Masterpiece Refining – Part 2 Holy Toledo

On Friday (December 14, 2012) PBF Energy stock closed up at $27 two days after its initial IPO listing at $26. The company purchased 3 refineries with 0.5 MMb/d capacity during the past two years. PBF’s Midwest refinery has since profited handsomely from access to cheap US and Canadian crudes. PBF is also leading the way with a novel outsourcing approach to its supply and marketing arrangements. Today we complete our two part analysis of PBF’s refineries.

Again we’ll repeat our disclaimer.  RBN Energy is not an investment advisor.  The purpose of this article is not investment advice or an endorsement of PBF Energy or any other company.

In Part 1 of Masterpiece Refining, we looked at the operation of PBF Energy’s two East Coast refineries 30 miles apart on the Delaware River in Paulsboro, NJ and Delaware City, DE. The two refineries had primarily been processing imported crudes that have been priced higher than domestic grades over the past two years. PBF has developed infrastructure at Delaware City to facilitate rail shipments of domestic light sweet crude from North Dakota as well as heavy crude from Western Canada. Refinery profitability has also gained from higher refined product prices in the Northeast because refining capacity in the region is limited.

This time we turn our attention to PBF’s third refinery located in Toledo Ohio. This 170 Mb/d refinery was purchased from Sunoco in March 2011 as that company retreated from the refining business. [Sunoco is now a subsidiary of Energy Transfer Partners]. The Toledo refinery is located in the current “sweet spot” of US refining – the Midwest “PADD II” region. The Midwest is a sweet spot because increased production of US domestic light sweet crude oil in North Dakota (the Bakken) as well as heavy crude in Western Canada over the past two years has swamped Midwest refineries since pipeline takeaway capacity to the larger Gulf Coast refining market has been slow to develop. The result has been that crude supplies have backed up in the Midwest and at the Cushing, OK storage hub. That logjam has led to a $20 or higher discount in crude prices based on the Midwest benchmark, West Texas Intermediate (WTI) versus more expensive crude at the Gulf Coast priced against the international benchmark Brent. Crude supplies for Midwest refiners have become cheap as a consequence.

The chart below shows the “crack spread” or refining margin that PBF use (according to their IPO prospectus) to approximate the performance of their Toledo refinery. We have previously explained how crack spreads are calculated (see The Bakken Buck Starts Here – Part IV). This version of the crack spread is a 4-3-1 representing 4 barrels of WTI crude as input and 3 barrels of Chicago gasoline, half a barrel of Chicago ultra low sulfur diesel (ULSD) and half a barrel of Gulf Coast jet kerosene as outputs. PBF believe the 4-3-1 crack spread is an appropriate benchmark for their Toledo refinery that outputs is 60 percent gasoline and gasoline blending components and 35 percent distillate, split 50/50 between jet fuel and ULSD. The blue line on the chart shows the crack spread over the period since PBF purchased the refinery in March 2011. The red line on the chart shows the trend in the crack spread. The Crack spread averaged over $27/Bbl since March 2011 and has ranged from a low under $10/Bbl to a high over $50/Bbl. [For reference if the refinery was running Brent crude (or imported crude priced against Brent), the crack spread over the past year would have averaged just $10/Bbl] The high crack spread margins reflect not only the lower crude prices that PBF are paying but also that refined product prices in the Midwest have held their own in spite of the lower crude oil prices. Robust refined product prices are primarily due to higher levels of exports that have pulled prices up to international levels derived from higher overseas crude prices.

Source: CME Futures Data from Morningstar (click to enlarge)

PBF’s Toledo refinery has two main pipeline sources of crude oil. The first is the Mid-Valley crude pipeline that belongs to Sunoco Logistics and runs through the Midwest from Longview, TX where it connects with the West Texas Gulf pipeline bringing WTI crude from the Permian Basin in West Texas (see New Adventures of Good Ole Boy Permian- Routes to Market). The second crude pipeline is the Enbridge Toledo pipeline that originates in Western Canada and brings Western Canadian and Bakken crude to Toledo via Chicago. Enbridge are in the middle of major enhancements to this pipeline system (see map below) that will increase the flow of light crude into Ohio. Two of the enhancement projects will increase the flow of crude to Toledo. The Line 6B Replacement increases capacity from Chicago to Sarnia by 260 Mb/d to 500 Mb/d and the Toledo Pipeline Partial Twin increases capacity to Toledo by 100 Mb/d to 180 Mb/d.

Source: Enbridge Investor Presentation, RBN Energy (click to enlarge)

The Enbridge pipeline is doubly advantageous for PBF’s Toledo refinery since it brings North Dakota Bakken light sweet crude as well as Western Canadian syncrude from Alberta. According to the PBF IPO prospectus, the Toledo refinery runs a mixture of 60 percent light sweet crude and 40 percent Canadian syncrude. Looking first at light sweet crude sources, the Toledo refinery has its pick of WTI and Bakken to choose from. At the moment Bakken crude prices are tracking closely with WTI but the pipeline transport cost from Clearbook, MN for Bakken crude should be lower than WTI from the Permian basin. Much of the Permian crude may be redirected toward the Gulf Coast next year (2013) when new pipeline capacity opens up. In any case, the close pipeline connection to Bakken crude gives the refinery premium access to competitively priced light sweet crude.

Now let’s turn to the Canadian syncrude crude. This is a sweet "synthetic" crude with an API gravity of 32 that is a semi-processed sweet crude oil produced from bitumen that is mined from oil sands then processed to remove the heavier ends.  Syncrude trades at prices close to Bakken and WTI light sweet crudes.  

Last but certainly not least, we want to bring your attention to the crude supply and refined product marketing arrangements that PBF has in place for its refineries. As we discussed in Part I, PBF is a pure refining company – meaning that they do not own any “upstream” (crude production) or “downstream” (refined product marketing) assets besides the refineries themselves. If you don’t happen to own crude oil production then in order to run a refinery you need to purchase crude oil and other feedstocks in the marketplace. That needs to be accomplished in a timely manner for two reasons. First because you don’t want to run short of crude oil and have to shut down processing units involuntarily. Second to make sure that the timing of crude oil purchases occurs as close as possible to when the crude is needed. That is the refining equivalent of “just-in-time” inventory control. At around $80-100/Bbl you can tie up a lot of capital in crude oil if it is sitting around too long.

Once the refining process is underway you have a stream of refined products being “manufactured” that need to be marketed – sooner rather than later. One of the worst things that can happen to a refinery is that it has to slow down or cease operations because it runs out of storage space for refined products. Just as with crude oil, the longer refined products stay in the refinery the higher the inventory cost. This is particularly important when prices are volatile since the refining margin depends on being able to sell products at a higher price than the crude feedstock used to refine them. The longer you wait to sell the products the more chance there is for the market to move against you.

There are a number of ways to juggle these supply and distribution logistics not to mention the price risks. The common approach is to set up a team of skilled crude and refined products traders and marketers. Those guys can also manage a lot of the price and inventory risks using futures and derivatives markets. Since PBF did not have a trading operation already set up, they chose to outsource these arrangements to third parties when they purchased their three refineries. They outsourced crude oil and feedstock purchases for the Paulsboro and Delaware City refineries to Statoil Marketing and Trading (US) and made a similar agreement for the Toledo refinery with Morgan Stanley Capital Group (MSCG). These trading companies purchase crude at PBF’s direction and then transfer ownership to PBF just before the crude is processed. PBF also has in place an agreement with MSCG to purchase all refined products at the two East Coast refineries as soon as they leave the refinery unit. MSCG and its subsidiary TransMontaigne Inc are then responsible for refined product sales. Pricing is based on published reference prices and MSCG get a margin on each sale plus sales incentives every quarter. At the Toledo refinery, approximately one third of the refined products are purchased and redistributed by Sunoco (the former owner of the refinery). 

These product offtake and crude purchase agreements are not unique to PBF. We saw a similar arrangement with JP Morgan by Carlisle Group, the new owners of the former Sunoco refinery in Philadelphia this past July (see Beginning to See the Light). However approaches like these are symptomatic of changes in the crude oil refining business these days. In effect, PBF is concentrating on their core skill – running refineries and outsourcing their supply and distribution logistics to trading specialists. By doing things that way they are also outsourcing some, if not all, of the price risk inherent in refinery operations because they have locked in “just-in-time” arrangements with their crude suppliers and their refined product customers. These are all part of a trend towards running refineries as processing units with limited exposure to commodity price risk. That links back to moves to run refineries as public master limited partnerships (MLPs) that we discussed in “Masters of the Midstream – MLPs Exit the Toll Road”. No surprise then that PBF Energy Inc is actually a holding company for two limited partnerships that operate the refineries.

It is too early to tell whether the PBF IPO will be a long-term success with investors. Prior to the listing PBF has made good profits from refineries that the previous owners gave up on. In the current crude price environment, the Toledo refinery is well placed to continue benefiting from high refining margins. If the East Coast refineries can leverage new routes to market to get access to cheaper Canadian and Bakken crude they should also do well.   All this sounds positive, but we always need to keep in mind that the refining business is highly cyclical, and most of the cycles in the last 20 years have not been good ones.  US refiners have a wild ride ahead over the next few years.