Last Friday, what many in the energy market had long suspected might happen, happened.
Valero, the largest independent refiner in the US, was forced to close another 200,000-plus barrel-per-day refinery — this time, its Delaware City unit — due to a lack of demand. The closure comes just three months after Valero shuttered its 235,000 barrel-per-day Aruba refinery in the Caribbean. Rival Sunoco, meanwhile, shut down a 150,000 barrel per day facility at Eagle Point in New Jersey in October.
These closures reflect just how badly the sector is doing, a fact which has also shown through in share prices:
The closure of Valero’s Delaware unit should, at least, be positive in financial terms for the refiner in the short run. But as Barclays Capital observed on Friday, the move does carry grave implications for the broader refinery market. The analysts explained (our emphasis):
VLO’s announcement speaks to the difficult conditions in the U.S. refining market at present. Although light-heavy differentials have strengthened throughout 2009 and the average 4Q09 differential between Maya and U.S. WTI is at $7.20/bbl (above the first three quarters of the year), the differential weakened from its recent peak of more than $8/bbl in mid-October to the current $6.00-6.50/bbl.
On the bright side, VLO expects to realize cost savings and lower capital spending requirements in 2010 as a result of closing the Delaware City facility. Furthermore, and important given the company’s rate of cash burn, VLO expects to generate $600-700mn of aftertax cash flow from inventory sales in 2010. We have been recommending VLO as a near-term long within the context of our longer-term Underweight on the sector. We still believe that news flow will be relatively benign for the next several months and the robust bid for credit will work its way through wider-trading names such as VLO (it is increasingly difficult to find investment grade energy paper trading with a 3-handle). We still recommend that long-term investors avoid VLO. In CDS, we continue to see no near-term catalysts for VLO to trade materially tighter than Sunoco, Inc. (SUN). We note that the spread between VLO and SUN in 5y CDS recently widened to as much as 25bp, but has since tightened to 15bp (covering the bid-ask by 5bp).
It’s worth noting that Valero’s closure had the immediate effect of boosting gasoline cracks, defined as the difference between the price of crude and gasoline). This makes sense considering x amount of gasoline output will be taken out of the system because of the closure.
The curious thing is what that says about the current state of the market, according to Olivier Jakob of Petromatrix.
As he noted on Monday, we now seem to be at a point where product values are being determined by refinery terminal shutdowns rather than by demand.
This is largely down to the fact that cheap floating storage has been carrying the industry for most of the year. As Jakob explains, many of these shutdowns would probably have occurred much earlier had refineries not had the means to disguise their difficulties by producing directly for floating distillate stocks.
Of course, what’s telling about the recent closures is that even the continued ability to process for offshore storage rather than solid demand has failed to avoid shutdowns completely.
Furthermore, the spate of closures now leaves the sector hugely vulnerable to any abrupt distillate discharge if and when it happens. As Jakob explained:
If the current floating stocks of Distillates were to be discharged too abruptly, the rate of shutdowns could accelerate and while the majors would be able to ride a storm of refinery shutdowns we would be extremely cautious on the economic sustainability of independent refiners.
In our opinion, the core of the current problem with US refiners is that too much of the capacity has been used to transform the US as a net exporter of Distillates. This was fine when China and South America were buying at whatever price in the first half of 2008 but the business model turned heavily sour when China stopped to buy after the Olympics and was followed by the mother of all credit crises. During 2009, US refiners have continued to buy foreign crude oil to transform it in Distillates but since there was no demand from the end-users they have filled higher and higher levels of floating stocks. US refineries can not run forever on a model of buying foreign crude oil to transform it into floating stocks of products.
In August of 2009, 1.7 myn b/d of the US refinery runs was accountable for the 450 mbpd of net Distillate exports. Given that the US does not have to be a net exporter of Distillate, and was not until 2008, it is that much refining capacity that is under threat if selling to floating stocks does not subsidize anymore the processing margins. Taking in account the terminal closure of Delaware City and Eagle Point this still leaves 1.3 myn b/d of US refinery capacity at risk of shutdown. For now the US refining system is trying to solve this oversupply of refining capacity versus internal demand by running at extreme low levels of capacity utilization but the longer it takes for real demand growth to materialize (in opposition to demand for floating storage) the greater the risk of more cold shutdowns within the US refining sector in the next few months. US refineries will also have to change the catalysts and the tray configurations to move the machines to maximum Gasoline/minimum Distillate yields.
On the flipside, while the ability to store distillate profitably offshore exists — i.e. there is a contango in the distillate market — there is no cap on how long floating storage will be able to offer a subsidy effect on refinery processing margins.
While that obviously doesn’t make for a sound business model in the long run, it might, however, prove the one thing that sees independent refiners survive the medium term (or the period until real demand picks up, however long that might be).
That’s important because the fewer independent refiners survive the current demand dearth, the higher gasoline prices will eventually end up.
The Daily Mail discovers contango – FT Alphaville
The GOD (glut of distillate) delusion – FT Alphaville
Oil, still fundamentally weak – FT Alphaville
Demand is in the toilet – FT Alphaville
Distillate hangover – FT Alphaville