Recent Developments in the Refining Industry

After two decades of fighting to stay in the black, the stars aligned in 2004 and refiners like  Valero Energy (VLO),  Frontier Oil ,  Sunoco , and  Tesoro  have been enjoying outsized profits ever since. With mandatory environmental upgrades and hurricane repairs pretty much in the past, and cash flooding in, refiners are setting their sights on boosting capacity, improving reliability, and increasing the complexity of their refineries. This increased investment will likely be the proverbial rain on the parade, driving refining margins back to more reasonable levels.

Growing Refining Capacity
As a refresher, a refiner's gross refining margin is essentially the difference between the price it sells a barrel of refined product and the price it pays for a barrel of oil. The more money a refiner receives for its products and the cheaper it can buy its oil, the more money it makes.

Refining bulls always make the argument that margins should remain wide forever, because a new refinery hasn't been built in the U.S. since the 1970s. But after increasing by 210,000 barrels per day (b/d), or about 1.2%, in 2005, domestic refining capacity is expected to increase by 2 million barrels per day by 2010, a 12% increase. Although all of this expansion is in the form of improvements to existing refineries, it represents the equivalent of eight new world-class facilities.

Expansion is proceeding at full steam worldwide as well--worldwide capacity is expected to grow by more than 10 million barrels per day over the same period. The majority of that capacity is being built in the thirsty and growing Asian market. Also, Saudi Arabia is planning twin 500,000 b/d export refineries, with one unit targeting Asia and the other targeting Europe and North America. Due to differing environmental regulations around the globe, refined products are not as fungible as raw crude oil, but the additional capacity should cause margins to contract worldwide as capacity growth is expected to outpace demand growth over that time period.

Improvements in Refining Complexity
In addition to capacity additions, refiners are also looking to improve the complexity of their refineries. This will allow them to handle poorer-quality crudes that often sell on the cheap and to produce higher-margin products like gasoline and ultralow-sulfur diesel. We think this is an excellent way to improve the competitive position of a refinery, as it makes a refinery less susceptible to periods of weak demand.

Low-quality crudes are expected to make up a growing proportion of the worldwide oil production mix. One of the drivers behind this influx of poor-quality crude is the number of Canadian oil-sands projects coming online over the next several years.  ConocoPhillips (COP) and  BP (BP) recently announced large-scale expansions designed specifically to handle Canadian crude from the oil sands. 

However, we have concerns that too much conversion capacity is being built. While production from the oil sands is expected to be heavy, the oil could be upgraded (i.e., converted into a higher-quality oil) in Canada before being transported to U.S. refiners, and this upgraded oil is expected to sell on par with light-sweet crude, the worldwide oil price benchmark. There are also several proposals to build an oil pipeline to the west coast of Canada, where the oil could then be shipped to other areas of the globe, namely Asia. Too much conversion capacity and too little heavy oil would cause the price of heavy oil to be bid up, eliminating the incremental margins earned by processing this type of crude.

Weighing an Investment in Refining
We believe that gross refining margins will remain above their long-run averages, but some risks remain. A simultaneous increase in refining capacity and a slowdown in economic activity would cause refining margins to collapse for a period of time. Moreover, engineering and construction firms like  Chicago Bridge and Iron ,  Fluor  (FLR), and  Foster Wheeler  are enjoying large amounts of pricing power, which could potentially inhibit returns for these expansion and improvement projects. Tesoro recently pulled a project off the table after a revised cost estimate for a proposed project increased by more than 40%. If more refiners pull or delay projects, we would expect the gross refining margins of complex refiners like Valero or Frontier to remain high for an extended period of time.

While we are cautiously optimistic about the future of the industry, we suggest that investors still itching to gain exposure to the refining industry set their sights on the major integrated oil companies like BP,  Chevron (CVX), ConocoPhillips,  ExxonMobil (XOM), and  Royal Dutch Shell  (RDS.A). The majors have loads of refining capacity not only in the U.S., but also in emerging markets. Moreover, unlike pure-play refiners, they have substantial upstream operations that generate stronger and more-stable returns on capital over the course of the cycle.