Valero's Refinery Business Turns Sweet As Sour Crude Pays Off
BY PETER BENESH
INVESTOR'S BUSINESS DAILY
Adapted from article published Dec. 6, 2004
There's nothing wrong with William Greehey's crystal ball. Back in 1984 the company he heads, Valero Energy, figured out that supplies of light sweet crude oil would shrink.
That's the easiest and cheapest oil to refine. As the good stuff ran out, demand for lower-grade, hard-to-refine crude oil would rise, Valero realized.
But heavy sour crude, as the low-grade oil is called, demands more refining technology. Valero began buying refineries and adding technology to process the poorer-quality oil.
Twenty years later, Greehey, who engineered Valero's spinoff from its parent firm in 1980, says the company "hit a home run." With 15 refineries, Valero processes about 10% of the oil used in the U.S.
The motor fuels from Valero's refineries meet the same rising environmental standards as do fuels from higher-grade oil.
"Our story today is the story we told 20 years ago," Greehey says. "We saw the environmental movement taking sulfur out of gas and diesel and we saw that many refineries could not handle heavy sour crude."
As of December 2004, 70% of the oil Valero refines is the lower-grade type. That will rise, Greehey says.
The more low-grade crude oil Valero refines, the higher its profit margin says Argus Research analyst Jeb Armstrong. The reason? Low-grade crude oil is a lot cheaper than high-grade.
The "spread" between light and heavy crude is more than $12 a barrel, Armstrong says. But the motor fuel coming out of Valero's refineries sells for the market price.
While Valero's refining costs are higher, the cheaper crude more than compensates. It costs Valero only $1.90 per barrel more to refine heavy crude than it costs other refiners to process light crude. That nets Valero more than $10 a barrel.
The spread has ballooned because refining capacity is limited and because new anti-pollution regulations are more easily met by sweet crude, Armstrong says.
Even when prices rise for top-grade sweet crude oil, "70% of our supply doesn't cost us any more," Greehey said. "We can process cheaper feedstocks and make more premium products."
Heavy crude is the wave of the future, Greehey says. "Sour crude was once surplus because there was only a certain amount of refining capacity."
But Saudi Arabia has begun to flood the market with sour crude and today only 24% of the world's reserves are sweet crude and only 35% of that is being produced.
"With the improving economy and rising demand for oil, heavier, sour crude will come into the market and the spread will grow wider," Greehey said.
Buying refineries proved a great strategy and showed foresight, says Jacques Rousseau, analyst with Friedman Billings Ramsey. "No new refineries have been built in the U.S. in 30 years."
Even 2004's strong oil industry earnings don't justify investment in new refineries, Rousseau says. "It costs $1.5 billion for a 150,000-barrel-per-day refinery."
That's just for starters. Add $500 million to $1 billion for a pipeline to bring in the imported crude oil from a seaport.
Most of the refineries Valero bought were owned by major exploration companies getting out of the refining business.
Valero snagged them cheap, Armstrong says. "They bought one refinery from a near-bankrupt company for 30 cents on the dollar."
Greehey feels vindicated. "We bought these refineries at big discounts and we were criticized by Wall Street for doing what we were doing. But we believed in the strategy and it worked out well."
But the bargains can't go on forever, Armstrong says. "People have caught on to Valero's strategy and prices for refineries are inching up."
Valero owns refineries in California, Colorado, Texas, Oklahoma, Louisiana, New Jersey, Canada and Aruba.
But antitrust regulators are paying attention to how much refining capacity Valero controls. Washington forced the company to sell off one of the three California refineries.
"The FTC made us sell the Golden Eagle refinery in 2002," Greehey said. "They said we would have had too much control of supply."
Valero is one of the biggest refiners in the U.S., says analyst Rousseau. "They face a situation where the regulators will prevent them from growing too much more."
Greehey says Valero could add one or two Gulf Coast refineries, another midcontinent and another in the Northeast. The company has $1 billion in cash and Greehey says it's considering prepaying debt.
While Valero still believes it can buy more refineries in the U.S., it's considering offshore purchases, Rousseau says. "They need a further growth strategy. They've talked about Europe."
More European cars run on diesel, thanks in part to government incentives, Greehey says. That leaves excess gasoline refining capacity.
Valero sees a two-way street. It bought the Aruba refinery to sell diesel fuel to Europe. If it buys one or more European refineries, it could ship gasoline to the U.S.
"Whenever we acquire a refinery there must be synergies with our existing refineries," Greehey said. "We're looking at what synergies there might be with Europe. They need diesel and we need gasoline."
The U.S. already imports 1 million barrels of gasoline each day, Greehey says. "That number will rise as gasoline demand goes up."
He identifies both BP and Royal Dutch/Shell as having refineries for sale in Europe. But Greehey is more focused on expanding the capacity of Valero's current refineries.
"Our priority is to upgrade existing refineries," Greehey said. The company has $2.4 billion in projects scheduled for 2005-2009.
"These are good projects with little risk," Greehey said. They include adding gear that will squeeze more products out of each barrel of oil.
The company has plenty of experience in upgrading refineries. It built its Corpus Christi plant from scratch and has tripled its capacity since it came on stream in 1983.
Valero is planning to put an additional $25 million into a St. Charles, La., refinery it bought in 2003. The company calculates that the investment should add $50 million to annual operating income.
Valero's strategy has included development of its own branded service stations and credit cards. The chain has 4,200 outlets around North America.
Valero Energy reported net income of $1.57 per share for the third quarter, up 109%.
Analysts project 2004 full-year earnings will hit $5.86, up 130% over 2003. They see a decline to $4.47 in 2005 and $4.35 in 2006.
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