Delaware Refinery Swims Against the Tide

When I saw this headline in today's Wall St. Journal, "Governor Stays Closure of Delaware Refinery," the first thought that crossed my mind was of King Canute and his order to stop the tide. Valero Energy Corp., which owns the Delaware City refinery, had announced last fall that it would be shut down and dismantled. That was a pretty remarkable turn of events, considering that not very long ago refining margins were at all-time highs, boosting the fortunes of independent refiners like Valero and causing politicians and energy experts to despair that the US didn't have enough refinery capacity to keep pace with future demand. But while I understand the state government's desire to preserve the jobs and tax base involved, it's worth asking whether Governor Markell and the firm that appears ready to buy the refinery for $220 million are making a good bet or merely postponing the inevitable. Two graphs of the key fundamentals for this sort of refinery raise serious doubts.

More than 100 US refineries have closed in the last several decades, but few of those were as large or sophisticated as the Delaware City Plant (DCP), which was originally built by Getty Oil to process heavy oil from the Neutral Zone between Kuwait and Saudi Arabia. My former employer, Texaco, owned it for a while, as a result of its acquisition of Getty, before putting it into its refining and marketing joint venture with Saudi Refining Inc., which later included Shell. That JV sold DCP to Premcor, Inc., an independent refiner then run by the current CEO of PBF Energy Partners, LP, the company that is now buying it from Valero, which has owned it since its purchase of Premcor in 2005. The number of times it changed hands probably says more about the evolution of the US refining industry than about any inherent shortcomings of the facility, which is a complex machine for turning low quality crude into lots of gasoline and other valuable light products. Unfortunately, that description encapsulates the two biggest challenges its new owners, creditors and employees face.

Start with gasoline, which remains the most important product for most US refineries, accounting for about half of all US petroleum product sales and roughly 60% of refinery yield on crude oil input. Historically, US gasoline consumption rose by a steady 1-2% per year, and refineries often struggled to keep pace with demand, resulting in significant imports of gasoline and blending components. Two factors have altered that relationship, perhaps permanently. First, rapidly-increasing ethanol production, backed by subsidies and a steadily-escalating mandate, is eroding the market share of the gasoline that refiners make from crude oil. So now even when "gasoline" sales go up, they include an increasing proportion of ethanol. And as a result of the recession, total gasoline sales--including the ethanol blended in--fell by 3.2% between 2007 and 2008. When you factor out the ethanol, the drop was more than 5%. So because of weak demand and increasing ethanol use, refineries like DCP have experienced a shrinking market for their most important product, as the graph below depicts.

Then there's the issue of refinery complexity, which is a two-edged sword. When both crude and product markets are tight, as they were in 2006 and 2007, complex refineries like DCP enjoy a cost advantage over less sophisticated competitors, because they can make the same products from cheaper, lower-quality crude oils--typically heavier and higher in sulfur and other contaminants. But when the global economy stalled in 2008 and oil demand plummeted, many of those low-quality crude streams were the first ones that producers cut back, because they yielded less profit at the well-head than lighter, sweeter crudes. With less supply, the discount for them relative to lighter crudes shrank, and with it the competitive edge of facilities like DCP. In the case of Saudi Heavy crude, shown below, it looks like that discount was cut in half starting in late 2008, which was probably the last time DCP made decent returns.
What must happen in order for DCP to become a viable proposition in the future, other than for PBF to buy the facility for a fraction of its replacement cost--even less than Mr. O'Malley paid Motiva for it in 2004? Number one would be for light/heavy crude differentials to widen again. That could reasonably be expected to occur when the global economy grows by enough to bump up against OPEC's spare capacity limits, again. With spare capacity currently standing at more than 5 million barrels per day, that's unlikely to happen soon. However, even with a wide enough discount for its preferred crude supply, DCP will still be pushing gasoline into a weak market, thanks at least in part to continued expansion of ethanol. One indication of that comes from Valero's earnings report for the fourth quarter of last year, in which its ethanol business earned operating profits of $94 million, while its refining business, with more than 40 times the throughput, lost $226 million.

I would have been sorry to see the Delaware City Plant, with all its history, sold off for parts and scrap. After all, this is pretty much the kind of refinery that some were hoping the US would build, just a few years ago: large, complex, close to major markets and outside the hurricane belt of the Gulf Coast. However, the world changed in the interim. Will it change back enough to make DCP a going concern, again, or are the taxpayers of Delaware sinking more money into a facility that is destined to be a victim of Peak Demand, as more efficient cars and more prevalent biofuels squeeze enough petroleum products out of the market to ruin the economics of all but the most-efficient, lowest-cost refineries? We should know within a few years.

Reliving Bankruptcy

As GM files for bankruptcy today, I can't help thinking about my own experience with corporate bankruptcy 22 years ago. The Chapter 11 filing of Texaco, Inc. in 1987 still ranks among the top five non-financial corporate bankruptcies in the US. After adjusting for inflation and the likely discount on GM's stated asset value they seem roughly comparable in scale. Although the causes were quite different--seeking relief from a crippling court judgment in one case, and the collapse of sales and cash flow on the other--the outcomes of Texaco's bankruptcy might provide some useful insights into what could lie ahead for GM.

This morning's Wall St. Journal included an example of the numerous recent articles speculating on the shape of a New GM that might emerge from bankruptcy this summer. Some of the elements are already evident: the sale of 65% of Opel and Vauxhall in Europe, along with the previously-announced decision to eliminate the Pontiac brand and sell or eliminate Saturn, Hummer and Saab. The new GM will be smaller and presumably leaner. That was true for Texaco, as well, which made a similar choice to sell mature assets in favor of retaining its growth platform in Asia-Pacific, in order to raise the cash to pay the $3 billion settlement with Pennzoil that allowed it to emerge from Chapter 11. So Texaco sold its German and Canadian operations, along with a 50% interest in its US refining and marketing business in the eastern half of the US. The latter formed the Star Enterprise joint venture with Saudi Aramco that later evolved into Motiva Enterprises LLC after a subsequent JV with Shell.

Even during bankruptcy, Texaco became leaner and nimbler. Corporate management was preoccupied with legal concerns, so local managers were empowered in ways that would never have been possible in the old, highly-centralized corporate culture. The company that ultimately emerged from Chapter 11 was lighter on its feet, more competitive, and less bureaucratic and paternalistic. It was also fatally flawed, in ways that took many years to manifest and that the architects of the future GM might do well to consider carefully.

The first problem was scale. Overnight, Texaco went from rough parity with its historical peers--other than Exxon, which was a giant, even then--to a sort of in-between status: much bigger than the second-tier integrated oil companies such as ARCO, Marathon, Conoco, and Phillips, but notably smaller than Shell, BP and Chevron, and consequently less able than these to participate in every market or new opportunity. The company struggled in this role for a dozen years, until the aftermath of the oil-price collapse of the late 1990s set up the industry consolidation in which Texaco was acquired by Chevron in 2001. The new GM might face a similar outcome. It will be much smaller than Toyota and possibly even smaller than Ford, and it must be nimble indeed to end up on the right side of the global car industry consolidation that many experts see coming. It would be truly ironic if GM, which in its first decade consolidated half the US car industry, survived Chapter 11 only to be gobbled up in a few years by a bigger fish.

Europe was a particular problem for Texaco, and it could be for GM, as well. Texaco hung onto its strong, integrated UK business, Texaco Ltd., along with marketing operations in the Benelux countries, Scandinavia and Spain, but the sale of Deutche Texaco put it at a permanent competitive disadvantage to the European majors and Exxon. It also left the company without an effective springboard into Eastern Europe once the Iron Curtain fell, and the shrinkage continued with a series of one-off asset sales. GM faces different challenges in Europe. Aside from the sheer size of the European market, it is the only place in the old GM's universe that already meets fuel economy restrictions as tough as the ones just imposed by the US administration. Although it will retain a 35% interest in Opel and Vauxhall, I anticipate that GM will struggle to extract technology and share model platforms with the alliance led by Magna International, which also supplies parts to GM's competitors. Ford and Nissan/Renault should have a clear edge in this regard.

I learned a lot about such alliances, when I led Texaco's alliance management group from 1994-97. Texaco's JVs in the US and Asia-Pacific enabled it to fight above its weight, giving it a much bigger footprint than it could have maintained alone. Our stake in Caltex allowed us to enjoy the financial gains from the rapid growth of Asian "tigers" S. Korea, Singapore and Thailand, along with near-tigers such as the Philippines. However, this came at the expense of quick decision making, cohesive brand management, and periodic turf wars and self-defeating instances of competing with ourselves. Even in a 50/50 relationship with another oil company, creating consensus wasn't easy. I can only imagine what this might be like dealing as a minority holder with a Russian bank and a car-parts maker, neither of which are likely to have much in the way of common interests to build on.

My sympathy goes out to the GM employees and managers today. The personal uncertainties of working for a company in Chapter 11 will be nerve-wracking, even if they've been anticipated for the last year or two. For their sake, I hope GM's ride through Chapter 11 proves smooth and quick--more like Chrysler's and less like the year that Texaco spent there. At the same time, as one of the 155 million new "shareholders" in GM, I would prefer that the company not put a higher priority on achieving a hasty exit from Chapter 11 than on ensuring the New GM can compete effectively in a global car industry and market for the long run. That means building reliable cars that consumers will be eager to own, and not just because they meet the new corporate average fuel economy and tailpipe greenhouse gas emissions standards.