U.S. Refiners Urged To Capture, Defend Prosperity

Jim Marcum
Peter Chadwick Inc.,
Dallas

Lamentations concerning the economic condition of the U.S. refining industry reflect the desperation of years of extreme competition, market volatility, and regulation. Since price deregulation in 1981, refiners have been involved in a fight to the death, each convinced that it will be the last warrior standing.

Yet, in spite of consistently low returns, the industry has invested more than $50 billion in refining assets over the period. Meanwhile, refining assets have depreciated to the point that, with few exceptions, those assets have sold for little more than the value of the working capital.

With the new maximum available control technology (MACT) regulations on pollution, Phase II reformulated gasoline (RFG), and new national ambient air quality standards (Naaqs), beleaguered refiners must feel as if the Fates are against them.

Consumers and regulators, on the other hand, believe that refiners are crying wolf. The political clamor and threats of antitrust action over the price of reformulated gasoline and higher heating oil prices in the Northeast this past winter are only a recent illustration of the public's antipathy toward the plight of the industry.

In such a negative climate, how can the industry stop its downward spiral? Refiners are faced with two challenges: first, convincing the public that higher refining margins are justified, and then finding a way to achieve them.

A comparison of the fundamentals of the manufacturing sector of the refining industry with other manufacturing industries provides some insight into both problems.

Manufacturing concepts

The public generally understands the basic concepts governing the manufacturing process. People grasp the idea that to make a flashlight, the manufacturer must purchase equipment and raw materials, pay labor cost, plus pay the light and phone bills.

The public also appreciates that the final price of the flashlight will reflect the cost of those elements plus a modest profit margin.

The average citizen, however, does not understand that the same economics must apply to the refining business. Refiners are seen as merely one part of an integrated business that does not require a return of capital at each step of the process as long as the overall return is adequate.

While this model of the petroleum business may have had some validity in the distant past, the structure of the industry has changed, and the number of producing companies that have exited the refining sector indicates that the model needs to be adjusted. Refiners now need to be judged as manufacturers.

Recent studies by the Department of Energy and American Petroleum Institute show that over the last 10 years the returns on equity for petroleum companies have been consistently lower than other nonenergy companies and that the major oil companies' refining and marketing profitabilities have been below their other business segments.

While these studies confirm poor performance in the manufacturing segment of the business, the diverse nature and capital structure of the various refiner/marketers make it difficult to isolate manufacturing performance for the purpose of comparing to other manufacturers by simply reviewing annual reports.

Operating parameters

The key operating parameters of value added, labor cost, and capital cost need to be examined in order to judge the performance of a manufacturing entity.

Aggregated industrywide data for these parameters in the refining industry as well as other manufacturing groups are provided by the U.S. Department of Commerce in its Census of Manufacturers. In noncensus years, annual estimates are provided in the Annual Survey of Manufacturers.

Although refiners normally express these parameters as a function of throughput, as shown in Fig. 1[83,700 bytes] , for clarity a comparison with other manufacturers must be made on a percent of sales basis.

Although numerous industries were examined in the study with similar results, the following industries were selected in order to cover a broad spectrum of manufacturing categories: Motor Vehicles and Car Bodies (SIC3711), Metal Cans (SIC3411), Computers (SIC3571), and Plastic Materials and Resins (SIC2821).

Value added

Value added is determined by subtracting the cost of materials, supplies, fuel, power, and contract work from the value of shipments with an adjustment for merchandizing operations.

For refiners, the merchandizing adjustment reflects the spot market price at the refinery gate. Fig. 2 [92,738 bytes] shows the aggregated value added expressed as a percent of sales for the years 1982-95 for the selected industries.

The refining industry average value added (Table 1 [42,670 bytes]) over the period was 12.8%, compared with Auto Bodies 27.0%, Metal Cans 31.1%, Computers 46.9%, and Plastics 38.0%. As can be seen, the refining industry has a much lower value added than the other industries and falls woefully short in this most fundamental manufacturing parameter.

The large difference in value added between refiners and other manufacturers indicates that there is a fundamental problem that must be addressed if refiners are to improve. Why is the value added low in the refining industry?

The surplus in refining capacity is frequently offered as the reason for poor performance in the industry. While overcapacity is frequently a problem for other manufacturing industries, the inefficiencies and surplus capacity created during the years of price regulation have been extremely difficult for the refining industry to eliminate.

Ironically, it appears that poorly performing refiners simply become more competitive by coming back to life at a lower capital cost. In addition, capacity creep in the domestic industry and competition from offshore refiners with fewer environmental regulations continue to limit value added improvement in the industry. The fact that refinery utilization rates increased from 65% in 1982 to 90+% in 1995 without creating a significantly improved economic environment indicates that overcapacity is not the complete problem.

Capital spending has not guaranteed an improvement in value added. With residual fuel oil demand declining and sour crude production increasing during the 1980s, many refiners improved value added by installing upgrading facilities that enabled them to process sour and heavy/sour crudes. Value is added when the price differential between sweet crude and sour crude exceeds the refiner's variable processing cost.

These projects have provided additional value added for refiners and are a major contributor to the slightly upward trend in the aggregated value added for the industry. The opportunity to capture value added by upgrading heavy/sour crudes has been extremely sensitive to the balance in crude supply.

The elimination of two of the larger producers of sour crudes (Iraq and Iran) as supply sources and changes in the marketing strategies of other heavy crude producers have reduced the amount of sour crudes available to refiners, which, in turn, lowered the relative price differential between light and heavy/sour crudes. As a result, even though the utilization rates for these projects have been high, the value added and return on capital have been less than expected.

The job shop

A major reason for the wide difference in value added between refiners and other manufacturers is a difference in operating philosophy.

Successful manufacturers produce a "product" for sale rather than operate a job shop. In a job shop, the owner contracts to produce someone else's product, essentially renting his equipment and employees on an hourly basis. As a hireling, the job-shop operator provides no discernable difference in quality, service, or security of supply than any other job shop, and therefore his service becomes commoditized.

While job-shopping can be profitable on the margin, the manufacturer must focus on its primary business of manufacturing a product for sale. As the percentage of job-shop work increases, a manufacturer finds his decisions being driven strictly by job-shop economics. A successful job-shop owner must be quick on his feet, clever, and possess many other admirable attributes, but, most of all, he must develop a strong niche to remain viable. As a result, the job-shop manufacturer always has a tenuous position in the marketplace.

Refiners, driven by the need to perform on a short-term basis, have developed a job-shop mentality. Without a difference in quality, service, and security of supply, the manufacturing process becomes a commodity with its product value based on the marginal cost of production. Determining the marginal cost can be an elusive target in the volatile multiproduct petroleum refining market.

In contrast to most job shops, refiners not only accept a low value added, they also absorb a significant price risk. One method of reducing this risk, processing agreements with producers, results in a job-shop operation and has the effect of commoditizing the manufacturing process.

Since a successful job-shop operation requires a strong niche, refiners have attempted to create niches based on competitive advantages in feedstock quality, processing arrangements with producers, process optimization, and lower operating costs. This has resulted in improvement for some refiners; however, much of the savings have simply resulted in a lower marginal cost and have been passed through to the consumer.

Labor costs

Fig. 3 [94,669 bytes] compares the aggregated labor costs for the various industries. These costs include labor at the manufacturing facility only and exclude fringe benefits and corporate overhead.

The refining industry has a slight advantage in the area of labor costs compared to the other industries, partially compensating for the low value added. The average labor costs over the period l982-95 as a percent of sales

(Table 1) are Refining 2.3%, Auto Bodies 7.6%, Metal Cans 11.3%, Computers 12.7%, and Plastics 8.2%.

Although refining labor costs as a percent of sales have increased over the period compared to declines for many other industries, refiners have done a good job of managing labor costs over the period. The industry reduced employment in the manufacturing sector from 101,000 employees in 1982 to 70,000 in 1995 through rationalization and restructuring.

Labor productivity improvement during this period can be expressed by the increase in the average barrel of crude processed per day per employee from 108 in 1982 to 198 in 1995 and an average value added per employee increase from $177,000 to $312,000.

As a result of these productivity increases, the aggregated refining industry total payroll (excluding benefits) increased by 25% over the 14-year period, while hourly wage rates increased by 57%.

Capital cost

Capital expenditures for the industry as shown in Fig. 4 [99,346 bytes] have not been excessive when compared to other industries on a percent of sales basis.

The average capital cost over the period 1982-95 as a percent of sales (Table 1) are as follows: Refining 2.9%, Auto Bodies 2.2%, Metal Cans 2.7%, Electronic Computers 2.9%, and Plastics 5.7%.

The capital costs of the industry do not place refining at a competitive disadvantage relative to other industries. The capital costs become excessive only when viewed from the standpoint of the value that has been added from the expenditures.

Frequently, a high sales to asset ratio can enable an industry to overcome a low value added and/or high labor costs. From the capital costs shown in Fig. 4 and the historical sales to inventory ratio for each industry, the following sales to asset ratios can be estimated: Refining 2.7, Auto Bodies 4.1, Metal Cans 2.6, Electronic Computers 2.2, and Plastics 1.5. Clearly, the sales to asset ratio will not overcome the low value added of the industry unless the asset value is reduced.

Net value

Finally, an overall comparison of the fundamentals of the industries can be made by determining the net value of the three parameters (value added less labor and capital costs).

Net value provides an indication of the cash available from manufacturing activities to cover corporate overhead, fringe benefits, interest payments, taxes, legal fees, environmental expenses, etc. Fig. 5 [97,664] reflects the net of these parameters over the 1982-95 period. The averages for the industries over the period 1982-95 shown in Table 1 [42,670] are: Refining 7.5%, Auto Bodies 17.2%, Metal Cans 17.0%, Computers 31.3%, and Plastics 24.1%.

The net value of 7.5% of sales available to the average refiner to cover costs is substantially lower than the other manufacturers. While to some extent this serves as a confirmation of the rationalization that occurred in the industry during the 1980s, the same grim statistics that shut down refineries in the '80s are still prevalent in the '90s.

Improvement needed

Comparing the manufacturing sector of the refining industry to other industries, it is clear that refining does not perform as well as other manufacturing groups. Although some refiners have performed better than others and may not view their position as critical, the performance of the manufacturing sector of the industry must improve if it is to attract the capital required to meet the challenges it faces in the next few years.

With demand for product increasing, additional heavy crude production changing the supply balance, and the prospect of more domestic refineries shutting down, the long term outlook for surviving refiners is improving.

Competition from foreign refiners, however, will likely limit margin improvement to less than required to attract new investment. While some improvement is achievable through cutting operating costs and optimizing operations, sustained improvement must come from the "decommoditization" of the manufacturing process. Step one must be for refiners to function as manufacturers instead of job shops.

Admittedly, decommoditization implies that the market is not as efficient as it is today, but that is the case for any discussion about increased margins for any industry. Improved performance by the refining segment cannot merely mean a reallocation of downstream revenues. Higher prices to the ultimate consumer are necessary.

Higher prices will, without a doubt, bring complaints from regulators, politicians, and the public demanding antitrust action and divorcement laws. Despite the outcries, refiners must recoup the financial cost of environmental mandates and earn a competitive return on capital.

To achieve this, the business process must be changed. Refiners must be prepared to capture and then defend their new prosperity.