The Ripple Effect

The fallout from the collapse of oil prices in the last quarter of 2008 is still rippling through the economy. Yesterday's announcement of a $34 billion write-off by ConocoPhillips, the third-largest US oil company, is the latest signpost of this phenomenon. It's not confined to the oil exploration and production segment, either. We've seen the earnings of non-integrated refining companies drop, along with the announcement by Valero, the largest US refiner, that it would idle its 225,000 barrel per day Texas City refinery for several weeks. At the same time, ethanol producers continue to struggle with low margins and financing problems. In short, only a quarter after fuel companies were reporting record earnings, the tables have turned and consumers are in the catbird seat, still paying less than half of last summer's pump prices.

Conoco's losses didn't surprise Wall Street, and they shouldn't have surprised my readers, either. In late December I examined the impact of low year-end prices on the oil and gas reserves carried on the books of the oil companies. The reasonable change in SEC regulations for calculating their value, which goes into effect next January, came a year too late to prevent massive accounting losses in the oil patch. However, I missed the impact on the value of acquisitions, to which ConocoPhillips may have been particularly vulnerable, having been assembled not just from one big merger, but from a long string of deals. The bones of Burlington Resources, Tosco, and Unocal's refining and marketing business are all buried in there, somewhere. Tomorrow we'll see whether ExxonMobil and Chevron report similar losses, though it's notable that Shell, which reports earnings under UK accounting standards, saw only a 28% drop in fourth quarter earnings, compared to 4Q07.

Meanwhile, the refining business has returned to a more normal situation, compared to the boom years of a few years ago and the dire straits of last month, when spot gasoline was selling for less than light sweet crude oil. The recent bounce in gasoline prices has put refiners back in the black. Since December, the calculated futures market "crack" spread, a simple estimate of the margin on making gasoline, has improved from a average loss for the month of $1.40/bbl to a profit of around $5.75/bbl, while the "3-2-1 crack", which includes the benefit of higher diesel fuel prices, has improved from about $5/bbl to roughly $10/bbl. Although this is a healthy margin, it won't result in banner profits, when US refineries are running at an average utilization of 82%. That's a lot of idle capacity, whether in the form of entire plant shutdowns, as at Texas City, or of reduced run rates at most plants. It's a reflection of just how far US gasoline demand has fallen that until this week, gasoline inventories continued to build, in spite of such low output.

Ethanol producers aren't faring much better. The operating margin, or "crush spread", that I calculate from today's Chicago Board of Trade corn and ethanol quotes is only $0.25/gal. That's a far cry from crush spreads over $1.00/gal that were routine in 2006 and 2007, and that helped fuel an ethanol plant construction boom that has now gone bust, at least temporarily. A growing number of ethanol producers have filed for Chapter 11 protection, and the largest of these, VeraSun Energy, has been forced by market conditions to idle 12 of its 16 "biorefineries." If it emerges from bankruptcy at all, VeraSun, which had been one of the most aggressive consolidators of the industry, will be much smaller. These are hardly the signs of a thriving biofuels industry, upon which a core strategy of US energy policy rests.

Any temptation to find morbid satisfaction in the diminished fortunes of the transportation fuels industry should be tempered by a clear understanding that its dips carry consequences that reverberate for years, because of the planning and construction lags inherent in its big projects. The oil platforms deferred or canceled this year will squeeze output in the mid-2010's, while the gas wells not drilled in 2009 and 2010 will tighten supplies much sooner. And even on the presumably greener side of the industry, an ethanol sector rocked by corporate bankruptcies and distilleries abandoned before they ever started up will be poorly positioned to deliver on the highly-ambitious renewable fuels targets set by the Congress in late 2007, and mooted for further expansion during last year's presidential campaign. The days of profits some regarded as unearned windfalls have clearly ended; however, if the fuels industry doesn't make "normal" profits this year and next, we will all pay for it down the road.