Exxon Announces Norwegian Refinery Upgrade To Boost Its Downstream Margins

Exxon Mobil (NYSE:XOM) recently announced plans to install a new processing unit at its Slagen refinery in Norway to enable the production of high-quality vacuum gas oil, which is a feedstock used to create high-value end products such as diesel. The company plans to install a new residual flash tower unit at the refinery that will improve its overall crude distillation process by replacing the production of lower value heavy fuel oil with lighter gas oil. We believe that the planned refinery upgrade would improve Exxon’s downstream margins in the long run by boosting its yield of higher-margin transportation fuels. ^[1]

Exxon Mobil is the world’s largest publicly traded international Oil and Gas Company. It generates annual sales revenue of more than $420 billion with a consolidated adjusted EBITDA margin of ~14.7% by our estimates. We currently have a $107/share price estimate for Exxon Mobil, which values it at around 13.4x our 2014 GAAP diluted EPS estimate of $7.96 for the company.

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Exxon’s Downstream Margins Have Been Under Significant Pressure

Exxon’s downstream margins have been under significant pressure over the past few quarters. This has been primarily due to industry overcapacity amid sluggish demand and higher crude oil prices. There have been certain bright spots as well, as refineries in the Midwest U.S. have been gaining from lower crude oil prices due to the fast-growing supply from unconventional plays in the U.S. and lack of midstream infrastructure. However, a sharp decline in international crack spreads over the past few quarters has more than offset this advantage for Exxon. Crack spread is a term used to refer the price difference between crude oil and refined petroleum products, such as gasoline, derived from it. During the first half of this year, Exxon’s international downstream earnings declined by more than 44% y-o-y, primarily due to thinner margins. ^[2]

Going forward, we expect global refining margins to continue to remain under pressure in the short to medium term due to industry overcapacity, which stems from the fact that governments in different parts of the world are willing to run uncompetitive crude refineries at very low or no returns, to sustain employment and reduce their reliance on imported fuels. (See: Key Trends Impacting Global Refining Margins)

Here’s Why Exxon’s Plan To Upgrade Norwegian Refinery Makes Sense

The Slagen refinery upgrade is Exxon’s second big investment announcement in the European refined products market this year. Just a couple of months back, the company announced plans to invest over $1 billion in the upgrade of its Belgian refinery. ^[3] It is interesting to note that these announcements have come at a time when several refineries across the continent are closing down due to weak demand for petroleum products and increasing operating costs. While the weakness in demand for petroleum products could be attributed to macroeconomic headwinds in the region, the increase in operating costs is primarily due to higher crude oil prices and more stringent environmental regulations. ^[4]

The refining sector in Europe is also facing tough competition from new refineries in Asia and the Middle East, which have lower operating costs due to less stringent environmental standards. In addition, refineries in the U.S. that are benefiting from lower operating costs due to cheap natural gas are also giving European refineries a hard time. According to Exxon, energy accounts for about 60% of the total operating costs of a refinery in Europe, but only 30% in the U.S. Because of these factors, as many as 15 refineries have closed in Europe since 2007 leading to more than 8% cut in the continent’s refining capacity from 15.8 million barrels per day (Mb/d) to 14.6 Mb/d currently. ^[4]

However, Exxon has taken a long term view on its downstream portfolio in Europe. The company’s Norwegian refinery upgrade plan also makes sense if we consider the following three factors. Firstly, the new processing unit would improve its yield of higher-margin transportation fuels, as it would convert heavy fuel oil which is a low-value, high-polluting product into vaccum gas oil, a higher-yielding feedstock, which can be used to create cleaner finished products such as diesel.

Secondly, the refinery upgrade will allow Exxon to tap into the growing demand for diesel fuel in Europe. Over the past few years, the demand for diesel fuel has grown at the expense of gasoline in Europe because of the shift in European automobile fleet towards diesel-fueled vehicles. From almost even just a decade ago, the use of diesel fuel in transportation has grown to more than 2.5 times that of gasoline in the European Union. Exxon expects the trend to continue as the popularity of diesel cars in Europe continues to increase. Last year, more than half of the new cars registered in Western Europe were diesel powered, compared to just 10% in 1990. ^[5]

Thirdly, increased diesel production would also impact Exxon’s sales volume-mix positively since margins on producing diesel from crude oil are thicker than gasoline. According to data compiled by Bloomberg, gasoline crack averaged at around $8 per barrel last year, compared to $14.3 per barrel for gasoil, a price benchmark for diesel. This could be partly attributed to excess gasoline supply in Europe, while diesel imports by the continent continue to rise. Last year, Europe imported 13% of its diesel, jet fuel and gas oil. ^[6]

We therefore believe that the planned Slagen refinery upgrade would improve Exxon’s downstream margins in the long run. We currently forecast Exxon’s adjusted downstream EBITDA margin to improve marginally to around 2% in the long run, which is more than 30 basis points below the historical average by our estimates. However, if its downstream margins improve to around 3% in the long run, there could be a 10% upside to our current price estimate for Exxon Mobil.

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1. ExxonMobil Announces Slagen Refinery Project To Upgrade Fuel Oil, exxonmobil.com [↩]
2. Exxon Mobil Corporation 2Q14 Earnings Presentation Slides, exxonmobil.com [↩]
3. ExxonMobil Announces Antwerp Refinery Investment of More Than $1 Billion, exxonmobil.com [↩]
4. European Oil Refiners See Bleak Year, wsj.com [↩] [↩]
5. Betting On Diesel Cars, Exxon Is Set To Expand Belgium Refinery, nytimes.com [↩]
6. Euro Oil Refiner To Keep Shutting Amid Wrong-Fuel Supply, bloomberg.com [↩]