If anything smells worse than an oil refinery, it's a big merger of oil refiners at a time when gasoline prices are at all-time highs. That's why critics of Big Oil cried foul on Apr. 25 when Valero Energy Corp. (VLO) announced an $8 billion deal for Premcor Inc. (PCO) that would create North America's biggest refiner. Naysayers raised concerns that more consolidation would reduce competition, letting refiners get away with underinvesting in capacity -- tightening supplies and driving up prices and profits. Said Senator Ron Wyden (D-Ore.), who sits on the Energy & Natural Resources Committee: "You had better believe I will be reviewing very carefully the effects of this transaction on the American gas consumer."
Despite the fears, though, Valero's purchase of Premcor might not be the disaster the Cassandras predict. While too much consolidation in refining is a genuine concern, there's intriguing evidence that this particular deal could benefit consumers by increasing the supply of American-made gasoline and other re- fined products. San Antonio-based Valero has a history of upgrading the refineries it buys and boosting their output. It vows to do the same with Old Greenwich (Conn.)-based Premcor, whose ability to expand has been hampered by a weak credit rating.
Skeptics argue that the new Valero would simply be too big. Absent divestitures, the merger would bring the U.S. market share of the four biggest refiners to 46%, up from 31% in 1990 and 40% in 2000, according to Energy Dept. calculations. The skeptics point to a May, 2004, report to Congress by the Government Accountability Office, which used a computer model to conclude that six of the eight late-'90s oil industry mergers that it investigated led to price increases, averaging 1 cents to 2 cents per gallon of gasoline. The critics also argue that if companies such as Valero want to expand, it would be better for consumers if they built new refineries rather than gobbling up existing ones.
But the critiques are misplaced. The Energy Dept. calculates that the U.S. market share of a combined Valero-Premcor would be just 12.7%, hardly a dominant position. Anyway, what matters is the degree of dominance in particular regions, rather than the U.S. overall. Valero and Premcor do own refineries 25 miles apart in New Jersey and Delaware. But even in the mid-Atlantic, their combined market share would be a distant third behind Sunoco Inc. (SUN) and ConocoPhillips (COP). Analysts who follow Valero predict that the Federal Trade Commission will O.K. the deal without requiring it to sell either refinery.
Sure, consumers would be better off if Valero built rather than bought refineries. But that's asking a lot. While refineries are highly profitable now, their checkered past of thin margins makes investors wary of new plants. Would-be builders also face strict environmental rules and not-in-my-backyard activists. Valero estimates that building the equivalent of Premcor's current capacity from the ground up would cost 40% more than simply acquiring the company. In a stab at solving the problem, President George W. Bush on April 27 called for simpler pollution rules and permit processes, and asked federal agencies to work with states and towns to encourage building new refineries on closed military sites.
Meanwhile, Valero is adding capacity at its existing refineries. Since 1996, it estimates it has added 380,000 barrels a day to its output -- a 5% hike. That's the equivalent of two big new refineries. And Valero, like Premcor, has focused on processing heavy, sour crude oils, which are relatively abundant and cheap. Gasoline would be even pricier were it not for the ability to process those less attractive crudes.
Add it up and the Valero-Premcor deal is "probably good" for consumers, says Colm T. McDermott of energy analyst John S. Herold Inc. It's hard to love a refinery merger, but this one just might pass the smell test.
By Peter Coy, with Wendy Zellner in Dallas and Eamon Javers in Washington