Two Big Reasons to Dump your Oil Refinery

Tony Daltorio, The Investment U Research Team

Quite simply, this is not a good time to be in the business of refining oil in the United States.

The obvious reason for this is the continuing recession which has led to lower demand for gasoline and other refined products. With the summer driving season past the halfway point, having the word ’staycation’ become commonplace is not good news for the refiners.

But that’s not all. And it goes well beyond simple economic downturn.

There are other factors at work. And unfortunately, many have escaped the notice of many investors and much of Wall Street.

While everyone was focused on the sharp rise recently of the price of WTI crude oil, other things have been conspiring against domestic refiners of all sorts. Here’s what you need to know and the two biggest reasons you should stay away at all costs.

Refiners’ Headache #1 – Higher Prices for Low-Quality Crude

There has been a remarkable move in the price between low-quality and high-quality crude oils.

OPEC’s production cuts, led by Saudi Arabia, have mostly removed from the market supplies of heavy, sour, low-quality oil. This action has forced low-quality crude prices to rise comparatively faster than those of light, sweet, high-quality varieties of crude oil.

This has caused the spreads between the varying qualities of crude to narrow – in some cases hitting eight-year lows – as OPEC’s campaign of production cuts has kicked in.

For the first part of this year, the discount between Mexico’s low-quality Maya oil and West Texas Intermediate crude oil has been $3.55 a barrel.

This figure is down about 70 percent from the 2004-2008 average of $12.30 a barrel. West Texas Intermediate and Mars oil, a medium-quality crude from the Gulf of Mexico, have traded at parity this year. This figure is down from the 2004-2008 average discount of $5.77 a barrel.

While higher prices for lower-quality crude oil may be good news for investors in Russian energy firms that produce a lot of heavy, sour crude, it is not good news for investors in U.S. refinery stocks.

The reduction in price differentials is reducing the profitability of modern, sophisticated refineries such as those in the Gulf of Mexico. These refineries have invested millions of dollars into complex units called cokers, which allow these refiners to turn low-quality oil into high-quality refined products such as gasoline and diesel.

The price differentials between various grades of crude have been a meaningful contributor to profitability for complex U.S. refiners such as Valero Energy (NYSE: VLO). Previously, refiners that could process more heavy, sour crude have been much more profitable than those limited to light, sweet crude oils.

Some companies have responded to narrower spreads by shutting down or reducing run rates at their coker units. And yet this doesn’t affect prices, or the producers, at all.

In fact, Saudi Arabia may not restore the volume of medium and heavy crude that they have removed from the marketplace. It might instead focus on increasing production of lighter, sweet crude from fields such as their 1.2 million barrel a day Khurais field.

It’s uncertain whether the spreads between the grades of crude oil will remain depressed, but without a large scale economic recovery, it’s unlike to happen any time soon. If this is the case, refiners will continue to have negative pressure from one of their more profitable products.

Refiners’ Headache #2 – New Climate Legislation

Narrowing crude spreads is not the only obstacle that oil refining companies and their investors are facing. The climate legislation being debated in Congress looks set to give the industry a major headache.

Refiners that have invested heavily in the past decade to shift their plants to refine heavy, sour crudes will likely face new hurdles in rules to limit carbon emissions expected to take effect within 10 years. These refiners now face the reality that with the advent of caps on carbon emissions, what once looked like a cheap feedstock (lower-grade crudes) may now mean a more costly carbon footprint.

Recent legislation that passed the U.S. House will give many of the carbon permits to polluting industries for free. Oil refineries are among the largest polluters regulated under the legislation.

Unfortunately, refineries were short-changed in the legislation.

Oil refiners would receive 2.25 per cent of their allowances free, but still have to acquire nearly 40 percent of the permits each year. These credits would go to cover the emissions at refineries and the carbon dioxide produced when cars and trucks burn fuels like gasoline and diesel.

Other potential future legislative moves designed to curb the production of carcinogenic gases could force refiners to embark on additional costly spending programs designed to cut such hazardous emissions. Many refiners have already been identified as falling well short of the new guidelines proposed by the Obama administration

As currently constituted, the climate-change legislation may lead to large capacity cuts at U.S. refineries and greatly increased imports of refined products into the United States. According to a recent study by consulting firm Deloitte, pending environmental regulations could shrink national refining capacity by up to 2 million barrels per day.

The fact is that as major carbon producers, refiners will face a higher cost of doing business in the future and nothing looks to change that anytime soon.

The Bottom Line

Major oil companies, being more diversified, are more insulated against the problems facing the refining industry.

Purer players in the refinery industry include: Valero Energy (VLO), Sunoco (SUN), Tesoro (TSO), Holly (HOC), and Western Refining (WNR) aren’t so lucky. These companies are facing strong long-term pressures on their profitability and viability.

Investors who hold large chunks of their portfolio may consider scaling back their exposure or even shorting during significant rallies. At the very least, you should tighten up your trailing stops should the bottom fall out of our domestic refiners.

Good investing,

Tony Daltorio