Once Dead Refining Industry Experiences Resurrection

From the heady heights of the summer of 2008, oil refiners have suffered from a downturn. Valero Energy Corp. (NYSE:VLO) and Tesoro Corp. (NYSE:TSO), which refine and market petroleum products exclusively, have suffered the most. Marathon Oil Corp. (NYSE:MRO), which has an E&P segment, got about a 27% of its 2008 income from refining. US majors Exxon Mobil Corp. (NYSE:XOM), Chevron Corp. (NYSE:CVX), and ConocoPhillips Corp. (NYSE:COP) reported downstream income percentages of 18%, 14%, and 6% (adjusted), respectively.

Since then, refining margins have been hammered by rising crude oil prices and lower demand for refined products. In the latest report from the International Energy Agency, in the 30 developed countries that comprise the OECD, demand for oil products has fallen by from a peak of 49.5 million b/d in 2006 to an estimated 45.4 million b/d for 2010. Yet total global demand has jumped from 85.3 million b/d in 2006 to 86.6 million b/d in 2010.

The developed world was consuming 58% of oil product demand in 2006, compared with 52% currently. All the growth is in the developing world, particularly China, where demand has grown from 7.2 million b/d to 9 million b/d (20%) in the five-year period. Doing the math shows that Chinese demand more than makes up for total global demand growth. Even other developing countries, as a group, are using less oil now than they did in 2006.

India, too, has grown its demand for oil from 2.32 million b/d in 2006, to 2.72 million b/d in 2009. The country expects consumption to drop slightly in 2010 to 2.67 million b/d. Even so, the five-year increase totals 13%, second only to China’s demand growth rate.

The demand for crude in Asia also increases the demand for refined products. And, as opposed to US refiners that have suffered from higher crude oil prices, refiners like India’s Reliance Industries and South Korea’s GS Holdings Corp. have gained back some lost ground. Reliance shares are up 28% over the past year, and GS Holdings shares are up 33% in the same period.

Reliance owns and operates the world’s largest single refining complex — a 1.24 million b/d behemoth in Jamnagar. What sets these refineries apart is their complexity, which gives Reliance the ability to process heavy or light, sweet or sour crudes. The two refineries at Jamnagar ran at more than 95% of capacity for the first nine months of the 2010 fiscal year. US refineries, by contrast, have run at around 80%-85% of capacity.

Reliance’s refining earnings have been lower than comparable periods in the previous year, but the refining segment’s earnings grew sequentially. More important, perhaps, the refining segment’s revenues grew significantly. Reliance has already passed its full 2009 fiscal year revenue total for its refining segment with its fourth quarter results still to come.

Korea’s GS Holdings is a 50-50 partner with Chevron in GS Caltex, the country’s largest oil refiner. GS Caltex didn’t help Chevron much in 2009, contributing a $191 million loss to Chevron’s bottom line. The upside, though, is that GS Caltex’s operating profit grew by 1.5% in 2009.

So, even though margins are fragile to non-existent, demand for refined products in Asia is expected to grow by 900,000 b/d in 2010 according to a report from Australia’s Macquarie Reseach quoted by MarketWatch. And the higher demand will prop up Asian refiners’ margins. In other words, no matter how much it costs for refined products, Asian consumers will pay.

And that’s because much of Asian consumption is by businesses that use burn the oil to run their business or generate electricity or a similar industrial use. Another thing that could improve margins at Asian refineries, especially Reliance’s Jamnagar, is a wider differential between the price of light and heavy crude. Because Reliance can refine heavy, sour crudes that have traditionally been cheaper, the company gets better margins.

With the exception of the Citgo refineries now owned by Petroleos de Venezuela SA (PdVSA), US refineries aren’t set up well at all for heavier, cheaper crudes. US refiners face the twin challenges of rising prices and falling demand. Even though capacity hovers around 80%, it makes no sense for refineries to operate more fully just so they can lose more money.

Refining margins in the US won’t pick up until crude prices fall. That’s not necessarily the case for Asian refiners. Refining may not be the cash machine it was a couple of years ago, but it’s no longer a four-letter word in Asia.

Paul Ausick