarily because the 321 marker we use implicitly assumes that two-thirds of our MidContinent refinery production is gasoline when it actually averages more like about a half.

So let me say in summary, putting all those numbers and relationships aside, clearly second quarter refining margins were very strong by any historical measure.

(Excerpt from full SUN conference call transcript)

Paul Sankey - Deutsche Bank

Hi everyone. I think we’ve just about hit all my questions, actually, but one that’s outstanding is the way the curves have shifted. Is there any meaningful impact for you from the moves that we’ve seen to backwardation in crude markets? As a follow up, any observations you could make about the fact that crude inventories, ostensibly, are quite high in the U.S., but we’ve seen obviously very high prices. At the same time, gasoline inventory is not super loose by any means, but a cratering of the price there - any observations you can make on those would be great.

Unidentified Company Representative

Well, I’ll speak to gasoline. Gasoline prices are very low. They’re very low on a historical basis. So the decline that we’ve seen in the margins there isn’t necessarily fundamentally driven. We’re entering the season where we will start blending butanes back in, and so we know that will have an effect on the inventories. Nonetheless, we go into that period with inventories at very attractive levels relative to previous years.

On the crude, the change in the market structure just means that we’re not paid to carry it right, so what we’ll do, what we always do, is we aggressively manage the inventory to the market structure, as we’ve done on the product side.

Paul Sankey - Deutsche Bank

Right, so I’d expect to see inventories continuing to fall, but maybe the price, nevertheless, staying high.

(Excerpt from full VLO conference call transcript)

Historically high industry-wide margins, our location advantage product prices, and record production levels at our facilities fueled the best quarter in Holly's history.

The pure gasoline and diesel prices in our markets, due to the tight supply/demand balance in our Rocky Mountain and Southwest markets, combined with lower raw material costs to create historical quarterly average gas and diesel cracks at both plants.

Higher runs at lower cost black wax crudes at Woods Cross and a widening of the discounts for sour crudes run at Navajo, compared to compressed WTI prices versus similar worldwide crudes, helped drive down our raw material costs.

Our folks ran both plants at 99%-plus utilization rate, realizing the full benefit of the 2006 midyear expansion of the Artesia refinery and enabling a virtual full capture of the great margin environment experienced during the second quarter...

Although, as in other markets, our margins have reduced substantially in July and August from the lofty levels experienced during the second quarter, we remain extremely bullish on the refining industry fundamentals.

(Excerpt from full HOC conference call transcript

Now I'm no energy expert, but it sounds to me like there is very little wrong with refining industry fundamentals. If anyone out there can enlighten me, please do so.