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It's no secret that the recession has choked gasoline demand and squeezed profits for independent refiners. But it's less well-known that anemic earnings might soon undermine refiners' debt covenants. That could make CEOs, creditors, and investors alike feel like jumping from the nearest distillate tower.
Little is fine for these refiners
According to a Bloomberg story released last week, bankers and analysts have fingered Western Refining (NYSE: WNR ) , Tesoro (NYSE: TSO ) , and Alon USA Energy among the at-risk group. Essentially, loan terms often include minimum ratios based on trailing-12-month earnings. As paltry quarterly results mount through the end of the year -- eclipsing the strong second half of 2008 -- the likelihood that companies can maintain those ratios sinks like so much heavy sour crude.
For the moment, however, refiners may be spared forced asset sales, share issuances, and other value-destroying measures. A Bank of America (NYSE: BAC ) energy chief interviewed by Bloomberg described a forgiving approach to the situation: “We will continue to work with companies on a case-by-case basis to get them through this period of time.”
Experts see other lenders following suit. But keeping the credit tap turned on will likely involve modified terms, possibly including current-spending restrictions and requirements that future cash flow be redirected from expansion plans and dividends to debt reduction. In other words, while any announcement of amended loan terms would be cause for relief, outright optimism could later be linked to investors having inhaled a lungful of fumes.
Crack spreads in rehab?
The problem with this whole picture is that temporary debt modifications rest on the expectation that refiners will soon enjoy a sustained recovery. Reality, I'm afraid, challenges that assumption.
The Energy Information Administration (EIA) sees 2010 gasoline demand rising a modest 0.6%, versus a roughly 1.9% year-to-date decline and a 2.2% drop in 2008. Depending on the direction of crude prices, that may not be enough to restore crack spreads -- the difference between the price of a barrel of crude and a barrel of finished product -- to historical averages. Regarding additional headwinds, Barron's recently cited sustained unemployment, fuel-efficiency improvements courtesy of the cash for clunkers program, and a decline in miles driven by graying baby boomers.
Moreover, with ample spare capacity in the system, any inspiring uptick in gasoline demand could be met with additional supply, in turn depressing prices once again.
All in all, investors might want to cap their refinery exposure to integrated majors such as Total (NYSE: TOT ) or ExxonMobil (NYSE: XOM ) , where E&P gains potentially offset refining losses. For those wedded to independent refiner exposure, I continue to favor Frontier Oil (NYSE: FTO ) , whose conservative debt position potentially makes it a safer play than Valero (NYSE: VLO ) and other competitors.
Ultimately, even if banks grant refiners immunity, the economy may not.
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