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Trying to Understand the Pain at the Pump

Todd Stein & Steven McIntyre
The Texas Hedge Report

April 14, 2005
Courtesy of www.texashedge.com

By now, you have no doubt been bombarded on CNBC and in the papers about the global oil/supply demand situation. To sum it up in a sentence, we are in a world that uses roughly 80 million barrels a day and that possesses less than 2 million in spare pumping capacity – at least that is the general consensus. Very smart people on both sides look at the same equation and come to different conclusions as a multitude of micro and macro issues come into play. We have chosen to remain on the sidelines as we still worry about the effect of a global slowdown in demand. To date that has not been a wise decision.

To start, we thought it might be instructive to look at the components of a regular grade gallon of gasoline. Many don’t realize that over a quarter of the cost goes to pay federal and state taxes. Refining costs are actually a relatively small fraction at about 15% of the price – hence traditionally there has been little margin for most of your big oil companies and many exited the business in large scale. Now with the average retail price a gallon at a record $2.28 these figures will have changed a bit but, by in large, the percentages are still accurate. The refining cost has increased, but is still one of the smaller inputs into the retail price.

Figure 1. What Do We Pay for in a Gallon of Regular Grade?

We thought readers might like a snapshot of the bottleneck that has occurred on the U.S. refining side and what’s behind it. Seven main factors come to mind:

1) Refining is a horribly capital intensive business with low ROA – hence the little capital investment over the last two decades

Valero is the largest independent refiner in the U.S. with a $20 billion market cap. Despite a very strong 2004, one can see that its 10 year average return on assets is only 3.3%. Hardly the returns that make one want to pour more capital into the business.

2) Most of the major E&P companies exited the business in large scale over the last two decades because they made little money

3) Environmentalists and the average citizen hate refineries because they pollute and often have explosions

4) New refineries in the U.S. are unheard of and total refinery count continues to decline

5) Existing refineries have been expanded and capacity has crept up over the years, but not as fast as end demand (light blue is capacity and dark blue is gross input)

• Falling petroleum demand and the deregulation of the domestic refining industry in the 80s led to 13 years of decline in refining capacity

• In 1996, the trend reversed and through 2002 approximately 1.4 mbpd have been added

• In 2002, distillation capacity was at 16.8 mbpd (1981 peak was 18.6 mbpd), DOE forecasts to grow to 21.8 mbpd by 2025 – a CAGR of 1.14%

6) Utilization rates have remained solidly north of 90% as refiners take full advantage of existing capacity

This is a double-edged sword. On one hand refiners have managed to keep utilization rates up, but on the other hand, achieving higher than mid-90s utilization is unlikely – leaving little hope for new supply

7) Environmentally led gasoline reformulations have created bottlenecks in the system

MTBE removal and low sulfur compliance along with different required formulations have forced refineries to produce for specified formulations and made the substitution-ability of refined gasoline formulas for one another very limited. Likewise increased worldwide demand and formulation complications have limited imports.

The combination of these 7 factors has led to the long neglected U.S. petroleum refining industry experiencing a renaissance in profits after years of sub-par profitability. Crack Spreads (see the example below) have jumped as refiners are reaping the benefit of tight capacity and higher oil prices. This step function in crack spreads may cool off a little but appears here to stay. Relief from higher oil prices if it is to come will likely be from exploration successes and a global economic cooling, not from a glut of refining capacity.

The refining stocks are up several-fold from their lows from a couple of years ago. Amazingly enough for an industry that for decades has struggled to make money, the earnings of these companies have grown faster than their stock prices and, as such, companies like Valero and Tesoro trade for less than 12x earnings. Hopefully, these companies will use the windfall profits to pare back debt and not on silly acquisitions. Like all energy at this point, we recommend investors stay on the sidelines and wait for the inevitable scary correction that will sooner or later hit the sector.

April 14, 2005

Todd Stein & Steven McIntyre

Texas Hedge Report

Todd Stein & Steven McIntyre are internationally known analysts and editors of The Texas Hedge Report, a market newsletter that highlights under and overvalued securities in the equity, bond, currency, and commodity markets

For more information, go to http://www.texashedge.com