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A Reversal of Refining Fortunes

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As the world turns, so do fortunes turn on a dime.

In the latter stages of oil's relentless climb, refiners struggled through painfully thin margins that persisted even beyond the monstrous oil price collapse of 2008. Now that the dust has settled, refiners are once again processing profits despite reduced demand and resulting production cuts.

Valero (NYSE: VLO  ) kicked off earnings season for the group a couple of weeks back with an 18% bump in earnings to $309 million, even though revenue slipped 51% on reduced throughput. Fools will quickly catch the pattern emerging through the remainder of companies reporting, as improved gasoline crack spreads offset production declines in the first quarter to return the sector solidly into the black. Tesoro (NYSE: TSO  ) , Western Refining (NYSE: WNR  ) , and Sunoco (NYSE: SUN  ) all managed to swing to profits from losses in the prior year thanks to similar sets of dynamics. Smaller refiner Holly (NYSE: HOC  ) , which this Fool has considered favorably relative to its peers, managed to bolster profit by over 150% to $21.9 million despite seeing revenue chopped in more than half to $651 million. Completing the pattern, Tesoro's revenue also diminished by 50% (to $3.3 billion).

As spot gasoline prices surged to a $5.75/bbl premium over diesel fuel, as compared to a $10.61/bbl discount a year earlier, Tesoro reported an 86% expansion in overall gross margin to an impressive $12.14/bbl after converting 5% of production from distillates to gasoline. Building further upon the reversal of fortunes theme, weaker distillate margins also suggest a reversal of prior margin strength for specialists like Calumet Specialty Products (Nasdaq: CLMT  ) .

Despite a very profitable quarter for the sector at large, demand for refined products remains significantly impaired by the ongoing economic malaise, and Fools are urged to proceed with caution. Sunoco Chairman and CEO Lynn Elsenhans sees a challenging market environment ahead for the remainder of 2009 but adds that Sunoco has taken the "appropriate steps" to adapt. Generally speaking, such adaptations are centered on capacity cuts or refinery closures, and are often attributed to causes like planned maintenance rather than weak demand.

With sector-wide capacity utilization appearing to settle in near the 80% to 90% mark, I question whether refiners have adequately responded to the potential for sustained demand weakness and continue to urge caution for the sector despite the profitable quarter.

Further Foolishness:

Nearly 4,200 CAPS members, including 1,224 All-Stars, expect five-star pick Valero to outperform the S&P 500. Will you follow the Fools, or blaze your own trail? Join the free CAPS community today and share your own thoughts about Valero.

Fool contributor Christopher Barker reminds Fools to perform DDDD: due diligence on demand destruction. He can be found blogging actively and acting Foolishly within the CAPS community under the username TMFSinchiruna. He owns no shares in the companies mentioned. The Motley Fool has a highly refined disclosure policy.

Read/Post Comments (4) | Recommend This Article (7)

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  • Report this Comment On May 13, 2009, at 10:36 AM, hweedle wrote:

    Can't speak Valero, Sunoco, Tesoro, et al, but I don't think CLMT really falls in this boat.

    CLMT is not dependent upon crack spreads for the bulk of cash flow, they rely on the specialy product margins. Further, they have a large portion of their crack spreads hedged over the next 2 years at very strong levels.

    The authors of this column have clumped them into a group because they don't understand the CLMT operations.

    Their lack of understanding on CLMT lead to the the previous article on the dividend being cut and now this one. You guys really need to do your homework.

  • Report this Comment On May 13, 2009, at 3:38 PM, XMFSinchiruna wrote:


    I'm not sure which article you're referring to about the dividend, but I assure you I have indeed done my homework on CLMT. Calumet's niche of specialty products does not set them apart entirely from the more traditional refiners, as fuel input costs and market prices for their respective product mixes wield influence over profitability in all the same ways. All the refiners hedge. The observation that heavy distillate gross margins are currently lagging light distillates represents a reversal of the prior trend, and does indeed hold ramifications for CLMT that are distinct from those for refiners that can shift production into gasoline as mentioned.

    Thanks for reading, and be sure to keep a close eye upon the demand side of the equation for CLMT's product categories. Apart from that, see my other articles on CLMT and discussions therewith. Good luck!

  • Report this Comment On May 14, 2009, at 9:41 AM, hweedle wrote:


    Still disagree with your assessment. You have been very negative towards CLMT, I agree it was justified when the LIFO move was made to stay compliant with debt covenants. Then in the second half of 2009, the operating results ware clouded by the hedging losses, but underlying results were very good. 1Q 2009 after unrealized hedging gains resulted in $50 MM EBITDA. Things are definitely on the uptick.

    The conference call was very positive with no concern expressed regarding covenant compliance, etc. If fact they even alluded to the future ability to reduce debt levels and possibly raise the distribution.

    While you may see signficant risk in this company, the fact is this is company with a 15% yeild (most of which is actually a return on capital and therefore not subject to ordinary income, but later wil be taxed at capital gains when the units are sold) and in my opinion the ability to see the unit price double in a year.

    I still think the bulk of the distillate issue you speak of are taken care of with the crack spread hedges they have (approx 75% of crack spreads are hedged based upon 10Q). Further at the end of the last quarter they have $54mm of other comprehensive income in the equity section of the balance sheet, the bulk of which represents unrealized hedging gains).

    So long as crude stays in a reasonable range +/- $15 from here they should do very well. If crude spikes, margins will be killed leading to problems.

    Last year when crude hit $120 they modified the hedging program and had to take huge losses in Q4 when crude plummeted, this has caused them to modified their hedging on Specialty products to a much shorter term. Hopefully this doesn't prove to be another overreaction leading to lost margin if crude spikes.

    Not without risk, but what stock isn't. But clearly at these levels and the apparent desire of managment to protect the dividend, the reward proposition seems acceptable.

  • Report this Comment On May 14, 2009, at 10:16 AM, XMFSinchiruna wrote:


    Thanks for the well-researched perspective. I don't really begrudge any company for missing the call on hedges during that ridiculous commodity collapse that no one could have predicted the severity of... but of all the upside down hedges I had seen, that one was particularly painful.

    My concerns for CLMT going forward are just as much about demand for their products as about the price of crude (which incidentally could jump higher in a heartbeat on geopolitical issues in Persia, etc.). I guess what I'm saying is that for all the company's attributes, which includes the yield of course, I could sure think of some safer sectors in which to invest.

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