Bleak Outlook for U.S. Oil Refiners

Our outlook for independent refiners in the U.S. remains bearish. After experiencing a very favorable macro environment over the last few years, the independent refining companies have been under pressure since the start of the second half of 2007 due to continued margin contraction, resulting from unusually high feedstock costs (peak-cycle oil prices) and relatively modest product demand.

The subsequent bottoming-out of oil prices has been beneficial to feedstock costs, and as a result refining margins started the year in robust condition, thereby bringing a much-needed reprieve to the refiners. However, this recovery is unlikely to be sustained for much longer as the ongoing long-term fundamental changes to the industry suggest future struggles.

The major factors that could have a sobering influence on refining profitability include weakening demand for petroleum products in major markets, commissioning of new refineries and conversion projects, and a decline in the price differentials (also known as spreads) between the ‘light sweet’ and ‘heavy sour’ variety of crude oils.

At the forefront of this weak outlook is the shifting balance in global supply and demand, with capacity additions outpacing incremental demand. The global refinery sector has been in the midst of several projects, especially in West Asia, China and India. Led by Reliance's 580,000 Bbl/d Jamnagar facility in India, over a million barrels of new refining capacity is expected to come on line in 2009.

At the same time, global demand for almost all fuel products (except gasoline) remains in a downtrend, precipitated by the economic slowdown. Current distillates and jet fuel demand remains significantly below year-earlier levels, while U.S. demand for motor fuels have been crushed by the recession.

With the likelihood of economic recovery in 2009 being remote, refiners will have to continue to adjust production to meet lower demand levels. As such, processing rates at refineries around the world is expected to remain below average, at least in the second and third quarters of 2009.

Refiners who have the capacity to process the cheaper heavy/sour grades of crude oil to make refined products would further boost their margin capture rates. Bloated stockpiles of light/sweet crude oil (current crude oil inventories in the U.S. are at multi-year highs), coupled with growing demand for heavy/sour grades as a result of new and expanding complex refining capacity has significantly narrowed these spreads.

We currently have a Sell rating on both our refinery stocks, Tesoro Corporation (TSO - Analyst Report) and Valero Energy Corporation (VLO - Analyst Report).