WHAT THE PHILLIPS-TOSCO DEAL SAYS ABOUT US REFINING

Analysis of Phillips Petroleum Co.'s agreement to acquire of Tosco Corp. has tended to take the perspective of investors. While there's nothing wrong with that, the deal is just as interesting from the point of view of other US refiners.

Analysis of Phillips Petroleum Co.'s agreement to acquire of Tosco Corp. has tended to take the perspective of investors. While there's nothing wrong with that, the deal is just as interesting from the point of view of other US refiners.

Phillips evidently is, as they say, upbeat about the refining business. To be more precise, it is $7.5 billion worth of upbeat.

That's the estimated value of its proposal to take over Tosco for stock and assumption of debt.

For the past decade, integrated companies have been shedding refineries. Some have exited the refining business altogether.

The reason is easy to see. It has been chronically difficult to make money by rearranging complex hydrocarbon molecules. Not even gasoline, volumetrically the most important refinery product in the vehicle-intense US, has been consistently profitable.

Most Americans don't know that. Most Americans think that some accident of commerce turned the gasoline station of yesteryear into the convenience store-with-gasoline-forecourt of today. In modern gasoline retailing, fuel plays loss leader for snacks and fountain drinks.

This is so because gasoline is a fiercely competitive business at the retail end with soaring costs entry at the manufacturing end. The entry-cost escalation comes from environmental regulations, which require heavy investment and raise operating costs.

To make matters worse, leaving the business can be more costly than continuing to operate a little or no profit. Clean-up costs and eternal environmental liabilities tend to extend the lives of economically marginal refineries.

Tosco made a tidy business out of all this. It bought eight of its nine refineries after 1992 from companies wanting out of the refining business or certain marketing areas.

Now Phillips plans to buy Tosco.

For the acquiring firm, it's a cheaper way to quintuple US refining capacity than building new plants, which it wouldn't be able to do anyway.

In gross terms, Phillips gets Tosco's 1.3 million b/d of crude capacity at $5,800/b/d. That's less than half what it costs to build refineries nowadays. And the calculation assigns no value to Tosco's 6,000 service stations and associated brands.

So it looks like Phillips stands to inherit the bargains Tosco scored when it liquidated other companies' regrets in the 1990s. More to the point, it looks like Phillips thinks refining is a good investment, after all.

Amid the inevitable second-guessing, some analysts say Phillips acted at the top of a refining cycle, reacting to period of profitability that will prove to have been fleeting.

Others hold to the view expressed by Tosco Chairman and Chief Executive Officer Tom O'Malley, who said at the announcement of the Phillips deal that refining profitability is in for a 4-5-year run.

There are reasons to agree with him.

The US products market, at about 21 million b/d, is growing at no more than 2%/year and probably won't achieve that rate this year.

But refining capacity is growing even slower. With grassroots construction still probably impossible, capacity growth can come only at existing refinery sites.

The rate of this type of growth, called creep, seldom exceeds 1%/year and is offset by the plant closures that occur when companies decide that investments required to shut down make better sense than investments required to meet environmental regulations. The most recent such casualty is Premcor's 76,000 b/d refinery at Blue Island, Ill. There will probably be others.

Because of these limits on refining, the US is increasingly dependent on petroleum products from abroad. It now imports nearly 3 million b/d of product in addition to the 8 million b/d of crude it acquires through international trade. And the products available in trade aren't always the ones the market needs.

The refining system in the US is seriously constrained. That is why refining margins in the past year, although fluctuating, have been unusually high.

The conditions will last as long as constraints remain in place. And as long as they do, the market will reward environmentally qualified refining capacity.

For US refiners, that's the message of most significance from Phillips's plan to acquire Tosco.

More in Editor's Perspective