Oil Refiners' Production Lows, Profit Highs

Where's the gas? As pump prices test $3, persistent problems, from old plants to a shortage of skilled workers, spur debate on the industry

by Moira Herbst

Fires. Explosions. Lightning strikes. This is the new state of affairs for U.S. oil refiners, hobbled in recent months by an unprecedented plague of bad luck and operational setbacks from California to Delaware (see BusinessWeek.com, 4/26/07, "$4 Gas? Fat Chance"). Facilities of all sizes and age have been struck, leading to supply bottlenecks in various regions.

On May 2 the Energy Dept. reported that refineries are operating at only 88.3% of capacity, barely above the 20-year low notched last week. Not surprisingly, gasoline inventories dropped for the 12th week in a row—the first such three-month stretch since 1993. All that has set gasoline prices on a dramatic bull run, with refiners' stocks setting all-time highs and U.S. consumers facing average pump prices of $2.98.

Strained System

What's gone so wrong in refining?

"They're cursed," says Phil Flynn, an analyst with Alaron Trading in Chicago. "You can argue that the refineries are old and they're squeezing more blood from the turnip than ever, but that explanation doesn't cut it. Maybe Al Gore has cast a spell on the industry."

Conspiracy theories aside, a number of factors are preventing more supply from flowing into the U.S. market. The overall picture is a system under such strain that any outages or disruptions ricochet quickly into retail prices. Because of high costs and a lack of public support, refiners haven't built an entirely new plant since 1976. While they've been expanding existing plants, the industry isn't keeping pace with growing demand. Any additional stresses—hurricanes such as Katrina or the persistent power outages—curb output. Add to that a shortage of skilled workers and government rules mandating cleaner fuels, and the reasons behind scarce supplies emerge.

High Margins

But while production hiccups may be an operational curse, refinery shareholders are now pondering a different question: What's gone so right with refining?

The price difference between a barrel of crude and a barrel of refined gasoline are now the fattest the industry has ever seen. With May 2 closing prices on the New York Mercantile Exchange, refiners could fetch $93.37 per barrel of gasoline, amounting to a refining margin of $30 per barrel, according to calculations by both Chicago-based consulting firm Oil Analytics and Peter Beutel of Cameron Hanover Associates. That's 50% higher than last year, when margins at the time hit historic highs of $20 a barrel, according to Oil Analytics. "Refiners are making a bundle now," says Beutel.

The steep margins led to Valero's Apr. 26 announcement that first-quarter profits were $1.1 billion, up a stunning 30% over last year; Chevron (CVX) reported first-quarter earnings of $4.7 billion, up 18% from last year. ExxonMobil (XOM) saw a 10% jump in quarterly net income, at $9.3 billion—the company's best-ever first quarter. For integrated oil companies, the results are from one factor: high refining margins. The segment of Exxon's business that includes refining, for example, earned $1.9 billion for the quarter, up $641 million from the year before.

The profits led to all-time closing highs last week for the shares of the two biggest U.S. refiners, San Antonio-based Valero and its cross-town rival, Tesoro (TSO). The stocks of integrated players Marathon Oil (MRO), ExxonMobil, and Chevron also set 52-week highs last week on their robust profits.

Deliberate Shortage?

"It's true we're enjoying pretty good margins right now and pretty good profits," says Bill Day, a spokesman for Valero Energy (VLO). "But that's in spite of, not because of, the refinery outages. In this environment, with the supply-and-demand balance so tight, this is really when you want your refineries running full blast. That's why we get heartburn every time we hear of an outage. You really want everything running full capacity."