The measure shown in Figure 1, termed return on investment (ROI), is net income contributed by the FRS companies' U.S. refining/marketing line of business (excluding unallocable items, mainly interest expense) per dollar of net fixed assets in U.S. refining and marketing, expressed as a percent. Also shown in Figure 1 is the analogous measure for all of the other FRS companies' lines of business on a combined basis. The profitability of the FRS companies' U.S. refining/marketing operations reached an all-time peak in the 1988 to 1989 period. Since then, profitability steadily declined to near zero in 1992 and, although registering a sharp uptick in 1996, was below the profitability of other businesses throughout the 1990's. As a general economic tendency, chronic subnormal profit performance should discourage investment.
The measure shown in Figure 2 is return on equity (net income as a percent of shareholders' equity, shareholders' equity being the book value of ownership), a commonly-used measure of a corporation's profitability. Profitability of publicly-traded, non-FRS companies specializing in U.S. refining/marketing operations (representing an additional 12 percent of U.S. refining capacity in 1996) has also declined sharply in the 1990's and generally has been below that of the FRS companies and industry overall.
Adjusted for general inflation (via the implicit gross domestic product deflator), the FRS companies' capital expenditures for U.S. refining doubled from 1989 to 1992. Since 1992, capital expenditures have steadily fallen to historically average levels. The only comparable surge in capital expenditures was in the late 1970's through the early 1980's. During this earlier period, the U.S. majors upgraded their refineries to process heavier, more sulfurous crude oil inputs into relatively greater proportions of lighter products, particularly gasoline. These investments were largely premised on wide price spreads between higher and lower quality crude oils and lighter and heavier refined products (see Figure 7).
Unlike the earlier surge in refinery investment, the upswing in capital expenditures in the 1990's appeared to be largely driven by increased expenditures for pollution abatement. In particular, the Clean Air Act Amendments of 1990 required production of oxygenated gasolines by late 1992, lower sulfur diesel fuels by late 1993, and reformulated gasoline by January 1, 1995. (It must be noted that both the Census and the API instruct the respondents to their surveys to include capital expenditures and operating costs incurred in meeting the Clean Air Act Amendments.)
The imposition of heightened environmental quality requirements on the U.S. refining industry stemming from the Clean Air Act Amendments occurred while industry profitability declined sharply and continued at low levels. This observation suggests that heightened environmental quality requirements may have played some role in profit performance. The remainder of this report attempts to assess the impact of heightened environmental standards on operating costs, capital requirements, and profitability in U.S. refining and marketing.
The net refined product margin (net margin), shown in Figure 5, is the gross refining margin (refined product revenues less purchases of raw material inputs to refining and refined product purchases) minus out-of-pocket operating costs per barrel of refined products sold. The net margin represents the before-tax cash earnings from production and sale of refined products and excludes ancillary activities such as non-fuel sales from convenience stores. The net margin is an important determinant of short-term decisions in refining operations. Basically, for a given scale and configuration of a refinery, output will tend to be expanded as long as the added output adds to cash earnings. The net margin is also closely related to refining/marketing profitability. Figure 5 shows that when cash earnings per barrel sold (adjusted for inflation) are high, so is refining/marketing profitability. The correlation between ROI and the net margin is 0.92, which is highly significant by the usual statistical conventions. 3 Some insights can be gained by examining the effects of pollution abatement operating costs on the net margin. More specifically, this report examines components of the net margin for 1988 through 1989, the peak years of profitability, and just prior to The Clean Air Act Amendments, and 1993 through 1995, the most recent years for which data are available.
As a share of total refining/marketing operating costs, pollution abatement operating costs ranged from 6 percent in 1988 to 1989 to 10 percent in 1995. Further, the increase in pollution abatement operating costs ($1995) over this period was 7 cents per barrel of refined products sold, or 5 percent of the $1.52 per barrel decline in the net margin. Based on these results, the direct effects on operating costs of heightened environmental standards from 1990 on appear to have had only a small role in the deterioration of cash margins in U.S. refining and marketing. This conclusion must be tempered with the possibility that the Census and API pollution abatement operating costs may not have captured all the costs of manufacturing reformulated gasoline, which commenced in late 1994. However, the results presented in this report are reinforced by one of the conclusions of a recent EIA report which did examine the added costs of reformulated gasoline, that "A close examination reveals that the change in refining costs attributable to RFG [reformulated gasoline] had no major impact on margin behavior between 1993 and 1995. In fact, other market factors overwhelmed any impact of the introduction of RFG." 4
The FRS companies' consolidation of U.S. refining/marketing operations and direct reductions in energy expense, gasoline marketing expenses, and other refining and product supply expenses have reduced operating costs (excluding pollution abatement operating costs) by slightly more than $1.30 per barrel of product sold between the period 1988 to 1989 and 1995, with most of the reductions occurring since 1992. However, the decline in the FRS companies' gross margin of nearly $2.80 per barrel more than offset the effects of consolidation and cost-cutting. The gross margin has clearly trended downward since 1988, unlike the 1977 through 1988 period when the gross margin, though volatile from year to year, showed no upward or downward trend. Although the FRS companies' raw material prices for inputs to refineries declined after 1988-1989, refined product prices realized by the companies have declined even more (Table 2).
The FRS companies directed much of the surge in their refining investment in the late 1970's to early 1980's (Figure 3) toward increasing their capability to process heavier, more sulfurous crude oils. For example, the FRS companies' capacity for increased processing of heavy-sour crude inputs, relative to basic crude distillation capacity, rose from 22 percent in 1974 to 30 percent in 1980 to 47 percent in 1993. 5 The expected returns on these type of investments were based on a growing spread in the price of high quality crudes relative to the price of lower quality crudes. For example, Figure 7 shows a large price differential until 1982, followed by a sharp decline in the price differential and then a steep rise in the late 1980's. The growing price spread between crude qualities in the late 1980's increased the returns to processing investments and contributed to the growth in U.S. refining/marketing profitability. Conversely, when the spread narrowed, returns to process upgrading investments deteriorated. During the 1990's, the quality price spread narrowed sharply, adversely affecting the gross margins realized by process-upgraded refineries, and did not register an uptick until 1996.
The FRS companies' average refined product prices in 1995 were down $4 per barrel ($1995) from the peak profitability years of 1988 to 1989. Gasoline registered the sharpest price decline over this period ($5.14) followed closely by distillate prices (down $4.83 per barrel) while the composite price of other products (mainly residual fuel oil and chemical feedstocks) was down a less steep $1.31 per barrel. That is, not only did refined product prices decline, but the spread in price between light products and heavy products deteriorated. This latter development was especially adverse for refiners who invested heavily in refinery upgrades to yield higher proportions of light products. In particular, the FRS companies increased their capability to produce greater yields of light products, relative to crude distillation capacity, from 56 percent in 1974 to 80 percent in 1993. 6
These disproportionate price reductions in the 1990's in large part reflect the growth in U.S. refiners' capability to produce greater quantities of light products in the face of moderately growing demand for these products. Part of the growth in light product capability was integral with meeting requirements to produce reformulated fuels by 1995. For example, according to a recent EIA publication, 7 the Clean Air Act Amendments resulted in downstream capacity additions ranging from 7 to 10 percent while the U.S. capacity to produce oxygenate additives (MTBE plus TAME) has more than doubled since 1990. However, the effects of complying with the Clean Air Act Amendments on light product capability and prices are transitory and basically a matter of timing. That is, compliance with heightened environmental standards can be viewed as having placed some capacity expansions in service earlier rather than later. Nevertheless, if future product demand growth is considerably lower than currently anticipated, then capacity expansions occasioned by pollution abatement compliance can prove to be a longer-term drag on refining/marketing profitability.
The capital intensity of a process refers to the amount of capital needed to produce a unit of product. Since capital goods tend to be heterogeneous, a common measure (such as dollars) is used to measure capital. For the U.S. refining operations of the FRS companies, capital intensity is measured by the ratio of net property, plant, and equipment (i.e., the balance sheet value of productive long-term assets adjusted for depreciation) to refinery capacity (barrels per calendar day of crude distillation capacity).
The capital intensity of U.S. refining registered a sharp rise in the 1978 through 1983 period, reflecting the surge in investments for upgrading refineries to process lower quality crude oils and increase light product yields. During this period, capital expenditures for pollution abatement in refining, adjusted for inflation, declined in amount and as a share of overall refining expenditures, from 30 percent to 10 percent. By contrast, during the latest rise in capital intensity, beginning in 1989, the FRS companies' pollution abatement expenditures for U.S. refining operations rose sharply, both in amount (Figure 3) and relative to overall capital spending for U.S. refineries (Figure 4) accounting for 31 percent of capital expenditures in the 1990-1995 period.
Profitability and capital intensity are related in that if a process becomes more capital intensive, then profitability will decline unless there is an offsetting increase in profit per unit of output.
One way to assess the effects of environmental requirements on refining/marketing profitability is to compare the actual return on investment (ROI) with an ROI that excludes operating costs and depreciation attributable to pollution abatement from income and excludes the value of net assets traceable to pollution abatement capital expenditures from the investment base. The ratio of income (after adjustments) to net assets (after adjustments) is an accounting-based measure of profitability excluding the effects on income and assets of pollution abatement requirements. This measure does not take into account the possible market dynamics that might have occurred in the absence of pollution abatement requirements.
The ROI (percent) shown in Figure 9 is the ratio of the FRS companies' annual U.S. refining/marketing operating income (i.e., revenue minus operating expenses) to the value of net property, plant, and equipment (PP&E) allocated to U.S. refining and marketing. This measure correlates highly with the ROI based on net income shown in Figure 1 but avoids having to allocate gains from asset sales and affiliate income.
To adjust for the effects of pollution abatement requirements, operating costs and depreciation charges traceable to pollution abatement requirements were excluded from operating income, and the value of net property, plant, and equipment (PP&E) allocable to pollution abatement was excluded from the denominator.
The key observation from Figure 9 is that the difference between actual ROI and ROI excluding the accounting effects of pollution abatement requirements was 5.2 percentage points in 1988 to 1989, compared to 5.6 percentage points in 1990 (the year of the Clean Air Act Amendments) and 6.9 percentage points in 1995 (the first full year of reformulated gasoline production).
Based on these comparisons, the effect of additional pollution abatement requirements in the 1990's is a reduction of 1.7 percentage points in the operating ROI (i.e., 1988 to 1989's differential of 5.2 percentage points minus 1995's differential of 6.9 percentage points). Since operating ROI is a before-tax measure, the after-tax effect (based on the Federal corporate tax rate of 35 percent) is 1.1 percentage points. This reduction is only a small part (9 percent) of the decline of 12 percentage points between 1988 to 1989 and 1995 in the FRS companies' after-tax return on investment in U.S. refining and marketing.
Author:
Contact:Jon A. Rasmussen
Neal Davis
neal.davis@eia.doe.gov
Phone: (202) 586-6581
Fax: (202) 586-9753
URL: http://www.eia.doe.gov/emeu/perfpro/ref_pi/keyfind.html
