Over the last six months of fiscal 2017, changes in the oil & gas market led to increasing refinery revenues and the expansion of margins. Earnings in the refining industry increased in fiscal 2017 as refined product prices increased, the crack spread widened, and volumes sold increased as demand rose. With recent gains in the industry and the effect of the Tax Cuts and Jobs Act of 2017, refiners should sail steadily through 2018. However, the future impact of many regulations surrounding the oil & gas industry is still uncertain.
Factors Providing Positive Momentum in 2018
Tax Cuts and Jobs Act of 2017
We start with the obvious. The Tax Cuts and Jobs Act of 2017 will increase net earnings. Many clients have called to ask, “What is the impact of the tax cuts on my company? If taxes decrease, will the value of my company increase?”
“Simply put, we can say, yes a lower corporate tax rate will make corporations more valuable, all else equal. Will all else always be equal? No. Appraisers will need to carefully consider the effect of the new tax law not just on rates, but on growth expectations, reinvestment decisions, use of leverage, operating margins, and the like for individual companies.”
As noted by George Damiris, CEO and President of Holly Frontier, on HFC’s fourth quarter earnings call, “The reforms to the U.S. tax code encourage capital investments and lower the corporate rate to better enable manufacturers to compete in the global market.”
Price of Crude Oil
Even if OPEC maintains production cuts, rising U.S. shale oil output is thought to temper the results of OPEC’s reduction in supply. This will likely result in falling or stable oil prices. Because refined product prices often lag crude oil, the crack spread should widen or at least remain steady in 2018.
Gregory Goff, CEO of Andeavor explains, “Last year, primarily because of rising crude prices throughout the year, we didn’t have any periods of time where the market was impacted by having a declining crude price and the lag effect of that. So, organically, the growth was muted a little bit by the weaker margin environment.”
Analysts polled by Reuters believe that oil prices will not continue to rise past the first quarter of 2019, because U.S. production will offset production declines by OPEC. We believe that oil price decreases could lead to higher margins in the refining industry over 2018. Holly Frontier, in their fourth quarter earnings call, provides an outlook of crude spread and product crack improvements in 2018.
Friendly Environment for Oil & Gas Companies
President Trump is positioning the U.S. to offer a more energy-friendly environment. The deregulation of the oil & gas industry was generally applauded on earnings calls at the beginning of 2018 and industry executives believe it will provide a more efficient marketplace for refiners.
Factors Providing Negative Momentum in 2018
The Future of the RFS is Still Uncertain
The final Renewable Fuel Standards (RFS) for 2018 were released on November 30, 2017 and contained a slight reduction in volume requirements. This will provide some relief for refiners. However, refiners have made it clear that a long term solution regarding the RFS is needed. While large integrated refiners have the capability to blend their own petroleum products with renewable fuels, small and medium sized merchant refiners do not have this capability and are required to purchase RINS, which have significantly increased in price. The cost of RINs has hurt the profits of merchant refiners over the last few years and will continue to do so unless the standards are reworked or repealed.
Potential Tariffs Could Hamper Exports and Increase Costs
As noted in the EIA’s Annual Energy Outlook 2018, domestic consumption of petroleum products is expected to decline due to increases in fuel efficiency. However, refinery utilization is expected to remain stable due to expected increases in petroleum product exports in the future. The imposition of tariffs on steel and aluminum imports does not directly affect U.S. oil refineries. However, steel is one of the most wildly used metals in the oil & gas industry. If the impacts of tariffs are passed onto the consumer, then the oil & gas industry could realize higher costs of steel.
Further, there is concern of retaliation and trade wars which could hamper growth in the industry if tariffs on U.S. products are imposed by retaliating countries. Over 33% of U.S. exports of refined products are sent to Mexico and Canada, who are currently except from the tariffs. However, growth in demand from other countries could be dampened by the soon-to-be enforced tariff.
What Does This Mean for Refinery Valuations?
Consistent with the view that markets are generally efficient, the new lower corporate tax rates seem to have been priced into the market shortly after election day. Thus when the tax plan passed, the expected increase in after-tax earnings did not come as a surprise to the market. Additionally, there has been talk of crude price decreases since U.S. production broke a production record 10 million bpd in November 2017. This was the first time the U.S. broke this record in 48 years. Since then it has been thought that the U.S. is on track to surpass Saudi Arabia and Russia in crude oil production, making OPEC’s production cuts less impactful.
Much of the positive momentum in the refining industry was expected by industry analysts. Valuation multiples have remained relatively stable over the last six months. EV multiples are trending between 7.5x to 8.5x EBITDA. According to Moody’s, “Outlook for the refining and marketing sector is stable, with earnings likely to increase 5-7% in 2018.” As earnings increase, company valuations will likely increase. However, refiner’s profit margins are highly dependent on management decisions. The degree of the effects of the new tax plan on your business depends on many company-specific decisions, such as the use of operating leverage. Further, management decisions regarding inventory management and price hedging can be the “make or break” in unexpected downturns. In order to understand the impact of these factors on the value of your refinery, you should contact an industry valuation specialist.
A Plug for Mercer Capital
Mercer Capital has significant experience valuing assets and companies in the energy industry. Our oil & gas valuations have been reviewed and relied on by buyers and sellers and Big 4 Auditors. These oil & gas related valuations have been utilized to support valuations for IRS Estate and Gift Tax, GAAP accounting, and litigation purposes. We have performed oil & gas valuations and associated oil & gas reserves domestically throughout the United States and in foreign countries. Contact a Mercer Capital professional today to discuss your valuation needs in confidence.