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Valero Energy Hunkers Down in Challenging Sour Crude Refining Market

Valero Energy may slow production and keep its Aruba refinery plant closed as it prepares to weather a storm of continued weakened global demand, narrowing diesel and jet fuel margins and lower sour crude discounts.

The U.S. oil refiner's second-quarter earnings fell to a loss of $254 million, or 48 cents a share, compared to net income of $734 million, or $1.37 per share, for the same period last year. San Antonio-based Valero's revenues in the second quarter were $17.9 billion, compared to sales of $36.6 billion for the same period last year.

Income in Valero's retail operations actually increased 33 percent from $49 million in the second-quarter of 2008 to $65 million this quarter. Its ethanol business -- a new segment since earlier this year when Valero acquired seven plants from bankrupt VeraSun for $556 million -- earned $22 million of operating income. A recent decrease in corn prices has been positive on ethanol margins and the profitability of our plants, said chairman and CEO Bill Klesse in a statement released Tuesday.

But the company, along with other refiners, has struggled with low demand for fuel, and narrowing margins on diesel and jet fuel. Valero's heavy, sour crude refining operations have been hit especially hard.

Valero business specializes in refining heavy, sour crude. The process is more difficult, but its been lucrative for Valero because until recently the refiner was able scoop up these heavy, sour crude oils at a discount and then sell the refined products at a well-padded margin. Suppliers of heavy grades of crude have pulled their product the market as global demand has decreased and discounts on these grades have declined, wiping out their previously hefty profit margins.

Just take a look at margins for Mexican Maya heavy sour crude differential to West Texas Intermediate crude, which plummeted 78 percent from $20.99 per barrel in the second quarter last year to $4.57 per barrel in the same quarter this year.

What this all means, of course, is slowing or shutting down refining plants, cutting costs and hoping demand eventually recovers.

"What we needed is a sustained recovery in the economy to drive growth and demand for refined products and to also pull lower quality crude oils on to the market," said Mike Ciskowski, chief financial officer. "This leads into Valero strategy, which is to maintain our financial health by cutting costs, optimizing our assets and preserving cash."

Valero's two hydrocracker projects on the Gulf coast have been placed on hold until the company needs more capacity. Its Aruba refinery is no longer active. Valero is conducting maintenance on the refinery, has retained all of its employees and will review whether to bring it back on line in a couple of months.

The Aruba plant, which has a book value of $1 billion, is still on the market and there are people who are interested, Klesse said during a conference call with investors. "Some of the people there we are still talking to that are interested in the refinery have an integrated approach," he said.

I wouldn't look for the company to be making any acquisitions in the near future either. Klesse and other Valero execs emphasized several times they would holding on to their cash position.

That doesn't mean if the right acquisition opportunity came along, Valero wouldn't take it. Rumors were circulating last week that Valero was considering a bid for New Zealand Refining Co. in an effort to reduce its reliance on the U.S. market.

Valero had bid for a 45 percent stake in Dow Chemical's Total Raffinaderij Nederland crude oil refinery. France-based Total, which owns the remaining 55 percent has said it will exercise its right-of-first refusal.

So, clearly there is an interest in acquiring the right international asset. But with dismal global demand and new refining capacity coming online around the world, Valero will likely sit out recent the spate of acquisitions in the industry and hold onto its cash.