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IOCs losing ground downstream

As the majors continue to cede their position in the refining sector to niche players, what is their future role in the downstream industry? Edward Osterwald and Roger Newenham of CRA International write

SINCE 2001, mergers and acquisitions in the refining sector have resulted in the transfer not just of refining capacity between companies, but also of capital value from the majors to specialist niche refiners. The poor timing of some sales suggests the majors' objectives may have been simply to dispose of the assets, regardless of the long-term financial implications.

CRA has compiled data on annual average refinery profitability in the main refining centres – the US Gulf Coast, the Mediterranean and Singapore – and related this to transaction values. But assessing deals on the basis of transaction value ignores the relative complexity of the assets sold and risks presenting a misleading picture. CRA normalised for this factor by using a measurement of transaction value per complexity-barrel. This adjusts for the differences in the technical configuration and makes comparison more reliable.

Timing is critical

There is a strong correlation between refinery profitability and transaction value (see Figure 1): refining margins, whether high or low, are immediately reflected in refinery valuations. The significance of this is that if a company decides to enter or exit the refining sector, timing is critical. The right time to enter and the wrong time to exit was in the early years of the decade, when margins – and, consequently, refinery values – were low.

In its analysis, CRA included only transactions where there was a clear value ascribable to refining assets. Deals that included significant pipeline, distribution, retail or petrochemicals assets were excluded, so the analysis reflects only refineries and not other assets that might distort the picture.

CRA then listed the companies that carried out refining-sector transactions between 2001 and 2007, splitting refinery operators into two categories: the majors – BP, Chevron, ExxonMobil, Shell and Total; and refiners – Petroplus, Tesoro, Sunoco and Valero (merchant, or with distribution and retail). The results were arranged by category (see Figures 2 and 3).

With certain exceptions, most of the majors have been steadily divesting assets although ExxonMobil has been far less active than its peers. BP and Shell both began selling their refining base at the bottom of the market; Shell's later divestitures have been better-timed; but many of BP's coincided with the period of low margins – and lowest sales prices – in 2001 and 2002.

Within the refiner category, Valero has not only acquired significant numbers of refineries, but its timing also appears to have been prescient. Valero completed its purchases by early 2004, at which point both refining margins and, in turn, refinery purchase prices (complexity-barrel transaction values) began to rise sharply. Much of Valero's portfolio was acquired during periods when average acquisition prices were substantially lower than at present. By predicting the rise of margins and exploiting the majors' desire to exit the sector, Valero increased the size of its asset base at substantially lower cost than at a later time. This will result in much higher returns on these acquisitions in future.

Through a combination of US refinery purchases and acquisitions of other specialist refining companies, Valero now owns over 3m barrels a day of atmospheric distillation capacity. This makes its 2007 refining asset base larger than all of the majors, apart from ExxonMobil and Shell.

Companies dedicated to refining tend to focus on particular regions. Valero, with the exception of the acquisition of its Aruba refinery, has been expanding in North America; so too are Sunoco and Tesoro; Petroplus has remained exclusively European. This suggests an important element in refiners' strategy has been to build strong regional positions offering geographical optimisation and trading leverage.

Buying ahead of the curve

Several niche players forecast and acted on the sharp improvement in refining margins that began in 2004. In so doing, they were able to make acquisitions at significantly lower complexity-barrel transaction values, ahead of a sharply rising price curve, achieved, of course, at the expense of the sellers – mostly, the majors.

That there have been so few sales by the likes of Valero and Petroplus suggests they expect continued high margins, otherwise they might now be seeking to reduce their exposure to a downturn, having already benefited handsomely by correctly predicting a significant improvement in profitability. The only recent disposals were Valero's sales to Husky and Suncor, both directly linked to the emergence of Canadian oil sands.

The majors' retail presence has already been significantly eroded in most markets by supermarkets; upstream, they face increasing difficulty maintaining their reserves base. This latest ill-timed retreat from a further link in the value chain – refining – suggests their historic dominance of the business is on track to deteriorate further.

The majors could, perhaps, reverse this trend by taking a lesson from younger and more nimble competitors such as Valero, Tesoro and Petroplus. Given the continued financial strength of the majors, they could seek to increase their presence in refining through focused investment coincident with the next downturn in the sector.

This would require them to seek to create value for shareholders by a counter-cyclical investment strategy and would no doubt be questioned intensely for going against the conventional wisdom at the time. But this is what Valero and Tesoro did earlier in the decade.

Another important lesson is geographic focus. The majors historically sought a presence in every significant downstream market in the world. The emergence of Opec caused them to lose control of global supply, which, in turn, made it easier for national oil companies, and subsequently niche refiners, to take market share. A counter-cyclical investment strategy would require a more regional focus, facilitating competitive advantage in markets where the presence of refineries would yield supply cost advantages for local marketers – as smaller, but more successful refinery operators have demonstrated.

In hindsight, the majors should have divested refineries only in areas where competitive advantage was unlikely to be achieved, rather than the broad and ill-timed exit from the sector. Indeed, most of the refineries acquired by companies such as Tesoro, Valero and Petroplus were purchased in the mid to late 1990s, when margins were low and assets were relatively cheap. These companies are reaping the dividends today.

 

 

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