Valero Refines Expansion Strategy

Premcor acquisition bolsters company's regional role, midstream and downstream

WILMINGTON, Del. --Valero Energy Corp.'s acquisition of refiner Premcor Inc., reported yesterday, gives the company another refinery to serve its expansion across the East Coast, both as a wholesaler and retailer, reported The News Journal.

The San Antonio, Texas-based company has spread its brand aggressively in Delaware and the region by taking over supply contracts with independent gasoline stations willing to convert to the Valero flag, said the report. Its takeover of Premcor's Delaware City, Del., facility will bolster its position as a supplier [image-nocss] of gasoline to both branded and unbranded gas stations, it added.

It gives us better buying power, Dave McComas, CEO of GPM Investments LLC, Mechanicsville, Va., told the newspaper. As reported in CSP Daily News, GPM signed a 10-year agreement with Valero last year to convert its network of 161 retail sites to the Valero brand. GPM operates 35 Shore Stop convenience stores in Delaware.

Consumers will see little impact on gas prices as a result of the takeover, Peter Horrigan, president of the Mid-Atlantic Petroleum Distributors Association, told the paper.

Delaware consumers can expect to see more Valero stations, the report said. Consumers should see more of Valero's teal-and-yellow signs popping up from Maine to Miami, Joanna Weidman, spokesperson for Valero, told the paper. We have plans to grow our entire network from 2,700 wholesale sites to nearly 5,000 by 2007.

In 2003, Valero increased its network by more than 600 sites. In the past year, 46 stations in Delaware have converted to Valero, said the report.

They seem to be popping up even faster than McDonald's, said Charlie Smisson, state energy coordinator, who noticed six Dover, Del.-area stations have converted to Valero in the past several months. Smisson told The News Journal that the Delaware City refinery's proximity to the area's Valero stations would give those stations an advantage over stations that rely on out-of-state refineries. Valero already operates a refinery in Paulsboro, N.J.

In addition to 2,700 Valero branded stations, the company sells gasoline to 2,000 stations under other brands, according to the report.

Expansion of the Valero brand throughout the East Coast will provide independent gas stations an option, said Horrigan. Station owners selling other brands do not expect their supplies of gasoline from Delaware City to be affected by the ownership change, said the report. Although they are aware of Valero's rapid expansion, they are not worried about competition. Valero doesn't have that much brand recognition, Wayne Baker, owner of nine Exxon stations in southern Delaware, told the paper. We have more brand recognition today. Five years from now, who knows?

In buying rival Premcor, Valero is betting that the riches enjoyed by the refining industry are here to stay, added a Wall Street Journal report.

For years, excess capacity and poor returns on investment plagued the industry, long the poor stepchild to exploration and production. Big oil companies have sold off many of their refineries, focusing on crude instead, said the report. Valero bucked this conventional wisdom and its maverick streak has paid off. Under CEO William E. Greehey, Valero built a company with one refinery in 1997 into a 15-refinery behemoth as limited industrywide capacity and strong demand for gasoline and other refined products pushed profits to their highest levels in years.

The result: Valero returned 380% to its shareholders from 2000 to 2004, compared with an 11% loss for the Standard & Poor's 500-stock index over the same period, said the Journal.

Valero's growth strategy was built in large part on buying refineries for as little as 20% of replacement cost, the report said. By contrast, Valero bought the four Premcor refineries for about 75 cents on the dollar, which has raised questions about whether the company paid too much.

Jay Saunders, an analyst at Deutsche Bank, said Valero is taking a significant risk, paying what he calculates as a 19% premium for shares of Premcor. Particularly troubling to Saunders is that he believes the industry could be just a year away from the peak of the refining market cycle, leaving Valero nowhere to go but down. Still, he rates both companies a buy.

For Valero, this is the Golden Age of refining, so named by analysts who believe that fat refining margins are here to stay. But even those in the refining industry warn that the good times may be short-lived.

Valero has been a contrarian bet almost since its inception, when in the early 1980s it transformed itself from a pipeline company to a refiner with the purchase of a troubled refinery in Corpus Christi, Texas. In 1997, the company launched a more-vigorous growth strategy, ultimately acquiring Ultramar Diamond Shamrock Corp. in 2001 for $4.03 billion plus the assumption of $2.1 billion in debt and getting with it a sizeable retail network.

With ROI in the single digits for much of the past decade, few followed Valero's lead, the report said. Instead, oil companies sold or closed refineries. The number declined to 149 today from 325 in 1981, according to the Journal, citing the National Association of Petrochemical Refiners (NAPR). With no new refineries built since 1976, capacity for refining crude fell 10% to 16.8 million barrels a day from 18.6 million barrels. That squeezed supply, playing into Valero's hands. At the same time, demand began to rise, yielding the high margins.

Valero made another shrewd bet, said the report, by upgrading refineries to process heavy crude. This high-sulfur oil costs more to refine than light, sweet crude. But because the world is short of heavy-crude refining capacity, heavy crude sells for considerably less than light, sweet oil. So those refineries able to process heavy oil have achieved better margins in recent years.

Premcor followed a similar strategy, with two of its four refineries capable of running heavy crude. That, and the geographic distribution of Premcor's refineries, made the company a logical choice for an acquisition, said Valero executives.

The major integrated oil companies such as BP PLC and Exxon are skeptical about the ability of the refining sector to sustain high margins in the long term, said the report. Though new refineries are unlikely because of their cost, environmental regulations and legal challenges, refiners have been adding capacity at about 1% a year. Valero itself has added 380,000 barrels a day to existing refineries since 1996.