Commodities 2021: Debt increase, biofuels to challenge US refiners

As oil refiners cope with the energy transition, the debt they have added to their balance sheets to weather the COVID-19 pandemic may force some companies to choose between debt reduction and dividend payments if the petroleum market recovery lags expectations.

High yield members of the group, including PBF Energy, CVR Energy and Delek US Holdings, have already suspended dividends in order to preserve cash. But during third-quarter earnings calls, executives at investment grade HollyFrontier, Valero Energy, Phillips 66 and Marathon Petroleum reiterated their commitment to return cash to shareholders despite the pandemic.

"The only thing that's going to stabilize ratings is the demand response," S&P Global Ratings senior director Michael Grande said. "When COVID hit, we were predicting by this time during the year, things would be better, and they're not. ... I wish I could be more emphatic about our belief that things are going to be better next year."

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U.S. fourth-quarter product demand is averaging 18.7 million b/d, below the year-ago level of 20.5 million b/d, S&P Global Platts Analytics estimates. While gasoline demand should begin to recover by March, it will only reach about 90% of the 2019 level of 9.31 million b/d, according to Platts Analytics.

"Overall, we see an improving environment, yet believe there needs to be more market rebalancing," Morgan Stanley said in a Dec. 15 report, noting there could be a near-term risk to demand and margins by the recent resurgence of coronavirus cases in the U.S.

"There also needs to be more refinery closures (we estimate a further 1.5 million b/d to 2 million b/d for a total of 4 million b/d to 4.5 million b/d in a conservative post-COVID demand scenario.)"

According to Platts Analytics estimates, 4.7 million b/d of U.S. refining capacity will be offline in January 2021, up from the 4.57 million b/d in December.

High grade or high yield?

Grande said he is "more cautiously optimistic than confident" about a petroleum market recovery. While some oil refiners retain their investment grade credit ratings for now, they risk downgrades if the market does not improve quickly enough, he said.

Investment grade companies have issued more than two thirds of the $14.80 billion of debt that the seven largest US refiners added to their balance sheets in 2020. With refining margins low and debt accumulating on balance sheets, leverage ratios have soared.

More diversified members of the group have offset some of the severe pandemic-driven losses of their refining segments with more stable earnings streams, but "this doesn't really work if the refiners are never profitable again," Grande said. "[Phillips 66 Partners LP] is cash flow positive because Phillips 66 pays them to use their assets for their refining business, which is cashflow negative."

According to a Dec. 11 analysis by investment bank Tudor Pickering Holt & Co., Phillips 66 is the only member of the group capable of paying down its incremental debt using free cash flow after dividends from 2021 through 2023.

Marathon Petroleum can pay back around three quarters of its incremental debt if it cuts its dividend by 50%, they concluded, adding the company plans to pay down some debt with proceeds from the sale of its convenience store business. Executives are still weighing how much debt to repay, but they plan to return a substantial amount to shareholders. Most of Valero's free cash flow goes to pay its dividend, so the company can only afford to repay 9% of the $5.46 billion of incremental debt it issued this year.

Tudor Pickering Holt analysts predict PBF, which has issued more than $3 billion in incremental debt, will be free cash flow negative through 2023.

"Liquidity should be sufficient to carry [PBF] through 2021, but the absence of a recovery in the second half of 2021 could lead to significantly tighter liquidity thereafter," Fitch Ratings analysts warned Nov. 16, noting that PBF's revolving credit facility matures in 2023.

Refiners face a "tough choice, given the importance of both maintaining the dividend as well as repairing the balance sheet," Tudor Pickering Holt analyst Matt Blair said in a Dec. 11 email. "As long as the general trend is improving, I think refiners will try to hold onto the dividend and wait a bit to repay debt."

For now, it appears that the debt the investment grade refiners are carrying into 2021 has not spooked bond investors.

"Refining looks like a tough business to be in for quite some time to come, but bondholders clearly see some levers the [investment grade companies] can pull in the interim," said LCD senior director John Atkins. "They are giving the space the benefit of the doubt."

Pulling the levers

US refiners with high complexity facilities are better placed to handle low margins and can survive a slow multiyear demand recovery, analysts agree. But biofuel markets pose another near-term challenge.

"Refineries that focus on costs, local markets, and integration with petrochemicals or transformation into bio-refineries will be well-placed to survive," S&P Global Platts Analytics said in a recent report.

As demand recovered from a second-quarter bottom, refiners' discipline has kept refinery utilization low for the back half of 2020, which has been supportive of margins, but not enough to avoid the shuttering of about 900,000 b/d of North American refining capacity. Biofuels will play a larger role in the looming demand recovery, but that could force more U.S. closures.

Platts Analytics expects U.S. biomass diesel demand will reach 200,000 b/d in 2021, with renewable diesel demand making up about one-third of that. That growth will come "as transportation fuel use rebounds and fewer refineries are relieved of their blending requirements through hardship exemptions," said Corey Lavinsky, a biofuels analyst at Platts Analytics.

Under federal law, finalized 2021 renewable fuel volume obligations, or RVOs, were due by Nov. 30, but the U.S. Environmental Protection Agency has not yet proposed them.

"That brings additional uncertainty into the market," he said. "Refiners do not know how much blending will be required to meet their renewable volume obligations. This usually results in an increase in RIN prices."

RINs are credits that refiners or other obligated parties must purchase if they are unable to meet RVOs.

Biofuel demand growth and regulatory uncertainty has some companies making investments in production of the lower-carbon fuels.

Credit Suisse analysts said Dec. 17 they expect projects announced by Valero, Marathon Petroleum, Phillips 66, CVR Energy and HollyFrontier to begin operating over the next six months to four years, which will both add to their non-refining earnings stream and reduce their RINs exposure.

But rising RINs costs will remain an expense for the sector into 2021, as observers expect the incoming Biden administration to further biofuel blending for transportation fuels.