Downstream Oil & Gas M&A Part 3: The Good, the Bad, and the Ugly
In our first article in this three-part series, we identified the unique impacts of the pandemic on oil products’ demand and pointed out that by the time the pandemic has resolved, there will likely be increased environmental legislation risk negatively affecting the sector. As such, acquiring downstream oil and gas assets may appear unwise in the current climate. In our second article, however, we challenged this notion by reviewing alternative-use strategies. Refineries may have value for bio-fuel production, their logistics assets could be used for product import/distribution on a stand-alone basis, or in the extreme case, these assets could be scrapped, and the land put to other uses. Furthermore, even in aggressive forecasts for the transition to low-carbon energy, the International Energy Agency still sees about two-thirds of the current refining capacity required in 2050.
So, the issue may not be whether it is risky to buy a refinery but rather, under which use-case (traditional or alternative use) does the asset have value, and what is it worth? In this final article of the series, we review our approach to downstream asset acquisition analysis and describe how Stillwater Associates sees things that others miss.
The economics of refining indicate that it is cheaper to move crude oil in large volumes over long distances to refineries which are sited near consumption centers rather than moving finished products over those same long distances (in smaller volumes to many customers). Refineries are often clustered around large population centers or linked to these centers by efficient pipeline systems and are referred to as refining enclaves. Generally, the refineries within an enclave compete for market share, although there is also some inter-enclave competition. Product will move between enclaves to, at minimum cover an area’s net long or short position.
A goal in refinery acquisition analysis is to identify the profitability of the refinery as currently configured and operated as well as the upsides that can be realized by the acquirer. The analysis begins by identifying the variable margin (i.e., the gross margin less the variable operating costs) and the net margin (i.e., the variable margin less the fixed cash costs). Refineries with lower fixed costs per barrel of capacity have lower break-even utilization rates but usually have an upside to reduce these costs. Ideally, comparing refineries margins within an enclave would indicate which refineries would cease operations with the decreasing demand predicted given the clean-energy transition. In reality, however, most market observers can only estimate margins based on assumed crude price inputs and proxies of the refinery operations via modeling in linear programs, or other approaches.
While competitive or margin analyses could provide insights, given the limitation on accuracy of modeling, other factors can sway investment decisions. Some of the key questions Stillwater asks are:
- What are the different assets within an enclave; what is the supply and demand outlook?
- What are the relative strengths and weaknesses of the different assets within an enclave?
- What are the asset’s unique characteristics in both refinery configuration and supporting logistics assets?
- What are the major customers for products, and are there any patterns in customer behavior that affect competitive positioning?
- What are the macro-level risks and opportunities and how will they affect the different assets’ competitive positions now and in the future?
- Are there opportunities to improve the configuration of a specific asset to change competitiveness?
- Are there opportunities to change the cost structure of the assets?
- Are there strategic relationships needing development between the asset owners and crude suppliers or product offtakers?
- If the assets are not competitive in traditional use, do its components have value in other uses?
One might argue that the factors Stillwater considers when evaluating an acquisition are difficult to ascertain from an outside-in view. Indeed, analysis of these factors requires a level of asset intimacy that only comes with years of experience working within the industry across the entire supply chain. Our team is made up of industry veterans who are intimately familiar with the assets in terms of configuration, logistics, and broad commercial terms. Often, we find that one of these issues will be the deciding factor in an asset acquisition decision and also are of significant value during the due diligence phase of M&A.
Stillwater sees things others miss, and now you can, too. Contact us to learn more.