Changing Times: What's Next for US Refiners?
December 17, 2010
Something significant is happening in the U.S. refining industry. Refining profits were up resoundingly for the second and third quarters of 2010. Additionally, utilization rates for U.S. refiners averaged close to 90 percent, up 10 percent over the same quarters last year.
This is a nice contrast to the entirety of 2009, when demand for fuel in the U.S. fell sharply for its second consecutive year. The prolonged Great Recession meant that earnings for refiners last year looked like a disaster zone, with investor conference calls peppered with promises to cut costs and pare marginal downstream operations.
During the depths of the recession there appeared to be a striking reaction by the industry: Oil companies said they would permanently close three U.S. refineries capable of processing 400,000 barrels a day of crude; that's about two percent of capacity in a sector where closures are treated as a costly last resort.
This was initially received as an important down payment on the reductions of one million to two million barrels a day needed to bring the business back into the range of long-term profitability. However, actions thus far by refiners to eliminate excess capacity have been largely offset by previously planned capacity additions that came online during this same time. And although there are hopeful signs that fuel demand is turning around along with the economy, the high refinery operating rates of the second and third quarters actually ended up increasing inventories at a time when they traditionally would have moved lower.
But even after the economy returns to steady growth, U.S. refiners will still have to contend with a long-term decline in fuel demand due to regulatory and economic shifts.
Mandates to steadily increase the fuel efficiency of U.S. cars, known as the CAFE standard, as well as a mandate to triple the amount of bio-fuels blended into gasoline will reduce petroleum-based gasoline over the next decade by as much as 20 percent. On top of this is the unknown impact on demand associated with rapid adoption of electric vehicles, or widespread use of compressed natural gas across America's commercial vehicle fleets.
Also, while Congress shows no appetite this year for passing a law to reduce carbon emissions, the Environmental Protection Agency (EPA) is nonetheless moving forward with rules that could hit refiners when they upgrade their facilities. Meanwhile, California is moving forward with statewide climate legislation that will have major implications on refiners. Both of these phenomena serve to increase operating costs for refiners and may even result in the closure of refineries that are unable to justify expensive upgrades.
Now the question is: What happens next?
The short answer is that it depends on how many refineries are closed and how long that takes. If demand projections by the Department of Energy's (DOE) Energy Information Administration are right, this will determine whether the years to come will be a Dark Age for refiners or something closer to the Golden Age they saw the second half of the last decade.
The demand drop is similar to one that began in the late 1970s, when a deep recession was followed by more fuel-efficient cars, tougher air-pollution regulations and reduced fuel demand—all of which increased the cost of refining. The result was a painfully slow die-off of inefficient refining capacity that stretched into the 1990s. In fact, things did not dramatically improve until refined product demand crept back to historical levels due to gradual increases in the U.S. population and the total number of vehicle miles traveled.
Looking at our current predicament, there are three likely scenarios:
- Rapid elimination of excess capacity—Refiners move quickly and uniformly to close old, inefficient plants in need of upgrades, resulting in higher overall utilization of remaining capacity and better margins.
- A slow moving battle of wills—Refiners endure a survival-of-the fittest stance and enter a protracted period of low profits hoping other companies will be the first to bite the bullet.
- New owners and new perspectives—U.S. refineries are sold to new players, perhaps teamed with international interests willing to accept low profit margins for cheap access to the U.S. market.
Based on the shutdowns so far, the first scenario may be achievable, but only if you are one of those who think we learn from history.
The second scenario, though, is much more in line with the last big refining downturn, for those who expect us to repeat it.
And the third scenario makes the second that much more likely. In others words, it would be a long period of excess capacity: a refiner's version of the Dark Ages.
Of course, historians now argue that the Dark Ages weren't as dark as commonly believed. If the protracted refining downturn that began in the late 1980s and continued through the 1990s and into the early 2000s can be evaluated without considering the dismal profit margins—admittedly a big if—it can also be seen in a more positive light.
Back then, the structure of the U.S. refining business went through a dramatic change. The sale of refineries by the major oil companies led to the creation or growth of a group of independents like Tosco, Premcor, Tesoro and Valero. They bought in at bargain prices, upgraded the refineries as needed, and focused on keeping operating costs low. This allowed them to earn acceptable returns in the lean times and to do very well when times were good.
Also during this time, deals were made between a number of major U.S. refiners with national oil companies (NOCs). Some of these NOCs were hungry to find outlets for heavy, hard-to-process crudes—or just wanted access to the largest refined products market in the world. These deals allowed the NOCs from Saudi Arabia, Mexico and Venezuela to gain access to the U.S. refining sector.
The deals took many forms, from tolling and netback arrangements to joint venture operating companies. For some U.S. refiners, it was a way to lock in thin, but guaranteed margins on at least a portion of their capacity. For others, it represented an opportunity to lock in a crude oil supply at heavily discounted prices. However, many of these deals were negotiated during a similar period of over-capacity in an effort to insure higher operating rates, reduce earnings volatility and ultimately served in many instances to just put additional pressure on overall U.S. refining margins.
This time around it's a similar mix of players, including major oil companies, independent refiners, NOCs, and private equity. What has changed, however, is that now both the major and the independent U.S. refiners would likely be sellers and there may be additional international companies in the mix.
U.S. refining - three possible scenarios
Fundamentally, the U.S. refining industry must eliminate spare capacity over the next 10 years or find new means of utilizing it.....
- 1+ million bpd of capacity is quickly rationalized over a brief period
- U.S. economy recovers from the "great recession"
- Average refinery utilization in low 90% and margins return to acceptable levels
Lingering overcapacity ("Battle of wills")
- U.S. economy recovery in 2010/2011 results in increased refined product demand and temporary improvement in margins and utilization
- U.S. refining capacity remains at current levels, with net expansions offsetting the few shutdowns that have occurred
- CAFE and RFS regulations "kick in" and gradually reduce demand over 10 year period, slow rationalization of excess capacity
New owners and perspectives
- Complex U.S. refining capacity sellig for well below replacement cost
- Foreign oil companies and private equity become financial and/or strategic buyers
- Chronically low margins and further "shakeout" among major and independent U.S. refiners
Alternatives for underperforming refinery assets
Last year when oil companies reported their final 2009 earnings, there was a lot of tough talk about eliminating unprofitable operations. But almost no details about what they will be selling or closing.
Once a company determines that additional cost cutting or capital improvements will not change the overall competitiveness of a refinery, there are usually three options for pulling the plug: they can sell the refinery and related assets for whatever the market will bear; shut the facility and remediate the site; or, discontinue the refining operations and convert to just a crude oil and/or products terminal.
Chances are, of course, that they would like to sell. This option typically is the cleanest and quickest way to exit an unprofitable operation. Unfortunately, selling an operating refinery does not solve the issue of over-capacity in the industry and the resultant pressure on operating margins, it just creates or strengthens a competitor.
Compared to an outright sale, closing even a moderate sized refinery represents an even bigger economic hit in most instances.
There is also a sizeable political aspect to shutdowns. A lot of people work inside refineries. A lot more work for companies supplying and maintaining them. It is easy to see why a refinery shutdown can garner a lot of unwanted attention.
In Delaware, the shutdown of a refinery, which had employed 550 workers, was an issue in the Governor's State of the State address. The company subsequently agreed not to dismantle the facility while negotiating with a private equity company to sell the refinery equipment and the terminal.
The specter of job loss and environmental impact mean it is often not a politically acceptable option to walk away from a location even if the refinery is no longer operating profitably. Environmental issues and strategic concerns surrounding closure of refining capacity are as important as the economic concerns.
The Delaware story makes it clear that there is more than meets the eye when it comes to shutting down a refinery.
However, in cases where a refinery is permanently shut down, the terminals and storage facilities left behind often remain valuable assets and can be operated on a profitable basis. Expertise in transport and storage fits neatly into an important role for refineries—serving as hubs for the increasingly complex U.S. fuel distribution system.
Even without an operating refinery, the rail, water, and pipeline connections commonly found as part of the infrastructure make them a logical spot to provide services like blending bio-fuels and moving imports and exports.
The terminal operations of refineries on the coast, for their part, could profit from the expected growth of imports and exports. The ever-increasing number of export refineries being built in the Middle East, India and elsewhere make it likely that the U.S. will be an enticing market for excess refined products. Plus, as diesel demand continues to grow on a worldwide basis, we could see the U.S. become even more relevant for supplying the export market. Likewise, the federal mandate requiring ever rising bio-fuels production may represent an additional dimension for an ailing refinery to be repurposed. The water, rail and pipeline connections, as well as the tank farms, make them the logical places to store, blend and ship the next generation of fuels.
So who would buy under this scenario?
One likely scenario would be NOCs. They are motivated by the need to find markets for excess crude, or the need for oil processing capacity, rather than the hope of fat refining profits. Additionally, the plethora of NOCs interested in the U.S. fuels market has likely expanded to include those from China, Brazil, India, and Russia. Companies with substantial oil sands holdings or others with the need for steady demand and predictable netbacks might also have an interest in the U.S. fuels market.
Potential alternatives to selling a refinery
- Performance improvement - Almost all major and independent refiners have undertook cost reduction programs. However, it may be increasingly difficult to wring out additional costs.
- Shutdown - Shutting down facilities is unattractive due to the write down of an asset, the environmental complance costs associated with the shutdown, and the political repercussions.
- Convert to a refined product terminal - Avoids environmentl remediation costs and is a common route. Provides the infrastructure to support import/export of refined products and can act as hubs for future bio-fuel production, blending and logistics.
- Backward/forward integration - Examples include joint venture arrangements with Canadian oil sans producers. Other options are being explored, but deals remain elusive.
Politics, private equity and MLPs
No matter which solution a refiner turns to, private equity may be crucial to the effort. It brings two vital elements to the table—ready cash and the willingness to put together complex deals.
Private equity investors were critical in funding the startup of the last generation of independent refiners, and could change the structure of refining again. This time using a business model that breaks from the past in several ways. By Perhaps teaming with various NOCs—like the Brazilian or Russian national oil companies—NOC's could add value to their large supplies of crude. Private equity investors could also target the big oil companies of China, which might be interested in locking up refining capacity to supply their country's rapidly expanding economy. In both cases, refining profits might not be a primary driver.
Moreover, some of these transactions could be even advantageously structured as master limited partnerships (MLPs). The simple version of such a deal is that the private equity company would create an MLP in tandem with a NOC. The private equity investor would be seeking to buy a refinery for a fraction of its replacement cost with financing backed by a long-term deal in which the oil company agrees to pay a fee per barrel processed. This structure provides the steady cash flow usually preferred by MLP investors and the market risk is retained by the NOC.
Going for the gold
The complexities of creating these long-term relationships will be good for bankers and lawyers, but not for refiners hanging on in hopes of earning a reasonable margin on their substantial investments in the current U.S. refining market.
The arrival of a large contingent of newcomers would make it that much harder for the U.S. industry to eliminate more than one million barrels of excess refining capacity needed to keep refining capacity healthy and, if combined with a solid economic recovery, ensure solid profits over the next decade.
So what scenario, or combination, will prove true?
That is a tough question to answer. There certainly have not been many deals yet. Sure, there are interested buyers, but sellers are asking more than the buyers are willing to pay. So it is too early to say which scenario, or combination of them, will predict the future.
With a long-term outlook like that, refiners face a simple question: A Tsunami of change has hit—now what?
The fundamentals have not changed, the most successful refiners have...
- Preferential access to low cost crudes
- Transportation/logistic cost advantage
- Stable/consistent supply
- Complexity suited to market, higher conversion capability than local competitors
- Large relative size
- Ability to optimize "networked" effect
Advantaged product markets:
- Proprietary pipelines and terminals
- Strong brand
- Close to end market
Source: Deloitte Services LP
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