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Valero Energy Sours on Heavy Crude, Sweet on Ethanol

Valero Energy announced the permanent closing of its Delaware City refinery last month, prompted by financial losses and annual cost savings of $450 million expected from the shutdown. Though refinery operations are struggling with soured demand for petroleum products, including gasoline, its nascent ethanol business looks sweet. Is there a profitable future in biofuel for the nation's largest oil refiner?

The company posted a $674 million operating loss in processing operations for the third quarter, due to a combination of industry overcapacity and weaker demand for end-product brands. In addition, an 18 percent reduction in operating expenses -- to $3.94 per barrel -- was offset by a 76 percent decline in sour crude differentials to $1.25 per barrel (from curtailed OPEC production), according to the third-quarter 2009 regulatory filing.

Valero is looking to improve margins by shifting its crude diet away from heavy sours to lighter "sweet" (lower sulfur content) grades of oil. Prior to the shuttering of doors at the 200,000 barrel-per-day heavy crude facility in Delaware City, Valero had idled about 20 percent of its total capacity of 2.8 million barrels of oil a day -- with another 24 percent of refinery utilization down for maintenance.

In my opinion, cost cutting will not be enough to shore up weak fundamentals. Though refineries coming online in China and Brazil are expected to serve domestic markets, capacity expansions in the Middle East and India are expected to cater to export markets, dampening any hoped for recovery in near-term refinery margins at Valero.

Supply continues to outpace demand, too. At November 27, gasoline stocks spiked 15.2 million barrels year-over-year to 214.1 million. Days of supply increased by 1.6 to 23.9, according to the Energy Information Administration (EIA).

The bright spot for Valero in the quarter came from its ethanol operations, which the company acquired from a bankrupt VeraSun Energy last April. With annual capacity of 780 million gallons a year, the purchase was originally intended as a dedicated source of feedstock for blending in its U.S. Renewable Fuel Standard (RFS) E-10 gas. With the crush spread -- profit margin between the costs of corn and price of ethanol -- at its best levels in more than a year, the company has opted to sell some product into the market place. September-ending quarter profits were $49 million.

Profitability in the ethanol industry depends heavily on assured blender tax credits and the cost of corn feedstock -- about 57 percent of total ethanol production cost, according to the EIA. With the development of cost-effective production alternatives from other ethanol feedstock either several years away from ramp up (like switchgrass), or cost prohibitive through selective import tariffs (such as Brazilian cane sugar), ethanol remains the best renewable fuel option in town.

With production at the erstwhile VeraSun facilities running close to nameplate capacity, ethanol to be a game-changer would require purchasing new plants. Valero is receptive to the possibility of acquiring more ethanol capacity. "We got the seven plants that were the best ones in VeraSun's portfolio," spokesman Bill Day told me. "Any additional acquisitions would have to be as advantageous to us."

And such investments do not come cheaply -- even during the worst of times. The $556 million VerSun acquisition (total costs) was funded with part of the proceeds from the issuance of $1 billion in debt last April.

The loan covenant looks safe -- as debt is only 27 percent of capitalization (maximum is 60 percent) -- but danger lurks below the waterline: earnings were insufficient to cover fixed charges by $903 million for the first nine-months and free cash flow bled $470 million. Ethanol will likely remain a part of Valero's fuel mix going forward, but as this business is cyclical, too, it is doubtful that a green spending spree is in Valero's future.

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