Value-driven strategies can help US downstream profitability

US refining and marketing profitability has been weak for much of the past decade. Despite many positive fundamental factors, 1999 was one of the worst years in the past 2 decades for US refining margins (Fig. 1).

World demand has continued to recover well from the Asian financial crisis, and US product demand has been boosted by economic growth. Excess refining capacity, market sensitivity to supply and demand imbalances, and crude oil market factors, however, drove refining margins to very low levels.

Margins after variable costs for sweet crude cracking on the Gulf Coast fluctuated around $1.00/bbl for most of the 1990s after a brief period of stronger margins from the late 1980s to the early 1990s.

Margins were weak in the first half of 1999; additional downward pressure resulted from the restart of idled facilities. Crude oil market factors also contributed to poor margins in 1999, as increases in refined products prices lagged behind rising crude prices. As a result, margins declined to $0.50/bbl in 1999, the lowest levels since 1987.

The annual average margins in Fig. 1 disguise much greater short-term volatility. The transparency of today's spot and futures markets makes it impossible to prevent margins from plunging to very low levels during downward cycles.

The international nature of the market exacerbates this problem by causing imbalances in any part of the world to spread quickly to all markets. As a result, margins are extremely sensitive to small changes in the supply and demand balance.

Continuing demand growth will tighten the supply and demand balance over the next few years. As a result, unexpected outages, turnarounds, extreme weather, and other such disruptions will cause more and longer periods of tight supply and higher margins.

If crude prices weaken as anticipated later this year, refining margins should benefit. Longer term, however, margins are expected to remain in the $1.00/bbl range, close to the levels experienced in 1996 through 1998.

The price differentials between light refined products and residual fuel oil and between heavy and light crude oils are key elements of refining profitability. These differentials also fell to exceptionally low levels in 1999 (Fig. 2).

Economics for converting residual fuel oil to light products have echoed trends in sweet crude cracking margins, reaching a peak around 1990 and falling after a wave of new capacity investment in the early 1990s. The production cutbacks of 1999 significantly tightened the world balance of residual components by preferentially reducing the production of heavy crudes.

Higher heavy-crude production will result in some growth in light-heavy differentials through the early years of this decade. If conversion-capacity additions remain at the current high rates or if a wave of overbuilding accompanies future sulfur-reduction programs, however, light-heavy differentials could remain depressed.

Gasoline retail marketing margins are somewhat seasonal but have been much more stable than refining margins (Fig. 3). Retail price changes typically lag behind spot price changes, resulting in short-term margin volatility. Margins have been remarkably stable, however, when averaged over 1 year or longer periods.

In constant dollars, margins have been essentially flat since the mid-1980s, and they will likely remain at current levels in the future.

The growing presence of nontraditional retail sites, such as discount stores and hypermarkets, should not exert the same level of competitive pressure in the US as it has in Europe. Although nontraditional competitors will likely accelerate the closure of smaller, less competitive outlets in the US, high-volume, efficient competitors already determine the fundamental margin structure.

Long-term concerns

While the improving supply and demand balance will help margins in the near term, the industry's tendency towards overcapacity must change for the longer-term outlook to improve.

Downstream strategies have historically focused on cost reduction. In the pursuit of lower fixed costs per unit of throughput, capacity creep has kept pace with product demand growth, continuing the pattern of industry overcapacity.

While margins have been weak, operating income from all but the least profitable facilities has been positive, and site closures have been rare. Instead, companies have sold marginal facilities to competitors, leading to continued or increased margin pressures. Even the recent wave of mergers and downstream joint ventures has resulted in only minimal capacity closures.

These behavioral trends have resulted in a pattern of chronic industry overcapacity, but more serious threats are now visible on the horizon. California has proposed to end the use of MTBE in 2003, which will require product quality and capacity investment by West Coast refiners to replace the contribution of MTBE to gasoline supply.

The rest of the US will begin a transition to very low sulfur levels in gasoline in 2004 and may later move to a much lower sulfur level for on-road diesel.

As with earlier low sulfur diesel and reformulated gasoline programs, refiners will likely seek to integrate the investments to meet the new regulatory requirements with larger capacity and capability expansions. Thus, a wave of increased supply may wash over the industry in the early 2000s, bringing with it additional overcapacity.

In the mid-1990s, the increases in capacity were undertaken in an environment of rising demand. A primary incentive for the tighter fuel specifications of the future, however, is to enable new, high-efficiency engine technology to enter the fleet.

Efforts to improve vehicle efficiency or to reduce greenhouse gas emissions may slow demand growth just as the new investments enter operation.

Unless industry rationalization accelerates, a prolonged period of weak profitability is possible. These trends are evident in the European market, which has seen flat to declining gasoline demand in recent years. Europe's gasoline surplus will sustain imports to the East Coast, maintaining pressure on US Gulf Coast refining margins.

Downstream profitability

To evaluate downstream profitability, the authors selected nine companies that represent the broad mix of companies that compete in the US downstream market. These companies range from large, fully integrated multinationals to smaller, regional US refining and marketing companies. Together, the chosen companies account for more than one third of US refining capacity.

The analysis excluded significant petrochemical operations, which are generally classified as separate business segments by the companies in the group.

Operating profitability is commonly measured by return on capital employed (ROCE), defined as operating income divided by average net capital employed. Operating income is net income plus nonoperating gains and losses after tax and interest expense after tax. Net capital employed is balance sheet debt plus shareholders' equity.

US downstream returns were calculated for each of the nine companies using financial information published by the companies. ROCE for the group averaged 7.5% in 1998, 10.1% in 1997, and 4.2% in 1996. Over the 3-year period, ROCE for the group averaged 7.2%.

ROCE and other conventional profitability measures provide limited insight into comparative performance because they ignore important accounting differences that exist among companies. They also provide little guidance about a company's performance relative to its cost of capital, which is the blended return that equity and debt investors expect to earn on their combined investment in a company.

RACE (return on adjusted capital employed) is a more meaningful measure of profitability because it adjusts for accounting differences among companies and enables direct comparisons to the cost of capital.

Much of the information needed to adjust operating profit and net capital employed is available from published financial reports. It is then a matter of applying the adjustments to the appropriate business segments. The major adjustments include:

• Adding permanent accounting reserves (such as deferred income tax reserves and site-restoration reserves) to book equity and adding annual changes in these reserves to operating income.
• Adding LIFO (last in, first out) inventory layers to book equity, and annual changes to operating income.
• Restating acquisitions to a cash basis and making corollary changes to operating income.
• Adding the present value of future operating leases to debt.
• Adjusting equity to reflect the cumulative effect of nonoperating gains and losses.

These adjustments, along with other less important adjustments, increased net capital employed by an average of 25% over the 1996-1998 period. The adjustments reduced operating income for the group as a whole in 1998 and 1997 but increased operating income in 1996, resulting in more stable earnings over the 3-year period.

RACE for the group averaged 4.0% in 1998, 6.0% in 1997, and 6.3% in 1996. Over the 3-year period, RACE for the group averaged 5.3%, appreciably lower than ROCE.

Fig. 4 presents a comparison of adjusted returns (RACE) to unadjusted returns (ROCE) for each company. Adjusted returns were lower than unadjusted returns for six of the companies and higher for three.

Only one company, Company D, earned the cost of capital over the 3-year period, estimated at 9-10% for US downstream operations. The more profitable members of the group benefited from a combination of higher-than-average margins as a percent of sales (margin efficiency) and a higher-than-average ratio of sales to capital employed (capital efficiency).

Differences in margin efficiency are largely attributable to differences in the mix of assets and operations of each company. Capital efficiency is primarily determined by the cost of fixed assets. Companies that acquired assets at prices significantly above their depreciated historical cost tend to cluster at the bottom of the profitability rank order.

Downstream profit drivers

To understand the causes of differences in relative profitability among companies in the group, the authors analyzed each competitor and determined its exposure to key sources of value in downstream operations.

Five profit drivers were identified that proved effective in explaining differences in downstream profitability. Each of the five downstream profit drivers described below is measured in terms of barrels per day of throughput, capacity, or sales.

• Base refinery throughput. This driver is the reported throughput in US refining operations.
• Refining capacity in niche markets. This driver is refining capacity in markets with the "niche" characteristics of limited competition, barriers to product entry, and advantageous crude cost (in some locations). Niche refining markets include California, Alaska, the Rocky Mountains area, and portions of the Upper Midwest.
• Conversion capacity. Conversion capacity is total capacity of refinery-conversion units. This is expressed in terms of fluid catalytic cracking (FCC) equivalents using factors derived for each type of conversion unit (such as for FCC, hydrocracking, coking, and visbreaking).

The factors reflect the relative amount of residual fuel oil destroyed by each type of unit so that the capacities of different units can be summed and expressed in barrels per day of FCC equivalents.

• Gasoline retail marketing. The profit contribution of gasoline marketing varies widely, depending on the sales channel.

Margins on sales through controlled channels are typically higher and less volatile than sales through wholesale channels. Controlled channels include company-operated facilities and sites supplied through dealer contracts.

This driver counts only estimated sales through the dealer and fully controlled channels.

• Finished lubricant marketing. While lubricant base oil manufacture has seen very weak prices and margins due to a recent surge of capacity additions, finished lubricant prices tend to be much higher and more stable. Consequently, only sales of finished lubricants are estimated and used as the volume basis of this profit driver.

The authors developed a measure of throughput, called "value barrels," to quantify the impact of the companies' asset mix on operating margins. The term incorporates the value contribution of volumes moving through the five profit drivers.

Each company's value barrel volume was determined by weighting the profit driver volumes by factors that reflect the margin contribution per barrel of the profit driver relative to base refinery throughput. These value contribution factors were developed using historical industry margin indicators and were adjusted annually based on changes in those industry margin indicators.

After multiplying each profit driver volume by its value contribution factor, the resulting value barrels were summed for each company. Fig. 5 presents a comparison of total value barrels and base refinery throughput for each company in the group.

Value leverage

The traditional combination of refining and marketing operations has a strong strategic rationale. It allows companies to focus on total refinery-to-consumer performance, rather than optimizing around the volatile midpoint of the value chain.

The benefits of refining-marketing integration can be viewed as one way of leveraging the value of base refinery throughput. Value leveraging occurs through expanded retail marketing, addition of high-value products such as lubricants, investment in conversion capacity, and operation in more profitable markets.

A "critical mass" of base refining operations, however, is necessary to create opportunities for value leveraging. The amount and efficiency of value leveraging determine the success of a competitor's strategy.

The degree of value leveraging achieved by each company can be represented by the ratio of value barrels to base refinery throughput. This metric-the value leverage index (VLI)-measures the extent to which the company has enhanced base refining operations with higher margin activities.

While the VLI provides a useful benchmark for downstream operations, its true merit lies in its relationship to company profitability. Fig. 6 compares VLI to pretax RACE for each of the companies in the study group. Pretax RACE is used because operating management exercises little control over the income tax position of the company.

During 1996-1998, VLI and pretax RACE are strongly correlated. VLI explains more than 70% of the variation in pretax RACE among the companies in the group. Companies that have achieved the highest levels of VLI have achieved the highest pretax RACE. Conversely, those companies with lower VLI generally earned lower returns.

Value-driven strategies

US downstream strategies should anticipate the aggregate impact of individual company decisions on the markets in which they compete. Strategies should recognize the true sources of value leveraging in downstream operations and address issues associated with industry regulation, industry consolidation, and overall downstream investment.

• Product quality. The regulatory push for higher product quality in pursuit of environmental improvement is being driven by public demand and the response of automotive manufacturers to technology developments. Improving product quality will not only provide the products that the industry's customers are demanding but also help ensure the long-term market position of traditional fuels.
• Merger strategy. The merger and consolidation wave may have crested due to the lack of potential candidates for additional combinations, as well as growing political aversion to increases in industry concentration. In any case, consolidation has yet to result in improved business conditions in the downstream industry.

As refiners look forward, the benefit of capacity rationalization rather than sales of marginal facilities should be recognized, particularly among companies that will compete with the facilities they sell.

• Downstream investment. A cautious approach to capacity expansion is consistent with maximizing returns on investment rather than minimizing unit costs by increasing throughput. As strategies are formulated to achieve new product quality targets, capacity expansions linked to quality upgrading should be carefully evaluated.

Given concerns about long-term product demand, expansion should be limited to facilities with long-term competitive advantages. Value leverage investments are likely to create long-term benefits that throughput expansion alone will not provide.

The concept of value leveraging offers a new and useful perspective on downstream strategy. The four most profitable companies in this study have achieved high degrees of value leveraging through a variety of strategies, with differing emphases on retail, lubes, and conversion capacity. They have used both acquisition and investment strategies to develop their asset bases and have very different profiles of integration with upstream and chemicals operations.

Value leveraging does not offer a cookbook for financial success, but it does provide an alternative to the single-minded focus on operating costs and scale economies that dominated downstream strategies in the 1990s.

The Authors

Blake T. Eskew is a senior principal in the Houston office of Purvin & Gertz Inc. He previously held a variety of planning, economics, and technical positions with Conoco Inc. and Ethyl Corp.

Eskew holds a BS in chemical engineering from the University of Texas at Austin and an MBA in finance from Columbia University.

David T. Lupia provides corporate financial advisory services to energy companies, energy consulting firms, and financial institutions. Previously, he held a variety of international and domestic corporate finance positions at Exxon Corp. and was a senior investment banker in Lehman Brothers' Energy Group.

Lupia holds an AB degree from Rutgers College and an MBA in finance from the Wharton School.