Crude tactics

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Big oil mergers have left the U.S. with fewer refiners and more costly petroleum products.

The Daily Deal NewsWeekly

For energy-strapped California, Shell Oil Products US’ unexpected announcement in November 2003 that it would close its refinery in Bakersfield meant more than just an additional ping or two at the pump. It had the hallmarks of another supply scandal. One consumer group labeled the move an “Enron-style shell game.”

Shell was “intentionally shorting the market,” charges Tim Hamilton, an industry gadfly and consultant to independent gasoline marketers.

Shell had acquired the 70,000-barrels-per-day refinery as part of a huge consolidation among major oil producers. Over the years, the 73-year-old Bakersfield facility passed from Texaco Inc. to a Texaco joint venture with Shell called Equilon Enterprises LLC. After Chevron and Texaco merged in 2000, the Federal Trade Commission forced the combined company to sell its interest in the refinery to Shell a year later. “It never occurred to us that Shell would close Bakersfield,” Hamilton says.

In the upheaval that followed Shell‘s move, Hamilton trotted out internal documents that showed that the refinery was hugely profitable, with the highest margins of any Shell refining complex in the U.S. Shell so wanted the plant shut that it refused to even entertain acquisition bids, Hamilton charged. The allegation: Shell was out to deliberately reduce California’s access to refined oil products.

“It was a classic example of an oil company’s shutdown to artfully drive up the price,” says Jamie Court, president of Foundation for Taxpayer and Consumer Rights, a consumer advocacy group based in Santa Monica, Calif., which hired Hamilton to study California’s refinery situation.

That accusation was vehemently denied by Shell and later dismissed by a Federal Trade Commission investigation. But it has been echoed elsewhere in the country following Hurricane Katrina. Whether or not they actively collude to keep prices high, oil companies are certainly in no hurry to boost refinery capacity either, since the status quo is so profitable. With supply constricted, however, any glitch can cause gasoline prices to skyrocket. “Oil companies feast off tight supply,” says Tyson Slocum, research director for consumer advocacy group Public Citizen’s energy program.

As the weather chills, heating bills rise, and oil company earnings soar, the cries of price gouging grow louder. Even laissez faire politicians feel the heat and are calling for voluntary capacity expansion. Energy Secretary Sam Bodman said oil companies have a “responsibility” to expand refining output. While Congress tried to push through tax incentives for new projects, President Bush even suggested new refineries be constructed on abandoned military bases, notions that were met with almost universal disdain. “The White House and Congress are pretty paralyzed,” says Slocum. “It’s pathetic.”

The industry and its supporters counter that all this brouhaha is a simple matter of supply and demand. Recent record refining profits mask years of low profitability and volatile returns. “The real issue is whether these higher margins are sustainable,” says George Morris, an investment banker with energy-focused investment bank Petrie Parkman & Co. For refiners to undergo major expansion, Morris says, “they have to believe [higher] margins will be there for a long time.”

Also, refining in the U.S. shouldn’t be viewed in isolation, industry backers stress. Refining is a global market. Imports remain the cheapest source of petroleum products. “We’re only one tanker away from importing gas or diesel from Europe or the Far East,” Morris says.

The finger-pointing, however, shows no signs of abating. About the only thing everyone agrees on is that refineries in the U.S. have been seriously affected by industry consolidation. “Mergers are the defining characteristic of the industry,” says Slocum.

In the past 15 years, oil companies combined and combined again. More than 2,600 mergers, acquisitions and joint ventures took place during the 1990s, according to a Government Accountability Office study. Refining fell prey to the M&A craze. Because of mergers, for example, the country’s fourth-, fifth-, sixth-, seventh- and eighth-largest refiners in 1982 no longer exist.

Some of those companies left standing have either rationalized their plants or jettisoned refining altogether. Beginning in the mid-1990s, some major oil companies such as Unocal Corp. made the conscious decision to either de-emphasize refining or get out of it altogether.

Acquisition plays have also seriously reduced the ranks of independent refiners. The most dramatic deal came in April, when Valero Energy Corp. agreed to buy Premcor Inc. for about $8 billion, including $1 billion in assumed debt. The two companies combined to form the largest refiner in North America, with 19 refineries and a capacity of 3.3 million barrels a day, or about 15% of total American capacity.

The Valero-Premcor merger culminated active dealmaking by both concerns. In
March 2004, Valero agreed to pay $465 million for El Paso Corp.’s refinery in Aruba. Two months later, Premcor paid about $900 million for the Delaware City, Del., refinery complex, owned by a joint venture between Shell Oil Products US and Saudi Refining Inc. called Motiva Enterprises LLC. Sunoco Inc., another aggressive acquirer, bought El Paso’s New Jersey refinery in early 2004 for $250 million.

The Valero-Premcor coupling isn’t unique, either. In June, Marathon Oil Corp. finally completed the $3 billion acquisition of Ashland Inc.’s 38% interest in their refineries joint venture.

The refining industry is far more concentrated now than ever before. At the end of last year, the five largest refiners Exxon Mobil Corp., ConocoPhillips, BP plc, Valero and Shell controlled 56.3% of the U.S. market. That’s more than the largest 10 companies controlled a decade earlier. Today, the largest 10 refiners hold 83.6% of the market.

What that means is a matter of perspective. To critics, the industry has engaged in willful constriction. “Facing what they deemed inadequate profit margins in the mid-1990s, oil companies readily recognized that the surest way to drive up profits was to drive down oil and gasoline supply,” charged Sen. Ron Wyden, D-Ore., in a report highly critical of the industry.

Because of this supply crunch, competition at the pump suffers. Refiners pocket higher margins. And according to a 2004 GAO study, some of the integrated oil companies reduced refining capacity to the point where they could supply their own branded gas but have little or no excess to sell as unbranded, leaving independent gasoline marketers in a nasty bind.

To industry backers, efficiencies and scale now dominate the field as it should. “Consolidation has been more a matter of survival,” says Priscilla McLeroy, a vice president at oil and gas advisory Randall & Dewey, now a subsidiary of Jefferies & Co. She maintains the refining industry looked far more risky and far less corpulent in the 1990s than it does today. “Small refiners just couldn’t compete.”

According to Department of Energy data, the number of refineries has been reduced from 194 in 1990 to 144 at the beginning of this year. With the most stringent pollution requirements in the country, California alone witnessed almost two-thirds of its refineries shuttered over two decades. From 1995 until 2000, California lost almost 800,000 barrels per day refining capacity.

Most of the refineries mothballed around the country were relatively small. They were either dependent on nearby domestic crude that is no longer flowing or unable to readily refine the crude that is now imported. Also, despite the reduction in the number of refineries, total capacity has increased from 1990 through major expansion projects from about 15 million barrels a day to 17 million, or a 13% jump. The average size of a refinery today is 115,000 barrels per day, according to Morris. That’s a jump of more than 40% in a decade.

However, over the same 15-year period, consumption in the U.S. has increased by almost 25%. Go back further in time and discover that U.S. refining capacity in 1981 was 18.6 million barrels a day, or 10% more than what it is today. Utilization rates in refineries now eclipse 90% and are closing in on 95%.

For years, says Morris, refineries “had the lowest return on the [energy] value chain.” Not anymore. According to Hamilton, a modern refinery now can count on earning 75 cents a gallon, or $31.50 for a barrel of oil. Breakeven for a modern refinery, he says, is $10 a barrel.

America’s refinery industry has realigned substantially over the past decade. According to a Congressional Research Service study published in August, a combination of M&A-related requirements for divestiture, inadequate returns from smaller refineries and a more global focus pushed majors to sell off refinery assets. Strong, independent refiners grabbed what they could.

The results are dramatic. According to the study, independent refiners topped the entire petroleum industry sector last year in terms of profitability. Among the six largest independents, the average percentage net income growth from 2003 to 2004 was 190%. That trend is accelerating. For the third quarter of this year, Valero’s profit almost doubled, to $858 million. Its refining margins stood at $13.43 per barrel, compared with $6.92 per barrel a year earlier. Its revenue jumped 62%, to $14.3 billion.

“Valero has been terrifically successful not only through acquisition but because it bought underperforming assets and expanded them substantially,” says Brian Byrne, a Washington-based antitrust lawyer at Cleary Gottlieb Steen & Hamilton LLP who has represented refiners. “In that case, consolidation has been positive.”


In defending Shell‘s actions in Bakersfield, a company spokesman says that when the decision was made to close the refinery, Shell got very little interest from potential acquirers. In a matter of months, interest grew dramatically, “so we initiated a pretty aggressive sales process,” the spokesman maintains. Shell sold to Big West of California LLC, a wholly owned subsidiary of Flying J Inc., for $130 million.

Hamilton counters that Shell put its refinery on the market only after California’s attorney general and U.S. Sen. Barbara Boxer applied intense pressure on the company to keep the plant open.

How all this will translate into new deals remains to be seen. One possible benchmark was the July purchase by Kelso & Co. and Goldman Sachs Capital Partners, the private equity arm of Goldman Sachs Group Inc., of a Kansas refinery and fertilizer plant. While the price wasn’t officially disclosed, Moody’s Investors Service tagged the deal at “over $720 million,” $500 million of which was financed through debt. The new owners pledged an additional $200 million for cleaning up the product and expanding capacity.

This acquisition culminated a remarkable turnaround. One year earlier, in March 2004, an investment group led by Pegasus Capital Partners paid $117 million and assumed $23 million in liabilities for Coffeyville Resources LLC, which was in bankruptcy. In 2002, Coffeyville had lost $465.7 million, primarily in impairment charges, according to SEC filings. By the end of the third quarter in 2004, after investing in a new pipeline, Coffeyville’s revenue jumped 31% over the first three quarters of 2003, its unaudited profit reached $51 million, and its Ebitda topped $86 million. Pegasus filed to take Coffeyville public in February, only to withdraw after the Kelso-Goldman Sachs offer. (Now there’s talk the new owners may float the fertilizer plant in an IPO next year.)

According to the trade publication Platts Oilgram News, Coffeyville was “one of the most expensive refinery deals on record.” That could be a function of supply. As McLeroy points out, there are few refineries up for sale and “a lot of very interested parties looking for additional capacity.” In addition to American players, Venezuelan, Russian and Chinese oil companies and the Indian petrochemical giant Reliance Industries Ltd. all covetously eye the North American refining market.

That, in turn, suggests those companies interested in expanding capacity may resort to buying others. Searching for possible candidates produces a laundry list of remaining independent refiners: Sunoco Inc., Tesoro Corp., Frontier Oil Corp., Holly Energy Partners LP and Giant Industries Inc. In the past four years, all, save Frontier, have acquired smaller rivals, refineries or refinery-related assets. Two years back, Frontier and Holly agreed to a merger. Holly backed out, however, citing class actions against Frontier, which turned around and sued Holly.

Even the Coffeyville acquisition was far cheaper and quicker than constructing a new refinery, which these days run anywhere from $2 billion to $3 billion. When Valero announced the Aruba purchase, it said the 315,000-barrels-per-day refinery’s replacement cost was $2.4 billion, or more than 5 times the purchase price. Traditionally, says Morris, over the past 20 years, old refineries were acquired for 10% to 20% of the cost of building from scratch. Even in the current, supercharged environment, an old refinery is half the price of a new one.

A new refinery requires pipelines, a nearby power plant, state-of-the-art environmental equipment and lots and lots of land.

That’s the theory. In practice, no one has constructed a major oil refinery in the U.S. since 1976. “There are huge barriers to entry,” says Slocum.

The one plan on the drawing board isn’t being treated seriously. A company called Arizona Clean Fuels LLC is proposing a $2.5 billion, 150,000-barrels-per-day plant in the middle of the Arizona desert. The project was first raised in 1999, then modified last year after environmental objections. Glenn McGinnis, the company’s CEO, says he’s now trying to raise the necessary capital. Industry analysts remain highly skeptical. “Economics just don’t justify the project,” says Morris, who points out that because there’s no crude in the neighborhood, it would cost another $1 billion just to build a pipeline to insure supply.

Industry spokesmen frequently blame stringent environmental regulations for the lack of new construction. In the next two to three years, refiners must spend more than $8 billion on current plants to meet Clean Air Act regulations on sulfur content. Yet to finger environmental standards for any lack of construction is more than slightly disingenuous. “It isn’t about the environmental laws,” says Slocum. “It about the profit margins.”

In fact, even industry partisans admit there’s been no compelling reason for major refining companies to embark on the expensive and laborious effort of building a new complex, a “grass roots” plant in industry lingo. Here’s how the situation was described by Coffeyville’s IPO backers, presumably in an attempt to put their company in the best investing light: “The current refining industry is characterized by capacity shortage, high utilization rates and reliance on imported products to meet the demand for finished petroleum products.” Not a whiff of talk about the costs of cleaning up dirty air.

In any discussion of new refinery entrants, the biggest wild card is the rank outsider with lots and lots of money. To break the cycle “it’s going to take a new entrant,” says Hamilton, although he believes one or two new small refineries won’t prevent gasoline prices from their continued escalation.

The latest to raise his voice is Richard Branson, the eccentric founder of the Virgin Group Ltd. Miffed by high fuel costs, Branson announced in September he will launch a subsidiary called Virgin Oil, which will be charged with financing and building a new refinery. Branson didn’t indicate where the refinery would be built.

Given tight capacity and the rationalization that has taken place following energy-related mergers, will the FTC allow further consolidation? Not surprisingly, views tend to fall along ideological lines.

“The FTC has been very, very rigorous,” says Byrne, and has forced “a large number of very significant divestitures” as conditions to mergers. Byrne cites an Exxon divestiture in California as part of the Exxon-Mobil merger, a Texaco divestiture in refining joint ventures as part of its merger with Chevron Corp. and, as condition to the Conoco-Phillips merger, the divestiture of Conoco‘s Denver refinery and Phillips’ Salt Lake City refinery. “The way capacity gets built is when somebody sees a financial incentive to build it,” he continues. “I don’t think mergers are the issue.”

“The FTC became a negotiator for the oil companies,” counters Hamilton, who argues that the commission is ineffective because it views its mandate to oppose anticompetitive action in very narrow terms. “What the FTC repeatedly ignored and refused to recognize is that the merger of BP, Arco and Amoco creates conflicts of interest elsewhere,” which in turn has a serious impact on the U.S. market. “Refineries in the U.S. are now merged with the interest of companies that also control refineries in Canada, Mexico and the Far East,” he says. A BP refinery in Asia, for example, is not going to undermine the price of an Arco refinery in the U.S. if they’re both owned by the same company, Hamilton says. “The behavior is legal, but it shouldn’t be justified.”

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