Forbes
Refiners (and investors) are loving that $2 gas
Prices simmer near record levels, and demand has never been so high nor supplies so tight. But Valero Energy, which supplies 10% of the nation's gas, is feeling no pain.
By Christopher Helman, Forbes
Nothing seems to put the brakes on gasoline prices. Not promises by the Saudis to spur production. Not the approaching handover of power in Iraq, where the fear of sabotage and terrorism is adding $6 to $8 a barrel to the price of crude, says William Veno, a research director at Cambridge Energy Research Associates. Americans want their gasoline and are willing to pay for it, up to a point. That puts some stress on the system, as well as on pocketbooks. Demand, at an all-time high of 9.1 million barrels a day, is outstripping the capacity of U.S. refineries.
All of which is great news to foreign refiners, which are supplying an unprecedented 10% of our gasoline -- and to domestic guys, as well. In the first quarter, downstream (refining and marketing) profits climbed 39% at ExxonMobil (XOM, news, msgs) and 19% at ConocoPhillips (COP, news, msgs). Valero Energy (VLO, news, msgs) topped them all with a 46% gain to $250 million.
As U.S. capacity tightens, refiners have gained control over the marketplace. Foreigners can export gasoline, but domestics are much closer to their markets and can respond quickly to shifting demand for the increasingly complicated fuel blends required by various states. A year ago, Valero's net margin was 1.75%. This year it's 2.25%.
A gamble on refineries pays off
"I'm not surprised that we are where we are," says Valero Chairman William Greehey. In 1997, he launched Valero on a spending spree, eventually grabbing 14 refineries for a slim fraction of their replacement value. The deal that catapulted Valero into the top tier was the $6 billion purchase of Ultramar Diamond Shamrock in 2001, which added seven refineries and 5,000 retail and wholesale sites.
Bigger is better. In the intervening six years, Greehey has boosted sales from $5.8 billion to $40 billion and net income from $96 million to $622 million. Valero's stock, up 45% this year, trades at just 12 times earnings; it was added to the S&P 500 in April. Every day, Valero turns 2 million barrels of crude oil into 40 million gallons of gasoline -- 10% of the nation's supply.
Full coverage on gas prices
Greehey, 67, has run Valero since the 1970s, when it was little more than a troubled pipeline operator. What triggered his dealmaking after two decades of slow growth? A seemingly lunatic conviction that the classically lousy business of running refineries could only get better. Over the last decade, the average refinery's annualized return on investment was only 5.5%, reports the Department of Energy, compared with 8.4% for long-term Treasurys. Tough government standards for cleaner fuels were driving up refining costs and forcing refiners into billions of dollars in upgrades or bankruptcies. Yet higher demand, Greehey figured, would send more motorists chasing after less fuel. While foreign refiners could pick up some slack, domestics would essentially control the market.
Or at least respond better to its vicissitudes. The last new refinery in the U.S. was built in 1984 -- by Valero. The Corpus Christi, Texas, plant cost $1 billion to construct and another $1 billion to upgrade since. How was Greehey going to earn back that investment? Two decades ago, 282 refineries operated nationwide; today only 149 remain.
The heavy dose of capital enabled Corpus Christi to process the thickest, cheapest crudes on the market. Heavy, sour crude sells at a discount of 10% to 25%, depending on blend and location, because it takes more refining to break down its hydrocarbons and remove its higher sulfur content.
Sour and sweet
The discounts have widened over the past year, playing into Valero's hands: 70% of its refineries are equipped to process the lowest-quality crude, a higher proportion than at any of the other big refiners. In its Aruba plant (bought from El Paso (EP, news, msgs) in March for $365 million, or 15% of replacement cost) Valero runs sour Maya crude from Mexico that costs just $27 a barrel. The refinery in St. Charles, La., once bankrupt and acquired for 20 cents on the replacement dollar in May 2003, can handle 245,000 bbl. a day of heavy crude. It generated $35 million in pretax profit in the first quarter despite some downtime for upgrades. Valero expects it to net $270 million for the year.
Profit potential is highest in California, which has the tightest refinery capacity and the most stringent clean-fuel regulations in the country. The banning of antismog additive MTBE (methyl tertiary-butyl ether) presented a new challenge. The additive made up 11% of California gasoline by volume, but only half that volume can be replaced by ethanol, forcing refiners to produce an extra 100,000 barrels a day of gas to meet demand. They've passed the added cost on to motorists. Valero handles 17% of the state's demand. In 2000 it bought a 175,000-barrel-per-day refinery in Benicia on the San Francisco Bay for just $760 million, or 38% of its replacement value, from ExxonMobil. New refineries might come onstream some day, but don't hold your breath. What with all the environmentalists and not-in-my-backyarders, a new plant would take at least five years from groundbreaking to spigot-opening.
How long can Valero and its larger rivals ExxonMobil and ConocoPhillips surf this wave? "In this industry, booms can turn to busts quickly," says Fadel Gheit, an oil analyst at Oppenheimer in New York. When? That depends, in part, on the rest of the world. Edward Murphy, a research director at the American Petroleum Institute, points out that it costs foreign refiners no more than 4 cents a gallon to ship gasoline to the U.S. That means increased imports from Europe, which has seen declining demand for gasoline as motorists opt for diesel.
The business remains as volatile as it ever was. Valero's net income per share has, of late, lurched between 83 cents in 2002 and $5.09 in 2003 -- but the long-term trend is up. Says Greehey: "There's no way it could get as bad as it got good."
Copyright 2004 Forbes.com. All rights reserved.
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