Big oil getting squeezed on refining margins

Drivers aren't the only ones being squeezed by record oil prices. A surprising casualty of the escalating cost of crude and sagging pump prices turns out to be the oil industry itself.

Even as oil futures set a new record north of $84 a barrel last week, a number of refiners warned that their third-quarter profits won't be as robust as once expected.

That's not to say they are destitute. Profits at the nation's three largest oil companies -- Exxon Mobil Corp, Chevron Corp and ConocoPhillips -- are forecast to drop 8.8 percent to $17.7 billion for the quarter that ended Sept. 30, compared with earnings of $19.4 billion in the same period last year, according to analysts surveyed by Thomson Financial.

The major reason is falling refining margins, or the difference between what refiners pay for oil and what they are paid for the products they make from it.

Gasoline prices have been moving lower in recent months as supplies have grown and demand has ebbed with the end of peak summer driving season. Crude oil, meanwhile, has surged on a mix of concerns about growing global demand, falling inventories and an influx of speculative investment money.

Many analysts believe either pump prices will need to rise to catch up with oil's recent advance, or oil prices will have to fall. "At some point, something has to give," said Jim Ritterbusch, president of Ritterbusch and Associates, in Galena, Ill.

Oil futures jumped above $84 a barrel for the first time ever during trading Friday, and they're up more than 20 percent since August. But gasoline prices have moved the opposite direction. Since peaking at $3.23 a gallon in late May, pump prices have declined to an average of about $2.76 a gallon nationwide for regular unleaded, according to AAA and the Oil Price Information Service.

Gasoline prices have been held down in part by rising supplies of ethanol, which is blended with gas at many stations and has been coming down in price in recent weeks. Ethanol production jumped 34 percent to 13.1 million barrels a month in July, the latest month for which data is available, from July 2006, according to the Energy Department's Energy Information Administration.

Imports of refined gasoline also have boosted supplies. In the week ended Oct. 5, for instance, gasoline imports averaged 1.3 million barrels a day, up 169,000 barrels a day from the previous week and up 253,000 barrels a day from a year earlier, the EIA said.

Add all that up and the result has been a startling decline in domestic refining margins. They plunged from a record of $37.40 a barrel in May, when gas prices were peaking and oil futures traded around $65 a barrel, to $2.90 a barrel on Oct. 1, according to Barclays Capital PLC. On Friday, the average margin hovered around $6, Ritterbusch said.

"When they get much below $5, (companies refine gasoline) out of obligation," and many actually lose money in the process, said Phil Flynn, an analyst at Alaron Trading Corp., in Chicago.

The shrinking margins are affecting companies that produce and process oil as well as those focused only on refining. Chevron and ConocoPhillips -- both integrated companies that find, pump, ship and refine oil, then sell the resulting products -- recently warned that third-quarter refining profits will fall sharply.

Valero Energy Corp, the nation's largest independent oil refiner, joined the warning parade, as did Marathon Oil Corp., (Charts, Fortune 500) a smaller integrated oil company.

It's easy to understand why a company like Valero is affected by low refining margins; it has to buy the oil it processes. But why are integrated companies which produce oil also affected?

"They don't actually refine their own oil," explained Ben Tsocanos, director of ratings services at Standard & Poor's in New York.

Oil majors don't run a pipeline from their production wells to their refineries. To keep both arms of an integrated oil company flexible and efficient, its production arms sells oil to the highest bidder, and its refining arms buy oil from the lowest bidder. "The businesses are somewhat separate," Tsocanos said.

But all oil companies pay attention to market forces, which means some refiners may decide to sit out the market for a while. That could lead to a drop in gasoline supplies and higher pump prices.

"At some point, there's going to have to be a situation where refiners who are down for maintenance will look at the margins and say, hey, let's stay down," Ritterbusch said.

Despite lower refining margins, investors tend to flock to oil company stocks when oil prices are rising. Shares of Exxon Mobil, the world's biggest publicly traded oil company, have traded in record territory of late.

In a research note Friday, Bank of America Securities analyst Daniel Barcelo said Exxon Mobil's businesses and cash flows were robust, and its shares were trading at a discount. Barcelo reiterated his "buy" rating and $98 per share target price.

Exxon Mobil shares ended the week at $93.48, up 12.2 percent since its most recent low on Aug. 16. Chevron shares have gained 12.3 percent over the same period, and ConocoPhillips shares rose 10.9 percent.

Get paid to blog