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Subject:  Re: Valero (VLO) Date:  1/23/2012  5:11 AM
Author:  saunafool Number:  8989 of 25574

As an industry insider, can you dissect what happened in 2007 in refining that made it so perfect for profits?

The period of 2003--2007 was a sweet spot for the refining industry which no one saw coming, but will likely repeat again somewhere down the road.

Normally, refineries make a small profit on the differential between crude oil and refined products called the "crack spread." Normally, the crack spread goes up when crude prices fall and goes down when crude prices rise.

In 2003--2007, this relationship changed. Not only did crude prices rise substantially, but the crack spread also hit record highs. Back in the 90's, refiners would operate on single-digit crack spreads. In California, because of their special gasoline formulation, crack spreads were higher--typically about $7/bbl. In the rest of the country, the crack spread would often be $3/bbl. (Note: perhaps because crude was only $20/bbl the gross profit % was similar to today, but I'd rather earn $20/bbl than $7/bbl, even if the gross profit % is lower.)

The reason for this decoupling was simple supply and demand. Back then, you'd hear every week about how no new refineries had been built in the U.S. since 1979. Bush proposed using closed military bases as potential sites. People blamed big oil for price fixing. Leftists proposed windfall profit taxes. No one remembered that refineries had been going out of business for decades and had very low margins.

Meanwhile, the must-have cars were the Hummer H2, Lincoln Navigator, Cadilac Escalade, or perhaps a pick-up truck with a Hemi (whatever that is), or for those with more refined taste a BMW. Average fuel economy made no improvement from 1987 to 2005, miles driven increased, and the number of cars on the road increased. Refining capacity did not increase.

It all came home to roost in that period from 2003 to 2007.

Now, here is the speculative part of why I believe it will happen again. There has definitely been demand destruction from the recession. U.S. petroleum consumption peaked in 2005 at 20.8 million bpd. Since then it has fallen to 19.18 million bpd representing a total drop in demand of 8%.

Since the recession, 1.2 million bpd of refining capacity has closed (this includes the recent closure of the Hess refinery in the Virgin Islands and Sunoco, Marcus Hook, PA closure.) So, there was a 1.6 mbpd drop in demand and a 1.2 mbpd drop in supply.

However, consumption in 2011 grew for the first time in the past 6 years at a rate of 2.1%. If the economic recovery continues, another 2% increase in demand will put the supply/demand balance as tight as it was in 2005 (1.2 million bpd lower supply and 1.2 million bpd lower demand).

However, it is highly unlikely that anyone will make a significant investment in new capacity due to fuel efficiency and ethanol mandates which are cooked into the equation through 2020. (The only exception is there is a proposal to build a refinery in South Dakota to handle oil from Bakken. It will be 7-10 years before anything is built, so we can ignore it for now.)

Therefore, what I forsee is periods of inflated profits during economic recovery, followed by closures and heavy losses during recessions. Perhaps undulating in this cycle for a very long time. One could argue that the refining industry has always been that way. I just think it will be more extreme (like everything else) for the next decade or more.

As a counterpoint, here is a seeking alpha article saying refiners are a value trap:
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