Closings, cuts may lay groundwork for another $4 summer.
Forecasting summer gas prices, says one Northeast retailer, is like playing red or black on a Vegas roulette wheel. The truth may prove more nuanced, with the safer bet and more likely scenario being the neutrality of black over the volatility of red, say many industry observers. That’s because the country is experiencing a combination of hefty supply and weak demand. But the wild card for 2010 is the nation’s refinery troubles.
So says—among others— Scott Hartman, president and CEO of York, Pa.-based Rutter’s Farm Stores. Initially betting on a weak economy to temper the normal rise in summer drive-time prices, Hartman says two refineries in the Mid-Atlantic market have shuttered since late 2009, threatening to “push prices higher regardless of the bigger economic conditions.”
With refineries acting as a base for supply disruptors such as hurricanes or political upheaval to provoke pricing extremes, could retailers be facing another $4 threshold? Could volatility govern operators’ daily lives for years— if not decades—to come? Could the country be forever dependent on foreign nations not only for the bulk of its crude supply but also for much of its refining? In a special CSP investigative report based on almost two dozen interviews, the following concerns have arisen:
- Weak Demand: Consumption rates dropped 3% in 2008 after several years of increases and are moving back to positive numbers by only fractions of a percent.
- Excess Product: Sluggish demand and intermittent zero-to-negative crack spreads reported in recent months illustrate oversupply and the difficulty refineries face in moving product.
- Infrastructure Under Pressure: Five refineries have shut down in the past year alone, with one more projected to shutter in the first half of this year.
- Major-to-Jobber Transition:Major oil’s divest-and-retrench decisions have restructured pricing models and, in many markets, neutered competitiveness.
- Good News, Bad News: Surviving refiners may ultimately rediscover profits as the economy turns around, but what that resurrection will mean in terms of retail margins, cost and supply has yet to be seen.
The aforementioned refinery closings came in the wake of the virtual collapse of refinery margins. “You’re going to see some folks make … decisions to rationalize and close down,” says Tom Kloza, publisher and chief oil analyst for Wall, N.J.-based OPIS. For some, the situation is so dire that many are saying, “ ‘Geez, I can’t even make it to spring,’ when there’ll be a little bit more margin,” he says. What does it mean for retailers? If history is any lesson, they can expect sudden volatility, supply interruptions and longer pickup lines at the terminals. When the McKee refinery in Sunray, Texas, shut down three years ago due to fire, the Denver market was thrown into chaos, reportedly forcing prices 15 cents above national averages. And two years ago, the ripple effect of Hurricanes Gustav and Ike, coupled with hoarding on the part of consumers, led to lines at pumps in Southeast markets reminiscent of the 1970s.
Those in the business of watching fuel trends warn that markets further from the Gulf Coast, such as the rural Midwest and Chicago, are likely to experience the “bullwhip” effect. “The only thing that’s kept [the Midwest] from tight supply is the recession,” says Lewis Adam, president of ADMO Energy, a fuel-buying consultancy based in Kansas City, Mo. “If demand recovers, the economy becomes stable and we lose a refinery, then the longer the supply chain, the more volatility. The tip [of the whip] is moving all that.”
Long-term, the shutdowns will compound the effects of an already outdated infrastructure. According to Andy Milton, vice president of supply for Mans- field Oil Co., Gainesville, Ga., while the refineries may be grabbing headlines today, the industry has undergone enormous change in just the past five years, including the 2006 conversion to ultralow sulfur diesel, the removal of MTBE from reformulated fuel and the onset of ethanol. All of which could add up to crippling supply-chain challenges into the new decade.
“Think about our infrastructure: The last refinery was built in 1976, so the infrastructure is old,” Milton says. “Now add the whole new component of ethanol. … How do you [overcome these challenges]?”
LESS THAN REFINED
The bumpy road refiners have faced is painfully evident. Tom Robinson, president of Robinson Oil Corp. and operator of 34 Rotten Robbie c-stores, based in San Jose, Calif., says he was buying gas this past winter at a price that nearly matched New York Mercantile Exchange contracts for unleaded gasoline. “Our differential to the Merc is hardly anything,” he says, citing how the typical difference between the price of unleaded on the Merc and his spot price is 15-20 cents—today, it’s 2.5 cents. “California refiners are not getting a premium for the product as they often would.” In mid-winter, crack spreads—the difference between the price of a barrel of crude oil and the wholesale price of gasoline—in Chicago dropped to zero. “It’ll be brutal for refiners through [early spring],” says ADMO’s Adam, predicting the Midwest will lose another refinery this year.
“In the early 2000s, we saw an increase in demand with demand outpacing supply,” says Milton of Mansfield Oil. “But in 2008, the economy [slumped]. Demand was absolutely seizing up. [Unfortunately], all these guys who made money in 2000 to 2004 went and said, ‘We can make more on production,’ [but that happened] at the exact same time the economy dropped.”
Refiners, including the nation’s largest independent refiner-marketer, San Antonio-based Valero Energy Corp., have reported huge losses. Excluding special items, Valero’s fourthquarter 2009 loss from continuing operations was $155 million.
“Weak demand, narrow margins and low discounts in the fourth quarter exemplified how difficult refining conditions were in 2009,” Valero chairman and CEO Bill Klesse said in the company’s announcement. “While 2009 may have been the bottom for refining profitability, there’s too much inventory and spare refining capacity in the industry right now for margins to rebound quickly.”
Klesse expects refining profits will continue to struggle. “2010 is expected to be another challenging year for the industry while refiners close marginal capacity and wait for demand growth to work down spare capacity,” he said.
To shore up its balance sheet, Valero has reduced capital spending and shut down unprofitable capacity to reduce cost, with refinery operating expenses in 2009 excluding depreciation and amortization to be $900 million less than the year before.
UP AND DOWN
Still, while the situation might not be favorable today, Jeff Morris, president and CEO of Dallas-based Alon USA Energy Inc., thinks matters could have been worse. He points out that refinery utilization hit 69% in the 1980s. At press time, it hovered around 80%. “So we’ve been through this before, and we’ll get through this again,” he says.
But recovery will require calculated maneuvering. Among those measures, Morris cited closing some refineries, which also occurred in the ’80s, as well as retooling others. This “ratcheting down” should worry retailers, says Aaron Walsh, director of sales and marketing for St. Louis, Mo.-based FireStream WorldWide Inc., a solutions provider for wholesale and retail petroleum marketers. When the economy rebounds, he fears, “I don’t know that reserves and refining capacity will be able to meet that demand over the coming second and third quarter of spring and summertime.”
Walsh isn’t alone. Internationally respected energy economist Philip K. Verleger Jr. says gasoline could be a real concern, with the beneficiaries being the surviving refineries. “If there’s a big refinery problem someplace, we could easily see very high refining margins and very high gasoline prices,” says Verleger, president of Carbondale, Colo.- based PKVerleger LLC, an economic energy and commodity consultancy.
Some might say the present turnabout is fair play, considering the early to mid-2000s, when refineries were making record-breaking profits. But others take a big-picture approach. Morris says refineries and the related transportation business they generate play a big role in the economy, with the sector both contributing to and reflecting the economic health of the nation as a whole. At least one c-store operator concurs. “From a retailer standpoint,” says Robinson of Robinson Oil, “we don’t care if prices are lower or higher. Well, we do care—all things being equal, lower prices are better for our consumer and we pay lower credit-card fees. But that said, there’s little difference between selling at $2 or $2.50 or $3. Demand is relatively inelastic.
“I’d like to see a healthy refining industry.”
PREDICTING STREET PRICE
Retailers concerned over refinery troubles may find relative comfort in the near-term moderation predicted by the U.S. Energy Information Administration (EIA), Washington, D.C. The agency forecasts the annual average regular- grade retail gasoline price to rise from $2.35 per gallon in 2009 to $2.84 in 2010 (possibly exceeding $3 per gallon in the approaching spring and summer) and $2.97 in 2011, because of the rising crude-oil forecast.
The EIA predicts an average of $81 per barrel spot price for West Texas Intermediate, which is a type of crude oil used as a benchmark for oil pricing. The predictions increase steadily into the middle of the decade, when prices will surpass the $100 threshold.
What government forecasts don’t discuss, however, is the volatility that has emerged over the past decade, and how futures “speculation” has become an industry gremlin. Morris says the correlation of crude price to the value of the dollar is well documented, with crude prices falling as the dollar rises. “Crude has become a financial instrument,” he says.
“It’s like gold,” says Robinson of Robinson Oil. “A jeweler needs gold to make jewelry. A dentist uses gold for teeth. That’s economic demand. But crude is also driven by financial fundamentals; it’s a hedge against something else.”
While crude-oil speculation has not and probably will not reach the $140 frenzy of a couple of years ago, Robinson is surprised that crude has stayed in the range of $70 to $80, considering how weak demand has been. “[For OPEC], it’s almost like being a landlord and having a rental property where the [tenant] is doing OK,” he says. “The hope is that the tenant doesn’t go looking for a cheaper place or doesn’t want to move.”
Morris agrees, to an extent. He says the fundamentals support a range of $60 to $65 per barrel, with oil companies able to produce 90% of crude for $50. “Somewhere in the $60 range is fair,” he says. “Drillers will drill for anything over $60. That’s why at the end of 2008, $30 crude was unsustainable; $60 to $70 is what’s needed. So yes, crude [at $78 per barrel at press time] is slightly expensive.”
With the price of crude—and gasoline prices these days riding on those coattails—being subject to factors outside of supply and demand, volatility appears to be a firmly entrenched norm. Kyle McKeen, president and CEO of Alon Brands Inc., the Dallas licensee of 300 7-Eleven sites and owner of the FINA fuel brand, admits that fuel logistics, formulation and volatility make for a complicated package.
“It’s a dramatic industry,” he says, “where in any two days, the change in your cost of goods can be more than your entire margin. We’re working on just being better retailers … and to keep our hands out of the volatility as much as we can.”
And now, the paradox. For all the talk about the national recession, there has been a positive byproduct: Simply put, the antidote to high gasoline prices is the weak economy. As the economy dipped in 2008, then plunged, gasoline demand dropped after years of single-digit percentage growth. The EIA reported flat demand last year and predicts less than a single percentage point of growth for 2010 and 2011 (see chart, p. 38).
Unemployment is a fundamental reason. “People aren’t going to work, and therefore they’re using less gasoline,” says Ed Weglarz, executive vice president of the Farmington Hills, Mich.-based Associated Food & Petroleum Dealers. “And they don’t have the money [to spend in our stores] if they’re unemployed.”
At press time, the unemployment rate was 9.7%, after fluctuating into record-breaking double digits.
Walsh of FireStream says the tides may be turning. “People have stopped with their ‘sky is falling’ mentality, and really have started to get back out there,” he says. “And while certainly everyone is a bit more conservative or a bit more frugal with discretionary spending, they’re still going to get out there and travel—and it’s going to require energy to fuel that movement.“
ETHANOL AND GLOBAL TERMS
If demand returns, the concern then falls back to the nation’s infrastructure and its ability to respond. According to Milton of Mansfield Oil, compounding the issue is ethanol, which he says is on a growth trend that will only apply greater pressure to a weak transportation and storage network.
“Say you have a [storage facility] with 10 tanks,” he says. “Today, one has to be ethanol, so now you only have nine tanks for either gasoline or diesel.” A major driver behind the ethanol push is the federal Renewable Fuels Standard, requiring biofuels’ production to grow from last year’s 11.1 bil- lion gallons to 36 billion gallons in 2022. Biofuels must make up 8.25%, or 13 billion gallons, of U.S. gasoline sales this year.
Although the rule was passed in February, it was made retroactive to the beginning of the year. “So that’s a big challenge in and of itself,” says Rayola Dougher, senior economic adviser for the Washington, D.C.-based American Petroleum Institute (API), “to have these retroactive requirements, in terms of the investments you’re going to make, and in terms of not having that regulatory certainty that you needed over a year ago to be going forward with your investment.”
Essentially, the rules are going to force refiners to blend in more ethanol, says consultant Verleger. “That’s why we’re exposed,” he says. “Ideally … if one refinery had a problem, somebody else could step in. In fact, the system doesn’t work that way. People are cutting back, and they wouldn’t be able to crank up quickly. So what the ethanol is doing is putting more pressure on refiners, and leaving the whole system more vulnerable.”
Morris of Alon disagrees. Not only does he feel ethanol demand has already peaked, but he also says refinery infrastructure and supply are not the critical issues, at least to retailers. “The pipeline and infrastructure built is larger than the market we have now,” he says. “We have more than enough infrastructure.
“Crude is not a problem,” Morris contends. “The biggest problem I see for retailers is liquidity and the availability of capital.” With refineries not making money, many are limiting retailers’ credit options, he says: “If you don’t have a clean balance sheet, you may have to pay in advance.”
So begins a micro-macro argument. While retailers may prioritize the micro because they have businesses to run, other observers say the larger issue of oversupply will continue to be macro. API’s Dougher says, “Our refineries are in competition in the world’s market, [and] there’s a lot of new planned capacity that’s going to be coming online this year throughout the rest of the world.”
Foreign countries, says Walsh of FireStream, have been watching the decrease in American demand and, as a result, have become more competitive: “[Exporting countries say], ‘We’re going to lower our price, because we want to [stay competitive],’ and when the price of crude comes down, it makes it more difficult for U.S.-native oil to be attractive to [companies here] to refine.”
FEWER BIG BRAND CHOICES
With infrastructure as a whole posing the question of viability, retailers are seeing fuel suppliers make drastic choices. Retail divestment is occurring nationally, along with supply pullouts in key regions. Virtually all the majors are two to five years into divestment. And Chevron and CITGO have announced pullouts from certain markets.
The result for fuel buyers is less choice. “One thing we know is there are fewer suppliers to play off one another,” says Adam of ADMO Energy.
Jobbers, dealers, retailers and independents in affected regions are forced to either find a new brand or go unbranded, says Milton of Mansfield Oil. Though his company supplies branded product in a contract network of about 350 locations across the country, he says unbranded marketing is gaining momentum.
“There are the guys who need image money or brand strength,” he says. “But it’s got to be a clean site, well-lit. That’s going to be more important in bringing traffic to a store than the flag.”
Of course, opinions differ. “There’s definitely a value to the brand,” says Michael Haynes, vice president of operations for PCF Saleco, a ConocoPhillips retailer based in Littleton, Colo., with about 100 locations. “Obviously, there are customers who aren’t as concerned, but when you have a fine oil company that stands behind its products—[one that has] the additives that clean engines—I can’t imagine going to someone that doesn’t have the same offering that major brands [have].”
Major-oil divestment is also playing a role as prices go from wholesale to retail. Major-oil, direct-dealer pricing is giving way to jobber control. For the dealer class, the new business environment can mean feast or famine.
“[Dealer opportunity] hinges on the rapport that you are able to establish, if there is an environment for a rapport,” says Paul Fiore, executive vice president of Service Station Dealers of America and Allied Trades, Bowie, Md. “Some [jobbers] are really hostile to the dealer community.”
For dealers, he says treatment is going to be “either more congenial, better for dealer profitability, or it will sink rapidly into business conflict, one that’s antagonistic and much less flexible in setting their own profit margins.” Either way, he says, the dealer class today has less ability to influence street postings. According to Robinson of Robinson Oil, Big Oil’s retail pullout has, whether directly or indirectly, resulted in something else: fewer pricing wars. Robinson believes the majors in certain markets were involved in “temporary, voluntary allowances” that created deeply subsidized pricing zones. In many cases, unbranded competitors couldn’t survive. “But it’s a different world,” he says. “These markets have changed. There’s less of the funny prices.”
Whatever happens this summer, retailers must rely less on the forecourt to fuel operational prosperity.
“You want to build store sales. Gasoline doesn’t produce income,” says Jim Smith, president of the Florida Petroleum Marketers and Convenience Store Association, Tallahassee, Fla. “Look at trends, new offerings … and specifically tailoring [your store], looking at the demographics of whatever neighborhood you’re in.”
What refinery troubles mean to retailers:
- Plan for refineries to cut credit options.
- Delivery trucks will have to drive farther.
- Lines at terminals may be longer.
- Expect volatility as crude becomes a financial hedge.