West Coast operations remain profitable despite refinery outages

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West Coast operations remain profitable despite refinery outages 1/29/2001 Report from the Energy Information Agency, Department of Energy Significant supply problems plagued the west coast area of the United States during 1999, raising the question of what the financial implications were for the west coast refining and marketing operations of the FRS companies. Two major companies, ARCO and Tosco, experienced lengthy and unscheduled refinery shutdowns during 1999 because of refinery fires, which affected product availability on the west coast of the United States, especially California. These shutdowns disrupted the supply of motor gasoline and diesel fuel that met the requirements of the California Air Resources Board. In June of 1999, the Olympic Pipeline, a key petroleum product route in the state of Washington, was shut down for the remainder of the year due to a fatal fire arising from a leak in the pipeline. The shutdown diverted product shipments to barges, resulting in higher shipping costs.

These developments plus the recurring concern that west coast motor gasoline prices are high raises a new round of questions concerning the profitability of refining and marketing operations on the west coast relative to refining and marketing operations elsewhere in the country. This highlight examines the financial results of west coast refiners relative to other refiners in 1999 using FRS data.

The west coast of the United States is entirely contained within the Petroleum Administration for Defense District Five (PADD 5), which includes Alaska, Arizona, California, Hawaii, Nevada, Oregon, and Washington. In 1999 PADD 5 had 19% of the U.S. population; 26% of U.S. refineries with 19% of U.S. crude oil distillation capacity; 19% of downstream processing capacity; and 11% of U.S. motor gasoline retail outlets through which 17% of U.S. motor gasoline was sold. Thus, PADD 5 refineries tend to be somewhat smaller (in terms of crude distillation capacity) than those elsewhere in the country and the motor gasoline outlets are about 50% larger (in terms of average sales volume). However, simply examining the physical characteristics of PADD 5 operations provides little insight into the profitability of these operations.

One way to examine profitability is to compare the rates of return to refining/marketing operations of PADD 5 refiners with those of non-PADD 5 refiners. The Financial Reporting System (FRS) database lends itself well, but imperfectly, to such a comparison. The FRS companies can be divided into two groups of refiners: those that are primarily based in PADD 5 (measured by crude oil distillation capacity) and those that are primarily based outside of PADD 5 ("Other"). The PADD 5 FRS group overall had 68% of their domestic refining capacity located in PADD 5 at the end of 1999. The Other FRS had 92% of their total domestic refining capacity located outside PADD 5 at the end of 1999.

After 1995 the profitability (measured by net income divided by net investment in place) of refining/marketing operations of the PADD 5 FRS refiners has consistently been greater than the profitability of the Other FRS refiners. During the first half of the 1990s there was, on average, little difference in profitability. Although the difference between the profitability of the two groups appeared to narrow in 1998, it grew during 1999 as the PADD 5 FRS refiners' return on investment increased slightly while the Other FRS refiners' return on investment fell 3 percentage points. Consequently, despite the 1999 refinery/pipeline outages, in there was little ill effect on the PADD 5 FRS refiners as, the profitability of PADD 5 FRS refiners showed little apparent ill effect, outperforming increased relative to the Other FRS refiners.

Because the net margin and refining/marketing profitability are highly correlated, examination of differences in the net margins should provide clues as to the source of profitability differences. The net margin is the gross margin (average price received for all petroleum products less raw materials costs and product purchases) less out-of-pocket refining and marketing costs on a per-barrel basis. The net margin for both the PADD 5 FRS refiners and the Other FRS refiners declined between 1998 and 1999, but the net margin of PADD 5 FRS refiners remained higher than the net margin of Other FRS refiners as has been the case since 1996. Each of the two components of the net margin (i.e., gross margin and operating costs) can be examined to understand why the net margin of the two FRS groups were so differed in recent years.

The gross margin for PADD 5 FRS refiners has been consistently higher than the gross margin for Other FRS refiners during the 1990s. In 1999, refined product price increases were less than crude oil price increases for the FRS companies overall. This margin reduction was more severe for the PADD 5 FRS refiners than for the Other FRS refiners. The gross margin of the former group fell US$1.30 per bbl (16%) and the gross margin of the latter group fell $0.51 per bbl (9%). This result suggests that PADD 5 FRS refiners' profitability would should have moved nearer, not farther, from the level of profitability of Other FRS refiners. Thus, operating costs associated with producing and selling the petroleum products is the more likely source of the observed differences in profitability in 1999.

Operating costs of the PADD 5 FRS refiners were also higher than those of Other FRS refiners over the 1990s. Between 1998 and 1999 they fell $0.66 per bbl. Meanwhile the operating costs of Other FRS refiners also decreased, but by a smaller $0.20 per bbl. The resulting situation was unprecedented in the decade, as operating costs of PADD 5 FRS refiners were only $0.98 per bbl higher in 1999 than were operating costs of Other FRS refiners. Over the 1990 to 1998 period the operating costs of PADD 5 FRS refiners averaged $2.30 per bbl more than those of the Other FRS refiners, with the difference peaking in 1996 and 1997 as the California Air Resources Board motor fuel regulations went into effect. Company news releases and other public disclosures indicated that companies went to great lengths to reduce costs during 1999.

Although the PADD 5 FRS refiners experienced significant and lengthy refinery outages during 1999, their aggregate profitability changed little. Profitability was largely maintained at 1998 levels through substantial reductions in operating costs, despite declines in gross margins. PADD 5 FRS refiners achieved lower operating costs by generally containing costs aggressively. For Other FRS refiners, gross margins also declined, but operating costs fell less.

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-- Martin Thompson (mthom1927@aol.com), January 30, 2001


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