Refining Cap-Ex, Shrinking or Being Diverted? (VLO, LEH, MRO)

Valero Energy (NYSE:VLO) today released a presentation it will be making at the Lehman Brothers (NYSE:LEH) Energy and Power Conference later this week. The presentation put a bit of meat on the bone of a statement in Valero’s earnings release that the company was reducing cap-ex by $700 million, from $4.5 billion to $3.8 billion.

In the presentation, Valero notes that it will defer two projects: theparaxylene project in St. Charles, Louisiana, and a coker project inPort Arthur, Texas. The company does plan to increase capital spendingin 2009 to $4 billion, still $500 million less than originally plannedfor 2008. The company does plan to continue investment in "keyrefineries."

Translated that means increasing distillate refining capacity. Marginsfor diesel fuel are much better than margins for gasoline, and Valerois planning to take advantage of that as quickly as possible. Thehydrocracking units at St. Charles and Port Arthur are long-termstrategies to increase distillate production. In the short-term, demandfor distillates is expected to grow in every part of the world –except the US. Distillates, particularly diesel fuel, are being refinedfor export, mainly to Europe.

Valero, and competitor Marathon Oil (NYSE:MRO), look to refineryupgrades that will help them extract more value from heavy sour crudes.Marathon is completing a $4.1 billion project to upgrade its Detroitrefinery to handle the sticky stuff that comes from Canada’s oil sands.The crack spreads on heavy sour crudes is still favorable for refiners.

Spot prices for gasoline are not falling nearly as quickly as crude oilprices. The difference is going into the pockets of the refiners. Andthere is still idle capacity that can be put into production to makemore gasoline if demand picks up.

There is also going to be pressure on heating oil prices this comingwinter. There should be enough to go around, but the price for heatingoil is likely to rise because refiners will continue to push out dieselfuel for export.

All in all, refiners may begin to see improvements in crack spreads andmargins, probably starting this quarter and getting better nextquarter. Keep an eye on commercial crude oil and gasoline inventories,distallate production, and heating oil prices and production if youwant to figure out if Valero, Marathon, and other refiners are going tomake a comeback.

Paul Ausick
September 3, 2008