The hurricanes that devastated New Orleans two years ago demonstrated brutally just how exposed cities on the Gulf Coast are to the forces of nature. But it also exposed another major weak spot in the region. Much of America’s oil production and refining capacity is concentrated in the area. In the wake of Hurricanes Katrina and Rita, oil prices hit more than $70 a barrel as production for the year was cut by 30%. Meanwhile, gasoline prices surged above $3 a gallon, with more than a quarter of the country’s refining capacity knocked out. With at least 17 storms expected in the coming months, there are fears that a repeat of 2005 could well be possible.
But even without the threat of hurricane season, gasoline prices have just hit a new record, leaping to an average of $3.07 a gallon, according to the AAA. The US motoring group blames the surge on maintenance and operating problems at America’s oil refineries, says The Daily Telegraph. “Almost all of the price pressure on gasoline can be attributed to America’s continuing – and increasing – inability to supply enough refined gasoline to the marketplace.”
A series of unexpected outages means the industry was using just 86% of its refining capacity in March – the lowest level at this time of year since 2002, says Robert Walberg on MSN Money. Meanwhile, fires at BP’s refinery in Indiana and Valero Energy’s refinery in Texas will keep refining below normal utilisation rates for some time. The last new US refinery was built more than 30 years ago, and the number of outages is likely to rise as the plants age, notes Walberg.
This bottleneck has proved good news for investors in oil-refining companies – shares in the sector have jumped by an average 37% since January, as refiners enjoy record margins. US gasoline inventories have fallen below levels typical for this time of year, while imports have fallen too, pushing prices higher, while the price of crude has remained well below its peak levels of last year. That has seen the spread between the price of crude and the price of refined products triple, from an average of just $3.56 in 1999 to $10.94 last year. These “crack spreads” are expected to stay at record levels throughout the summer, according to Bart Melek of BMO Capital Markets.
If there is such a shortage of refinery capacity, why not build new ones? One reason is that environmental regulations in the US make it extremely costly to build new plants. And with metal prices rocketing in recent years, refiners have also been put off by the cost of building new refineries. Merill Lynch reckons that refinery construction costs have risen by 70% in the last three years, with no less than 22 projects being shelved or delayed last year as a result. “The global refining system continues to face severe bottlenecks, with little chance of respite before the decade ends,” the group says.
Meanwhile, demand for gasoline is only going to rise as the US goes into the summer driving season – the time when most Americans hit the roads to go on holiday. While high prices are likely to attract more imports and higher production from domestic producers, Guy Caruso of the Energy Information Administration warned that the EIA expects “gasoline markets to remain fairly tight this summer”. As Merrill Lynch says: “We believe the outlook for 2007 remains highly favourable.” And that’s assuming a benign hurricane season. A repeat of 2005 “could add significant upside risks to our forecasts”.
Oil refineries: the best shares in sector
Valero (NYSE:VLO) is the largest oil refiner in North America, operating 17 refineries that process more than 3.3 million barrels of per day. It is a very attractive play on the sector, says Garry White of Outstanding Investments. The company specialises in refining the heavier and “sour” blends of oil, which gives it among the best margins in the refining business. As Byron King notes in his Outstanding Investments report, for every 25 cents that a barrel of heavy or sour oil is cheaper than lighter oil, Valero makes roughly another $300m in operating income, or 30 cents per share. There have been triple-digit gains for the Valero share price over the last four years, but there is “much more to come”, according to White. The shares trade on a forward p/e of 8.8 for 2008 and have a dividend yield of 0.7%.
For a more diversified play, look at Galp Energia (Lisbon: GALP), a
Portuguese mid-cap oil refiner, marketer and explorer. The company is executing a five year e3.4bn investment plan that is boosting earnings as it emerges as one of the most efficient refiners in the sector. Merrill Lynch says that exploration in Brazil and Angola could result in new finds “in some of the world’s most lucrative areas”, with around 60 exploration wells being drilled this year. The shares trade on a p/e of 9.2.