Bloomberg News

Rising Crude Price Squeezes Refiners’ Earnings on Oil Purchases

January 23, 2012

Jan. 23 (Bloomberg) -- U.S. refiners may have lost as much as $700 million in the fourth quarter as a surge in crude prices turned energy contracts that were profitable through most of 2011 into money-losers.

A fourth-quarter profit-squeeze became more pronounced for Tesoro Corp., Marathon Petroleum Corp. and Valero Energy Corp. because of a risk-management strategy they used to purchase oil to feed their refineries. The effects of a lower profit margin for refiners will continue to be felt through the year, analysts from Deutsche Bank AG, Macquarie Group Ltd, and Global Hunter Securities LLC said as they downgraded their ratings on refiners and forecast lower profits for 2012.

A 4.9 percent decline in oil prices from a high this month of $103.22 has provided some relief for refiners, although analysts project per-share profit for Valero, Tesoro and Marathon Petroleum to decline 6 percent or higher compared to 2011, according to average estimates compiled by Bloomberg.

The companies bought crude linked to global prices and used U.S. oil futures contracts to protect against price swings. When U.S. and global prices took a surprise turn, refiners lost millions on the contracts, said Cory Garcia, an analyst with Raymond James and Associates Inc. in Houston.

Energy contracts that lock in the price of crude cost Marathon as much as $350 million, Valero $200 million and Tesoro $150 million, Jeff Dietert, an analyst at Simmons & Co. International Ltd., wrote Jan. 9 in a note to investors.

“All the refiners got beat up this quarter and will post losses because of this,” Garcia said in a telephone interview.

Marathon spokeswoman Angelia Graves declined to comment on the company’s hedging strategy. Valero spokesman Bill Day and Tesoro spokeswoman Tina Barbee also declined to comment.

Earnings Cut

Valero said Jan. 16 that falling prices for gasoline combined with changing crude prices, cut earnings to less than 10 cents a share. Tesoro said Jan. 5 that it lost between $77 million and $112 million in the quarter, and Marathon Petroleum said Jan. 10 it would report a “small loss.” A “break-even” fourth quarter in refining for Chevron Corp. led the integrated oil and natural-gas company to announce Jan. 11 that its earnings would be “significantly below” the July-to-August period.

Losses stemming from the practice known as hedging worsened a quarter in which refiners saw profit margins from processing oil into fuel fall 39 percent, according to data compiled by Bloomberg.

Hedging Losses

Hedging involves trading financial instruments that commit both parties to exchanging commodities or money at an agreed- upon price at a future date. The transactions are used mostly as insurance by oil producers and processors to guard against price swings in crude prices, said Sam Margolin, an analyst with Global Hunter in New York.

The practice can sometimes boost profits. Hedging activities by Western Refining Inc. resulted in a pretax gain of $298.2 million, the company said in a statement Jan. 11.

Refiner hedging losses in the fourth quarter are rooted in a disconnect that developed in 2011 between prices for West Texas Intermediate Crude, the U.S. benchmark, and Brent from the U.K.’s North Sea, which is used for oil produced around the world.

A 13 percent increase in U.S. crude production in 2011 compared to 2008, including in shale formations in North Dakota and Texas, led to a supply increase that depressed WTI prices for most of the year. A civil war in Libya and other unrest in the Middle East boosted Brent prices, leading to an unprecedented spread between the two benchmarks that averaged $22.52 in the third quarter.

Losses on Contracts

In the first three months of 2011, Brent jumped to an average of $105.52 compared to $94.60 for WTI, the highest-ever difference between the two grades. During the quarter, energy companies missed out on potential profits from an oil rally because they had locked in lower prices before crude surged 20 percent.

Valero reported $352 million in losses in the first quarter on contracts tied to sales of gasoline and diesel.

Unprecedented swings in the spread between the two grades of crude happened in every quarter in 2011. Before that year, the average difference between Brent and WTI had never reached higher than $5 in any quarter.

Brent crude has only outstripped WTI 12 times in the past 95 quarters, including the last seven quarters.

In the fourth quarter, WTI gained an average of $4.52 and Brent dropped $3.07, narrowing the difference between the two by $7.62. That’s the biggest quarterly change in the two prices ever recorded as WTI gained, according to data compiled by Bloomberg.

The margin between oil costs and fuel prices led to near- record profits in the first nine months of the year for refiners, since many were able to buy U.S.-produced oil at a discount and sell gasoline and other types of fuel at prices linked to the global crude benchmark.

Discount Disappears

That changed Nov. 16, when Enbridge Inc. and Enterprise Products Partners LP announced plans to reverse a pipeline to carry oil from an oversupplied storage hub in Cushing, Oklahoma, to the Gulf of Mexico.

Much of the discount for WTI was wiped out almost immediately, moving from a record high of $27.88 on Oct. 14 to $9.28 the day of the announcement, according to data compiled by Bloomberg.

“Nobody saw that coming, and a lot of people got hurt with that announcement,” said David Hackett, president of Stillwater Associates LLC, an energy consulting firm in Irvine, California.

Marathon Petroleum fell 6 percent, Tesoro fell 4.4 percent and Valero fell 4.8 percent on that day as investors anticipated that the profit margin between oil costs and fuel prices would shrink, Hackett said.

Pipeline Reversal

Before the Seaway pipeline reversal was announced, the Standard and Poor’s Oil and Gas Refining and Marketing index gained 4.9 percent, outperforming the Standard and Poor’s 500 in that period which rose less than .01 percent. Since November 15, the day before the announcement, the refining index has fallen 3 percent compared to an S&P 500 increase of 4.5 percent.

Many refiners with operations on the West and Gulf Coasts had agreed to buy oil linked to Brent prices and used WTI futures contracts to protect against price volatility, said Chi Chow, an analyst in Denver with Macquarie Capital USA Inc.

“These companies bought Brent-based crudes and hedged with WTI contracts,” he said.

The contracts had boosted profits earlier in the year, said Chow, who downgraded Marathon and Valero on Jan. 3, before energy companies began announcing fourth-quarter refining losses.

“The easy solution is to hedge with Brent-based contracts,” he said. “Then you wouldn’t necessarily see these wide gains or losses.”

--Editors: Jessica Resnick-Ault, Susan Warren

To contact the reporter on this story: Bradley Olson in Houston at

To contact the editor responsible for this story: Susan Warren at

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