Hostile operating climate augurs further closures for U.S. refiners

In 1992, Sun Oil Co. severely curtailed operations at its Tulsa refinery, shown here. Output from the refinery is now limited to lube oil production. Almost 30 U.S. refineries have shut down since 1990. Most of these refineries were small plants with limited operating flexibility.

Refiners who have idled plants cite low margins and strict environmental regulations as the main driving forces.

Despite the loss of 29 plants, a mechanism called capacity creep has enabled the U.S. refining industry to maintain distillation capacity at 15.4 million b/d. In the meantime, conversion capability, and thus fuels production, has increased.

A simple measure of processing capability is the total capacity for catalytic reforming, alkylation, fluid catalytic cracking, and hydrocracking, expressed as a percentage of crude capacity. In 1991, this figure was 67.9% for U.S. refiners (see chart, p. 22). By 1997, these processes accounted for 73.5% of crude capacity-a significant increase for a sophisticated processing center like the U.S.

This growth in light products supply, coupled with the high costs of operating in today's regulatory environment, have inadvertently held margins in check. Continuing pressure from government regulations during a prolonged period of paltry refining margins is likely to spur further refinery closures in the U.S. Factors affecting the viability of remaining refineries include location, size, complexity, and general efficiency.

Roger Hemminghaus, chairman and chief executive officer of Ultramar Diamond Shamrock Corp., San Antonio, said, "Obviously, it's the smaller, less efficient plant that cannot spread its cost over a lot of barrels."

The shutdowns

The shutdowns were simply a matter of economics, Hemminghaus explained:

"Back in mid-1980s, there was a general surplus of refining capacity in the U.S., and this depressed margins. With this history of poor margins and prospects of increasing operating and capital costs-and requirements as refiners were looking to comply with additional environmental and OSHA (U.S. Occupational Safety and Health Administration) regulations-smaller, less cost-effective refineries were faced with some tough decisions."

According to Hemminghaus, these refiners had three choices: They could make only investments necessary to meet new operating regulations and hope to continue marketing conventional fuels; they could prepare to produce low-sulfur diesel and reformulated gasoline (RFG); or they could shut down.

Clint Ensign, vice-president of government relations for Sinclair Oil Corp., Salt Lake City, testified before the U.S. Environmental Protection Agency during a hearing on EPA's proposed new National Ambient Air Quality Standards (Naaqs) for ozone and particulate matter. Ensign appeared on behalf of the Small Refiners Coalition, a group of about 15 refiners operating plants of 75,000 b/d or less in the Rocky Mountain and central plains states.

Upon the request of an EPA official, Ensign researched published reports of refinery closures to determine whether or not environmental regulations were the real cause.

"That is the prime factor that refiners cited as a reason for closure," said Ensign.

Plants involved

A historical analysis of Oil & Gas Journal's annual refinery survey shows that 29 U.S. refineries have shut down in the past 6 years (see table, p. 23). The 29 inactive refineries represent 16% of the number of refineries operating on Jan. 1, 1991, but only 4.4% of total U.S. distillation capacity at the time.

Of the 194 refineries operating in 1991, 115, or 59%, had a capacity of 75,000 b/d or less. These refineries owned 25% of U.S. distillation capacity (OGJ, Dec. 23, 1991, p. 33). In 1997, 95 of the 163 operating refineries have capacities less than 75,000 b/d. Although these small refineries account for 58% of the number of plants, they now hold only 19% of U.S. distillation capacity.

A number of the idled plants were small topping refineries. Ten had capacities of 10,000 b/d or less.

Data collected by the Energy Information Administration (EIA), Washington, D.C., reveal a similar trend. Between Jan. 1, 1990 and Jan. 1, 1996, EIA's count of the number of operable refineries declined to 171 from 205. That's a net decline of 34 refineries and 350,000 b/d.

According to Tancred Lidderdale, a refining industry analyst with EIA, the idled refineries produced a proportionately small volume of gasoline.

"Of these 34 refineries, 17 produced motor gasoline, 14 did not produce motor gasoline, and 3 never operated," said Lidderdale. "And even though 17 of these were gasoline-producing refineries, they were not significant light products producers."

"The 34 refineries that shut down-16% of the refineries running in 1990-accounted for only 1.5% of U.S. gasoline production and less than 1% of finished motor gasoline inventories," said Lidderdale. "They held less than 4% of gasoline stocks at refineries on Jan. 31, 1990."

According to the May 1996 issue of EIA's Petroleum Supply Monthly, this round of refinery rationalization has not affected inventories in the same way as did rationalization in the early 1980s (see chart, p. 24). Motor gasoline production averaged 7 million b/d in 1990, compared with 7.4 million b/d in 1995. During the past 6 years, however, while gasoline output has increased 6.8%, refinery inventories have de-creased 6%.

Average finished gasoline stocks at refineries have decreased from 6.1 days' supply in 1990 to 5.4 days in 1995-a decrease of 12.6%. Similarly, refineries' total gasoline stocks (including blending component) have decreased 12.2% in the past 6 years, from 11.2 days' supply in 1990 to 9.9 days in 1995.

The 34 idled refineries also operated at utilization rates well below those of complex gasoline refineries.

"Complex refineries operate at utilization rates of 90% or higher," said Lidderdale. "The non-gasoline-producing refineries operated at utilization rates of only 50-60%."

Another factor to consider when evaluating the idled capacity is that most of the shutdown refineries produced heavier products, such as asphalt and lube oils, says Lidderdale. And demand for these products has declined in the last 10 years.

While refiners tend to blame environmental regulations and market conditions, said Lidderdale, it is important to consider the characteristics of the refineries that have shut down. These plants depended strongly on heavy fuels markets, and those markets have performed poorly during the last 10 years.

EIA's figures show that, between 1987 and 1996, motor gasoline demand increased 9.2%, distillate fuel oil demand increased 12.8%, and LPG demand jumped 25.3%, largely as a result of a cold winter in 1996. In contrast, residual fuel oil demand declined 34% and lube oil demand decreased by about 4%, while demand for asphalt and road oil increased 3%.

Lidderdale said, "Looking at conventional refining economics in terms of cracking margins, which depend on motor gasoline and distillate prices relative to crude oil, is misleading, because I think these refineries were more driven by the heavy fuel margins rather than the light product margins."

Regulation

Refiners cite the high cost of complying with environmental regulations as the major hurdle to continuing operations. The regulations that have had the greatest effect on the viability of U.S. refiners can be divided into two categories: fuel quality standards and operating requirements.

Urvan Sternfels, president of the National Petroleum Refiners Association (NPRA), Washington, D.C., believes the regulations affecting the manufacture of fuels are the most critical, although he says the stationary source rules have not been insubstantial.

"RFG and, to a lesser extent, anti- dumping rules have been a very big cost item for the industry," said Sternfels.

Hemminghaus agrees but also stresses the importance of operating requirements, such as closure of waste ponds, minimization of fugitive emissions, and compliance with the OSHA process safety management rules.

"This regulation has obvious benefits, but there were additional costs to the industry, and we have not been able to recover that," said Hemminghaus.

Lidderdale draws different conclusions about the causes of this decade's refinery closures:

"When you attribute the shutdowns of the 1990s to margins or, in particular, environmental regulations, the question is: 'What environmental regulations were implemented in the 1990s?'

"They were the product quality regulations on the light products, as opposed to the regulations on refinery operations, like fugitive emissions. As a result, these refineries were probably less directly affected by environmental regulations than the large, complex refineries.

"There's no question that, at the margin, environmental regulations which require capital investments will have a significant impact on the business decisions of some refineries," he continued. "But it's not evident that there were decisions to shut down because of those investment costs, or that the shutdowns of refineries have not contributed to the marginal economics of the refining industry."

Margins

Despite the closure of the 29 refineries in the 1990s, there has been no improvement in refining margins. Refiners say huge expenditures needed to meet the requirements of legislation such as the Clean Air Act Amendments are one reason for continuing low profitability in the refining industry.

According to Hemminghaus, "In the past 5 years, margins haven't improved, even for those who have invested to make reformulated fuels. The intent of these refiners was to add economic value to the investments added for regulatory purposes. But these investments involved the addition of conversion equipment, which had the added effect of increasing product capacity."

Coincident capacity creep has contributed to low margins, says James Dudley, a senior manager at Ernst & Young Wright Killen, Houston, and a director of the firm's transaction advisory business.

As of Jan. 1, 1991, 194 U.S. refineries had 15.479 million b/d of atmospheric distillation capacity. By Jan. 1, 1997, the number of refineries had fallen to 163, but total capacity was 15.432 million b/d, only 47,000 b/d less than the 1991 level.

Dudley said, "It is frequently discussed and, I think, well documented that, in addition to complying with the regulations, almost every plant also increased capacity. While some plants were being shut down, others were being expanded. This means that margins have not shown any improvement as a result of the shutdowns."

Profitability is particularly bad for those refiners who are not in good technological shape, said Sternfels.

The refining industry remains under heavy economic pressure, says Hemminghaus. "The American public continues to get a very good deal on quality refined products at prices barely above cash operating costs," he added.

Sternfels says most industry experts agree that "capital requirements will equal or exceed anticipated earnings of most refiners for the foreseeable future. That presents a problem for companies that have to answer to shareholders, and particularly for those smaller refining facilities that don't get the economy of scale from all these improvements that larger facilities do.

"It's very tough to convince shareholders to spend money when they're seeing returns that could be equaled or exceeded by putting the money in the bank."

Consolidation

Dudley is not surprised by the refinery closures and the general consolidation taking place in the U.S. refining industry.

"The industry is one that has evolved over a long period of time-since the early 1900s," he said. "And it has evolved in a way that doesn't efficiently serve the marketplace in all regards today.

"The closure of the less-efficient refineries is not something that happened exceedingly fast," said Dudley. "The industry has really been in a period of rationalization or consolidation ever since decontrol in about 1981. Certainly, there were people...who thought that the post-decontrol consolidation would go much more quickly than it has."

As part of this consolidation, some refiners have chosen to sell their plants rather than shut them down.

"When you sell a plant, rather than shut it down," said Dudley, "you haven't achieved any rationalization to improve the rest of your business. In fact, you may have increased the competition for the rest of your business and...done yourself a strategic disservice."

As a manifestation of the uncertainty that is ubiquitous in the refining industry, many of these transactions have included pay-outs in addition to the purchase price.

"That provides an insurance policy to the seller-a mechanism for them to benefit in the future profitability of the plant if they were wrong," said Dudley. "If the plant suddenly makes money, or the industry suddenly turns around and the margins in that refinery respond, then they are in line to share them."

In 1995, Clark Oil & Refining Corp. purchased Chevron U.S.A. Products Co.'s Port Arthur, Tex., refinery for $200 million. The acquisition included a provision that Clark would pay Chevron an additional $125 million, if refining margins exceeded an agreed- upon level.

Another example of this sort of deal is Tosco Corp.'s purchase of the BP refinery at Ferndale, Wash. (OGJ, Oct. 4, 1993, p. 46).

In addition to a purchase price of $125 million for assets and about $50 million for inventories, BP can participate in future refining and marketing profits, up to a level of $150 million, if conditions improve during the 5-year period following the 1993 purchase.

Cost reductions

One way that Dudley tries to bring objectivity to his evaluation of refining industry transactions is to draw comparisons with other industries.

"One difficulty in the refining business that doesn't have very many, if any, analogs in other manufacturing industries is that the gross margin is very thin," said Dudley. "The raw material cost is not 50% of product revenue, it's 80% of product revenue-sometimes more.

"You're dealing with a very thin slice that's operating cost-related. There has been a huge focus on that. There has been a lot of money spent on lowering operating costs through process engineering improvements and so forth."

Dudley says many companies have offered their refining executives management incentives. In such cases, the executives' compensation is partially dependent on such operating improvements and cost reductions.

Dudley has performed some preliminary calculations that show that operating costs in the refining industry have declined remarkably in the last several years, sometimes as much as 10-15%/year.

"If you saw that happen in most industries," said Dudley, "you would see some profit improvement. But in this industry, it's all been passed on to the customers of the refinery."

The situation is odd, he says. Management has focused strongly on costs, and the efforts have been successful, but there has been no corresponding improvement in profitability.

"A fair amount of it has to do with the fact that, every time somebody does something to reduce costs, in one way or another, they end up making more product. I refer to this as the 'marginal economics death spiral,' " he said.

Traditional linear-programming analyses indicate that these cost-saving measures are a good idea, says Dudley. But they don't take into account the broader supply chain effects of continuing to make more product and depress prices.

Regulatory outlook

Although U.S. refiners have cleared the first hurdle of producing reformulated gasoline and low-sulfur diesel as required by the Clean Air Act Amendments of 1990, there are other obstacles to come. One of these is the uncertainty surrounding the proportion of U.S. gasoline that will have to be reformulated in the coming years.

Once again, the EPA is considering allowing areas with adequate air quality to join the RFG program, if they so desire. If these "opt-ins" are admitted, they could greatly increase demand for RFG. This increased demand would mean additional investments for refiners.

"These kinds of issues portend huge expenditures by the refining industry," said Sternfels, "not only because of the changes in equipment just to make the fuel, but also because they will increase the proportion of fuel that will have to be reformulated. It gets much more expensive, incrementally, to produce most, if not all, that refineries make as reformulated gasoline than it does to do so for just a limited amount of the market."

Another major concern for refiners is EPA's proposed revisions of Naaqs for ozone and particulate matter. Ensign says, if passed, the changes required by the tightened standards will bring fuel specifications closer to California standards.

Ensign says that only one of California's small refineries (75,000 b/d or less) is making gasoline to California Air Resources Board specifications. That refinery is Ultramar Diamond Shamrock's 68,000 b/d plant at Wilmington.

"All of the other small refineries have either closed, or they are making specialty products like asphalt," he said.

This is a concern for the Small Refiners Coalition because it represents the Rocky Mountain region, and all of the refineries in this region are small.

According to Ensign, "If the direction of regulations on fuel is toward California standards-and we've seen what has happened to small refineries there-there are some serious implications to the refining industry in the Rocky Mountain region and also in other rural regions of America, where small refineries serve a rural population.

"All of the product that is refined in the Rockies stays in the Rockies. There are some serious concerns about supply and what another layer of regulation that goes beyond the Clean Air Act means to the refining industry in the west. What is alarming is that groups like DOE seem to be indifferent to the closures that have happened and to these types of concerns."

Sulfur concerns

Another environmental issue of concern to refiners is the threat of further, more severe reductions in gasoline sulfur.

Says Sternfels, "There is this undercurrent of discussion going on, mostly initiated by the auto industry...with respect to sulfur in gasoline. If it were to be done, this would be an immensely costly and damaging initiative to a lot of the smaller independent refiners."

Sternfels says there are three main issues yet to be solved:

• How much more RFG are refiners going to have to make than was contemplated?

• Are they going to have to make boutique fuels for various regions, which have tougher but different standards?

• Will they have to reduce sulfur in gasoline?

"We don't know what else we're going to get hit with," said Sternfels. "As with most of these regulations, they do not hit evenly in the industry. There is no way you can plan for these kinds of things. It has to do with the facilities, it has to do with the crude sources, which vary, and it has to do with the wherewithal of the companies."

Further shutdowns

According to the Journal's most recent construction survey, U.S. refiners plan to add only 10,000 b/d of distillation capacity this year (OGJ, Sept. 30, 1996, p. 55). Planned capacity increases for 1998 total 25,000 b/d.

"Supply and demand are coming better into balance," said Hemminghaus, who believes that bodes well for margins "at some point in the future."

But what will happen until that balancing takes place?

According to Dudley, "The analyses that we've done suggest that there will be some more closures in the next 2-5 years.

"Preliminary estimates indicate that there might be as many as another 30 refineries close over a long time horizon."

The refineries most at risk are smaller complexes, which have spent little and, therefore, have the least modernization and flexibility.

Says Dudley, "The ones most likely to close probably would be part of a company that had several refineries, and, therefore, they were making the decision to idle a portion of their capacity."

Two recent examples of this are refineries in the Sun Co. and BP America Inc. systems.

The Sun refinery at Tulsa has substantially scaled back operations and no longer produces fuels. But Sun has since acquired the former Chevron refinery at Philadelphia (OGJ, May 23, 1994, p. 40).

In addition, BP tried to sell its Lima, Ohio, refinery (OGJ, Jan. 15, 1996, p. 32). BP gave up after a fruitless search. BP is idling this refinery, reported Lima News on Nov. 9, 1996.

Dudley says the fear of environmental liabilities prevented some operators from closing their plants. The lack of news reports about major liability issues at idled refineries indicates that these fears were perhaps unfounded, he says.

The refiners that averted closure because of potential liabilities chose to stay in business while they waited for other shutdowns to result in improved margins.

"But they didn't get that response," said Dudley, "and now they're forced to make the decision all over again: 'Can we endure this level of profitability, or do we go spend the money?'

"The forces that have precipitated shutdowns in the last 6 years continue to be there," he added. "I believe that any kind of planning for the refining industry over the next decade needs to be on margin projections that oscillate around what they have averaged over the last 3-4 years-around 80¢/bbl for the average Gulf Coast refinery." (For the last 2-3 years, it has been more like 50¢, he said.)

Sternfels said NPRA is, "girding for the fact that the trend of consolidations, closures, and acquisitions, will continue. Clearly the performance of the industry has not been laudatory, and, in some cases, has been very dismal.

"There will be survivors," continued Sternfels, "but, if all these things are done, there's going to be a very significant decline in U.S. refining capacity overall, and more dramatically in some areas. This will have very detrimental effects not only on jobs and local economies, but also with respect to the issue of dependency on other sources.

"Clearly refinery construction isn't going to happen in a significant way in the United States, given the existence of the environmental resistance that we have experienced in the past, coupled with an administration that is clearly not friendly to the use of oil to begin with," concludes Sternfels.

Despite fears of further closures, Hemminghaus remains positive: "Despite any prior or future closures, I really believe that this industry will continue to respond to make adequate quantities of quality refined products for U.S. consumers."

Copyright 1997 Oil & Gas Journal. All Rights Reserved.