Sunday, March 13, 2005

Like bartenders putting cheap alcohol into their cocktails, some U.S. refiners are reaping huge profits by using lower quality crude oil to make everything from gasoline to diesel.

The difference is that, unlike martinis mixed with barnyard booze, these finished fuels, after a little extra work, are the same quality as those made with top-shelf ingredients and therefore fetch the same high price from consumers. But the initial cost per barrel is $7 to $17 cheaper.

Despite the extra costs associated with processing lower quality crude, the profit margins of independent refiners able to handle it are up sharply. Valero reported net income in 2004 of $1.8 billion, nearly three times its results a year earlier, while Premcor Inc.’s profits tripled to $478 million.

Valero’s shares have more than doubled in the past year, while Premcor’s are up slightly less than that. Shares of Frontier Oil Corp. also have soared.

Valero attributed its stellar fourth-quarter results to its “superior leverage to sour crude discounts,” which were $10 per barrel cheaper, on average, than the price of West Texas Intermediate, the light, sweet oil that futures prices are pegged to on the New York Mercantile Exchange.

More than half the oil used by Valero — about 1.3 million barrels a day — was sour during the fourth quarter, including Mexican Maya, which accounted for nearly one out of every five barrels and averaged $16.75 per barrel cheaper than WTI, the company said. Valero also processes heavy, sour crude from the Gulf of Mexico known as Mars, which has become the U.S. benchmark.

In the past two years, Valero has significantly expanded it ability to process heavy, sour crude by acquiring a 315,000-barrel-a-day refinery in Aruba and a 185,000-barrel-a-day refinery in Louisiana. The company also completed in late 2003 the expansion of its heavy, sour processing capacity at a refinery in Texas by 45,000 barrels per day.

Fadel Gheit, senior oil analyst at Oppenheimer & Co. in New York, said the decision in recent years by Valero and others to expand their heavy, sour refining capacity has proved to be “brilliant.”

Most refiners prefer premium oil, described as light, sweet crude. It is low in sulfur and easy to process, and yields the most volume per barrel of the transportation fuels in greatest demand. This preference has been encouraged by environmental laws that require the industry to produce cleaner burning fuels.

But as the world’s oil thirst swells to more than 84 million barrels a day and producers struggle to keep up, the extra supply being brought onto the market, primarily by Saudi Arabia, is the heavy, sour variety. Not all refiners have the equipment to process it.

As a result, the high price of light, sweet crude has risen, with each barrel selling for more than $50 on futures markets. By contrast, there is a relative abundance of medium to heavy crudes that sell for much less. Refiners who can process reap the reward.

Depending on the precise chemical composition, lower quality oil is selling at discounts ranging from $7 to $17 per barrel, when compared with light, sweet crude. A year ago, heavy, sour crudes, whether from Mexico, Venezuela or Canada, were discounted by about half that much.

“The sweet-sour spreads have never been this good,” said Gene Edwards, senior vice president of supply and trading at San Antonio-based Valero Energy Corp., the nation’s largest independent refiner and the leading processor of sour crude.

The gap narrowed after the Saudis reined in production earlier this year to comply with reduced output targets set by the Organization of Petroleum Exporting Countries. Analysts say today’s sharp price disparity is likely to narrow further over time, as more sour crude refining capacity is added and more producers tap new fields that produce lighter crude to meet rising demand.

However, assuming the global demand for oil remains strong, the discounts are not likely to return to historical norms anytime soon.

“The same trends are likely to be in place for the next three to five years,” Mr. Edwards said.

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