Buying Your Own Refinery

Has the high cost of fuel got you down? Why not buy your own oil refinery? That's apparently what Delta Air Lines is considering. With jet fuel purchases constituting one of the largest operating costs for carriers like Delta, and with several refineries in the Northeast US facing permanent closure due to poor profitability, it's not hard to see why this idea would seem attractive, at least superficially. However, there are a host of reasons why most of the press I've seen on this story is negative, including today's Heard on the Street column in the Wall St. Journal, entitled, "Delta Chases Fuel's Gold." The fundamental problem is the same one that has made me skeptical about the benefits of airlines investing in the production of renewable aviation fuel: Any advantageous pricing they may choose to provide to their airline division must come at the expense of lost opportunities for the fuels business, because the value of that fuel is set by the market.

How a company should reflect such opportunity costs in its inter-departmental transfer pricing is an age-old problem. I dealt with this routinely when I traded refined products for Texaco's west coast refining and marketing business in the 1980s. The marketing department always wanted to receive the output of the refineries at a lower price than we were charging them, so that they could capture market share and justify investments in new and remodeled gas stations. But making them look good at the cost of the refineries just made it harder to justify the investments needed to keep the refineries operating efficiently and in compliance with current and future regulations. Delta might buy ConocoPhillips' Pennsylvania refinery at a low price today, but they could be forced to invest at least as much within a few years to meet new gasoline sulfur regulations or other changes. It doesn't trivialize the situation to put it into the category of no free lunches.

Then there's the question of reorienting a refinery to make a lot more jet fuel that it has done historically, as one article suggested Delta was considering. Modern refineries are fairly flexible, and it would be possible to do that to some degree, though within limits that would require significant investments to exceed, making the proposition look much less attractive. Moreover, refineries optimize their output every day to make the slate of products that yields the highest profit, as crude and product prices fluctuate. Steering a less flexible course would almost certainly make the facility less, not more profitable, and it's only on the market because it wasn't sufficiently profitable as it was.

The only scenario in which I could see this idea actually working to Delta's benefit is if the refinery closures now being planned tightened the supply of jet fuel into the New York market so significantly that Delta was able to effectively corner that market, forcing other airlines to pay it a significant premium, either in cash or in jet fuel supply in other locations, while artificially keeping costs for its own flight operations low and allowing it to expand its share of the important NY air market. But New York isn't some isolated inland location, and they'd always be competing with jet fuel cargoes brought in by vessel, or with fuel shipped from Gulf Coast refineries via the Colonial Pipeline, which is expanding to meet the new demand its faces in light of the pending refinery closures. They might eke out a few extra cents, but would that be enough to justify taking on the enormous capital and operating costs--not to mention the substantial operating risks--of owning a refinery? If Delta has discovered some enticing angle I've missed, I'd love to know what it is.

The East Coast Refinery Gap

I see that ConocoPhillips has announced it will idle its 185,000 barrel-per-day Philadelphia area refinery, as a prelude to selling it or closing it permanently. Combined with the recent announcement that Sunoco would exit the refining business and sell or close its two refineries in Philadelphia, this amounts to just under half of the operating refining capacity on the US east coast, and that's counting PBF Energy's Delaware refinery, which is apparently in the process of starting up again after having been sold last year by Valero. If none of these three facilities finds a buyer, the resulting closures would leave a large gap in the east coast petroleum product market that must be filled either by shipping more products via pipeline from the Gulf Coast, to the extent capacity permits, or by means of increased imports from Europe and Canada. East coast gasoline and diesel prices could be higher for years to come.

The story in Reuters gives a good overview of the circumstances leading to Conoco's decision, and you've read about most of these factors in previous postings here. Topping the list is the persistent divergence of crude oil prices between the US mid-continent and the global oil market, due to a bottleneck at Cushing, OK resulting from several factors. Last week the gross margin ("3:2:1 crack") for importing crude priced at the level of UK Brent and turning it into gasoline and diesel or heating oil for the northeast market stood at a breakeven, and it's only a few dollars a barrel in the black today, after yesterday's market recovery. That's not much of an inducement to hang onto massively complex, capital-intensive facilities and to continue investing in them to keep them in compliance with ever more stringent regulations. Sometimes it just makes more sense to take a write-down and sell to someone else, who then starts with a lower capital base and has a better chance of making a return--not unlike the restaurant business. The problem in this environment is that it's not obvious who would step into the shoes of Sunoco and Conoco in Philadelphia. A few years ago buying refineries from integrated companies that wanted to redeploy their capital was a thriving game, with lots of players. Not so much, now.

Conoco's timing on this move is interesting, too. If it were only a question of margins, I'd think they'd wait to see how much profitability improved after Sunoco's plants shut down. Instead, it appears they are focused on a bigger picture. Even if they don't find a buyer, closing a marginal or money-losing facility will improve their overall refinery portfolio as they prepare to spin off the refining and marketing business, while allowing them to use the capital expenditures they won't have to put into the Trainer refinery for more lucrative opportunities like shale gas, which the company has been touting in a series of ads. That probably makes sense for the company's shareholders, though it won't do much for consumers in my neck of the woods, especially if the company's larger New Jersey refinery meets the same fate.

Oil refining has always been a tough business, with its occasional good years normally more than offset by years or decades in the doldrums. But the combination of reduced demand from the recession-weakened economy and the increased supply of biofuel--mainly corn ethanol, so far--has increased the pressure. When I ponder all this it makes me wonder why so many startups are so eager to get into the fuels manufacturing business, even if it will be based on biomass rather than oil, when they will ultimately be exposed to similar market forces.

Petro Profits

This energy crisis has given rise to a new American ritual: every quarter, after ExxonMobil's earnings are announced, the media breaks them down into dollars per hour, minute and second, and then cues to reaction shots of consumers expressing outrage that any company should benefit so much from their pain at the gas pump. Although I'm not suggesting we should all feel warm and cozy about oil company profits, we might be better served to focus our fulminating on the dog that doesn't bark. If the largest US oil company produces only 3% of the world's oil and still made nearly $12 billion last quarter, what did the national oil companies that own most of the world's oil make, and who paid for that?

Considering the average price of oil in the 2nd quarter, no one should be surprised that Exxon had stellar results, in spite of earning 54% less on refining and marketing and a third less on chemicals than they did last year at the same time. Allocated over the 26 billion gallons of petroleum products they sold around the world in the quarter, these profits equate to an average of 45¢ per gallon, with 87% coming from finding and producing the oil that went into making those products. It's not unreasonable for consumers paying roughly $4 per gallon to grouse about that, though it does say something about our current national mood that the media chooses to highlight that reaction, rather than someone seeing the results enjoyed by Exxon's shareholders and wanting a piece of the action, no matter how small. But whatever the US oil companies, including Chevron, ConocoPhillips, Marathon, and numerous others make, at least most of their profits get recycled into the US economy, in the form of new investments and the savings and spending of the millions of us who collect their dividends, directly or indirectly. The same can't be said for the profits of Saudi Aramco, the National Iranian Oil Co. (NIOC), Kuwait Petroleum Co., PdVSA, Rosneft, and so on.

Consider NIOC, the second-largest producer among national oil companies, at 4.15 million barrels per day, about 60% of which is exported. Iran is a relatively low-cost producer, though probably not as low as Saudi Arabia. If their total costs per barrel averaged more than $15 per barrel, I'd be surprised. So at an average price for Iranian Heavy for 2Q08 of $113.85/bbl., that works out to a quarterly gross profit just on exports in the neighborhood of $22 billion, excluding NIOC's earnings from domestic sales, refining and its substantial production of natural gas. Those might add another $10 billion to the total. Lop off a billion or so for overhead, and NIOC is probably reporting to its sole shareholder second-quarter results north of $30 billion. That'll buy a few centrifuges.

So go ahead and grumble about big US oil companies making record profits, while we pay near-record prices at the pump. But don't forget that we import 12 million barrels per day of oil and petroleum products, for which each and every quarter we must send roughly $135 billion outside the country, at current prices. Mr. Pickens is right to bemoan this enormous and unsustainable transfer of wealth. In that context, a smart national energy policy would not bog down in trying to choose among expanded drilling, conservation, and renewable energy, as though these were mutually exclusive options; it would pursue all of them, vigorously, and without vilifying companies for wanting to produce more energy here in the US.

Whose Responsibility?

Today's Wall Street Journal reports that ConocoPhillips has become the first US integrated oil company to call for a cap on greenhouse gas emissions. This is a noteworthy development, because until now, only European oil firms such as BP and Shell had endorsed aggressive action to control climate change. The article supplies several good reasons why an oil producer and refiner might support a measure that would ultimately require it to reduce its own emissions, but it leaves open the question of who will be responsible for the much larger pool of emissions resulting from the use of petroleum products. With oil and auto firms pointing at each other in this regard, it's easy to ignore the role consumers must play. Unless we are willing to pay more for fuels or voluntarily conserve, emissions reductions from the transportation sector will be elusive.

Based on detailed well-to-wheels emissions analysis by the Argonne National Laboratory of the Department of Energy, the entire process of producing oil, refining it, and delivering gasoline to service stations consumes about 20% of the energy content of the original crude oil. Greenhouse gas emissions are directly correlated to energy use, so for every gallon of gasoline we buy, the supplier emitted up to 5 lb. of CO2-equivalent, compared to the 20 lb. that will be emitted when we burn it in our cars. However, because much of the energy used in the refining process comes from natural gas or electricity, rather than the oil itself, actual "upstream" emissions are generally lower than that 5 lb. estimate. Even if an oil company can reduce its emissions by 25%, that only cuts the total emissions from the gasoline value chain by 3-5%. In order for transportation emissions to come down materially, someone needs to take responsibility for that downstream 20 lb. of CO2 per gallon.

As I discussed yesterday, carmakers can contribute by producing more efficient cars, and that will almost certainly happen. But unless consumers buy them in large numbers, the net result will be that the manufacturers will pay fines, but emissions will remain unchanged or grow. Oil companies can also contribute by blending up to 10% ethanol into the fuel they sell. If that ethanol is derived from corn, this will only reduce vehicle emissions by about 2%. So unless consumers buy more efficient cars and/or drive less, we're looking at a maximum reduction of about 7% of the total emissions from the oil well to the tailpipe. That's not enough to reach a target like California's, which would require a cut of 25% by 2020.

Unless lawmakers are willing to let consumers shoulder a large part of the burden, as the ones using most of the energy that creates these emissions, then the producers of energy must ultimately slash their own emissions and offset ours. At $20/ton of CO2 credits, that would equate to another 5 cents per gallon in added cost for a 25% reduction in emissions. One way or another, consumers will pay more at the pump, because the cost of producing and distributing motor fuel will go up significantly under an emissions cap.