No business model is proven until it survives a calamity. In fact, to test the efficacy of a business model, we often subject it to extreme tests to see how well it responds, or conversely, how quickly it breaks. A problem, though, is that reality sometimes churns out scenarios--such as the economic shock in the wake of the COVID-19 pandemic--that we wouldn't normally consider likely. The stress scenario imposed by this economic shock is important to our relative assessment of cross-sectoral performance. The impact of the economic shutdown also gives us the opportunity to collate data points that help us assess the intensity and duration of our downside stresses.

We receive questions about the comparison of the refining and independent power producer (IPP) sectors, especially because we rate five investment-grade refiners, but only one U.S. IPP-- Energy Harbor Corp.--has an investment-grade rating, if only because it recently emerged from bankruptcy and has no net leverage. We note, however, that we have positive rating outlooks on three IPPs-- NRG Energy Inc., Vistra Energy Corp., and Calpine Corp.--while we have recently revised outlooks on a few refining companies to negative. Table 1 below lists the recent rating actions and outlook changes in the refining and IPP sectors.

In this commentary, we briefly compare and contrast the two sectors and discuss the credit factors that influence our views of companies in each sector. This commentary is an overarching comparison of the sectors in terms of key credit risks and credit drivers. For detailed credit views on the sectors in the wake of COVID-19, please see the referenced commentaries below.

Table 1

The Refining Sector Is Much Larger In Scale And Scope Of Operations, As Well As Balance Sheet Size

Our business risk profile (BRP) assessments essentially capture the competitiveness of an industry and the competitive position of a company within that industry structure. Based on competitive advantage, scale and scope, and operating efficiencies, refiners are dominant players and are much larger than the IPPs (table 2). For instance, our expectations of pre-COVID-19 EBITDA levels for refiners was almost two to three times that of the largest IPP.

In addition to geographic diversification across the Petroleum Administration for Defense Districts (PADD) regions, the refiners also diversify operations within the midstream and downstream segments across other businesses such as pipelines, specialty chemicals, renewable diesel, and retail operations. While corporate average fuel economy standards have resulted in declining gasoline usage, and longer-term substitutes (electric vehicles) will further cut into gasoline and diesel demand, consumption of refined products will remain high over the foreseeable future. Entry barriers are also steep because of high capital costs and stringent permitting requirements, even for debottlenecking existing capacities.

The midstream business offers refiners such as Marathon Petroleum Corp. and Phillips 66 greater diversity compared to, say, a peer such as Valero Energy Corp. because the refining and midstream segments behave differently under various crude prices. When crude prices rise, the diversified refiners perform better than pure play refiners, because their midstream segment will thrive in such a scenario as a result of the increase in oil volumes produced and transferred at higher prices. Conversely, when the price of crude collapses, the refining segment becomes the most profitable segment because low crude prices improve the demand for oil products and boost refining margins.

We note that in an unusual market scenario such as this where product has limited avenues through which to flow, access to discounted crude is less relevant. However, even under the prevailing conditions, we think diversity in Valero's operations across PADDs is advantageous because we have a more negative view on midcontinent refining as U.S./Canadian production slows. Valero, for instance, is better positioned among peers, given its low cost structure and access to discounted crude and commercial capabilities. With the highest Nelson complexity index in this peer group, Valero can benefit the most from the price gyrations of oil and refined products by optimizing its blend of feedstock and products. Specifically, Gulf Coast access and coking ability presents Valero with a larger slate of crude availability, evacuation routes for products, and potentially higher capacity utilizations.

Table 2 presents a broad comparison of the major players in the refining and IPP sectors. Note that for this comparison, we self-selected the investment-grade refiners (with Flint Hills Resources LLC excluded as a division of Koch Resources LLC).

Table 2

Compared to refiners, IPPs have lower EBITDA and weaker balance sheets. The price-taking nature of the power fleet exposes the wholesale power business to the vicissitudes of not only power prices but also to prices of various fuels. IPPs had historically mitigated merchant power risks by ratably hedging their economic generation forward two to three years. And power markets had typically provided better pricing discovery and recovery over a three-year period that allowed some predictability of revenues. However, the proliferation of renewables and advent of cheaper shale gas since 2011-2012 have resulted in a secular decline in power margins for conventional generation assets. While the refining and IPP sectors have seen substitute technologies emerge (electric vehicles and renewables/batteries, respectively), with the largest fuel switch already under way, disruptive forces are playing out in the power industry.

In recent years, IPPs have adopted an integrated wholesale-retail power model that has provided additional protection from the volatility of commodity prices. Retail power customers provide a home for the company's wholesale power business. When well-matched, the retail business provides a native hedge for the wholesale business, and the company becomes a better-integrated power platform.

From a credit perspective, we note that until COVID-19 spread to the U.S., even as power markets were in a secular price decline, IPPs operated in a relatively sanguine period of mild to moderate volatility. We believe the business model has not yet been stress-tested enough, and IPPs have not demonstrated a performance track record that the refiners have established over the past decade. How the IPPs perform through this stress period through third-quarter to year-end 2020 will inform our reassessment of their business risk.

Refiners Are More Levered To The Economy; In Contrast, IPPs Appear Resilient Thus Far

The strength of a business risk profile is also reflected in the stability of the company's generated cash flow. That aspect of the BRP is subsumed in the assessment of a company's absolute profitability and the volatility of that profitability.

Refiners are directly levered to the economy; an economic shock hurts demand immediately. Also, refined products are typically not hedged, and refiners feel the pricing impact (crack spreads) of an economic slowdown swiftly. We saw gasoline demand fall over 50% in late March and early April 2020, to about 5.1 million barrels per day, a level not seen since January 1969. We note that U.S. gasoline inventories peaked in April on a days-of-demand basis. The increase in U.S. distillate inventories is less severe than the increase in gasoline inventories, and diesel inventories are still near five-year historical average ranges. Most refineries have paid for high-priced crude oil feedstock and received much lower prices on their refined products during the pandemic-related lockdowns, and that has been a significant use of cash.

To be clear, IPPs are also affected by slowdowns, but the effects lag: A slowdown in industrial and commercial activity dominoes into lower electric usage. Also, power companies ratably hedge their economic generation and are typically heavily hedged in the prompt, or current, year. The IPPs have also promoted their integrated business model as one that is more about managing the retail load to wholesale generation matching, rather than the long commodity position. They contend that as natural gas prices have moderated and become less volatile, the merchant commodity risk is now manageable through a proportionately sized retail business because it moves countercyclical to the wholesale business.

Chart 1

The effect of these differences is evident from charts 1 and 2, which compare our expectations of pre-pandemic financial performance with our current estimate of performance for these companies in both sectors.

For the refining sector, our estimates factor what we anticipate will be an extremely weak second quarter, weakness that we think will continue into the third quarter. Our forecast assumes that demand gains momentum in the fourth quarter, which will lead to profitability and EBITDA that is closer to more normalized refining margins. Most refining margins are currently well-below historical levels, which are the result of depressed crack spreads. We note that refiners may remove guidance as a result of the uncertain environment. If EBITDA figures deviate substantially from expectations, rating actions will likely follow. The negative outlooks on some indicate such uncertainty.

There are regional differences: The Gulf Coast is performing relatively stronger. Of the refiners we compare Marathon Petroleum has seen the most negative demand effect across the West Coast and midcontinent regions. In the second quarter, we expect the company's utilization to be about 65%, and that accounts for turnaround activity at the Carson (Los Angeles) and Galveston Bay refineries. Utilization on the West Coast has been lower relative to the rest of the system, or about 50%, given the more severe demand impact in that market. Marathon Petroleum indicated it has temporarily idled its Martinez and Gallup refineries. Similarly, Phillips 66 noted that it ran crude utilization in the high-60% area in April with economic run cuts, as well as turnaround activity at Alliance, Sweeny, Los Angeles, Bayway, and Ponca City during the quarter. We note though that the second half of year turnarounds might become a poor decision from a lost margin perspective if economy turns around.

Chart 2

In contrast, IPPs typically hedge their economic generation substantially in the prompt year, and most companies entered 2020 with 90% of generation hedged before the crisis deepened, insulating themselves from the immediate impact of demand destruction. Although that mitigates power price risk this year, there could still be volumetric risks because load shapes shift and moderate. Also, the margin at risk from wholesale power business presents a larger risk for companies such as Vistra Energy Corp. and Calpine Corp., which are materially long in generation capacity relative to their retail load, compared to companies such as NRG Energy Inc. For instance, Exelon Generation Co. LLC is significantly long in wholesale electric generation in the Midwest and mid-Atlantic compared to the retail load it serves, while Vistra and Calpine are long generation in Electric Reliability Council of Texas (ERCOT).

Power contracts in the small commercial and industrial (C&I) and large commercial and industrial (LCI) segments tend to be block and settle, or indexed, or fixed-price products. The break-out is important because fixed-price products have volumetric risks. C&I contracts in the Northeast and Midwest have a higher proportion of fixed-price products (90%-100%) than in ERCOT (65%). Compared to the 2008/2009 financial crisis, we now are seeing a greater effect on commercial sales, given numerous establishments are outright closed. While the impact was muted in the first quarter, we expect to see higher levels of credit weakening as the C&I segment experiences the full onslaught of the slowdown in the second quarter.

In our forecasts of the pandemic's impact, we have focused more on companies that contract power with small C&I and LCI exposure. We also reviewed the nature of hedging activities in these sectors. In terms of demand loss for our analysis, we are assuming C&I demand is down 15% through August, and down 10% through December. We also assume a 20%-25% reduction in to-be-sold volumes through 2020.

We Are Monitoring Performance Through This Stress

In our view, refiners have demonstrated the ability to bounce back in an eventual economic recovery, as evidenced by their performance following the Great Recession, as well as the first half of 2016, when oil prices crashed from a combination of a slowing economy in China, a supply excess from new U.S. shale basins, and unabated oil pumping from Middle Eastern players.

At present, Gulf Coast 3:2:1 refining margins remain below five-year average levels. Yet, they have recovered from the late March bottom, driven by a steady improvement in Gulf Coast gasoline margins, which are now near 2019 levels. We also think demand likely bottomed in mid-April with 10%-20% improvement off the lows since, depending on the region. However, the pace and slope of the recoveries remain uncertain.

As we move through 2021, we expect refining and chemicals margins to move back toward midcycle levels. However, this assumes some momentum in an economic recovery and no resurgence in U.S. COVID-19 cases. It also assumes that the industry will work through the significant gasoline inventory glut that has accumulated since stay-at-home mandates began in mid-March before refining operations can ramp up. A W-shaped recovery, or a deeper impact into the third quarter, would further pressure refiners' credit qualities.

Our concern is that declining loads could have a secular slant (i.e., some segments do not rebound and are permanently impaired) that could hurt power prices over the long run, just as the past recession lowered load 4%-5% for a sustained period. We expect to see lumpier changes for industrial load since economic activity slowed dramatically in early April. As more manufacturing facilities shut down, the impact of industrial demand for natural gas has been larger than that during the financial crisis. Market experts we spoke to estimate the resulting demand decline is about 2-2.5 billion cubic feet (Bcf)/day (10% of weather-normal use). Similarly, the effect on gas demand for power burn also appears to be larger than what we observed during the financial crisis at about 1.75-2 Bcf/d in April-May 2020 (7.5% of weather-normal use).

We expect industrial activity will climb back in the third quarter and recover significantly through December 2020, while power demand recovers more quickly through September, except in pockets of slower growth such as the C&I segment. This is an important assumption for our views on the sector.

The Two Sectors' Differing Exposures To The Economy Influence Our Financial Risk Assessments

Table 3 presents how we score the subcomponents that inform our business and financial risk profiles for refiners and IPPs. We're focusing on the volatility of profitability for both sectors and assessing whether retail power operations of IPPs provide them with enhanced diversity that could eventually improve their business risk profiles.

Table 3

The past decade has lulled the refining industry into a state of moderating volatility, aided by wide domestic crude differentials as a result of the shale revolution, consistent economic growth, and consumer demand. However, refining cash flows can swing wildly. It is no coincidence that refiners typically operate their business at low leverages. It is not a choice; it's a requirement.

That is because expectations are more realistic than forecasts because they provide a vision of the future stripped of all false precision. If a refiner knows a slowdown will come at some point over a five-year period, it operates the business at a leverage that can withstand the shock as financial ratios decline to midcycle--or even downcycle--levels. Because refiners do not hedge their production, putting extra padding around the risks they can see is the way to prepare for the risks they can't see.

Many of the refiners we rate experienced a drain on cash liquidity because of the sudden and dramatic drop in crude oil prices, which was due to the working capital changes and the timing of crude payments. As a result, the current focus remains on capital discipline and liquidity. Most refiners are taking steps to boost liquidity during the stay-at-home periods through short-term credit facilities with their bank groups, public note issuances, or a combination of the two. We saw all three major refiners raise $1.5 billion-$3 billion of three- to five-year notes over the past two months.

Refiners are also trimming capital expenditures. Marathon Petroleum announced it has reduced 2020 consolidated capital spending by $1.4 billion, to $3 billion. Similarly, Phillips 66 indicated that it has deferred some turnaround activity to later this year and into 2021. Deferred projects include CP Chem's final investment decision on the Gulf Coast II project, as well as the deferral of the fluidized catalytic converter unit upgrade project at the Ponca City refinery. Valero updated 2020 capital spending guidance to $2.1 billion from $2.5 billion, as a result of slowing work on the Port Arthur Coker and the Pembroke Cogen unit, delaying mechanical completion by six to nine months. Dividend reduction, or elimination, and asset sales are other levers that refiners can consider, such as what PBF Energy Inc. announced in March.

Because IPPs hedge their generation on a ratable basis over two to three forward years, they operate at higher leverage levels. However, S&P Global Ratings has been skeptical about the long-term efficacy of the retail offset. While the retail businesses have indeed provided some stability to cash flow over the past decade, we do not have good visibility into how these business performed during the Great Recession because the typical retail business was small at that time. We think a recession could hurt both wholesale and retail terawatt-hour volumes. In fact, we wanted to see the resilience of the integrated business model in a recessionary environment to hone our assessment of the volatility of profitability for IPPs.

We base the volatility of profitability on the standard error of the regression for a company's historical EBITDA, EBITDA margins, or return on capital. While we typically believe that seven years is generally an adequate number of years to capture a business cycle, perversely, this pandemic-driven demand decimation would likely suffice as a stress test to validate that claim. How well these companies can handle the volumetric risk would be a vindication of that model, in our view.

What This Means For Credit Quality And Relative Performance

Our analytical approach to rating independent refiners accounts for the possibility for significant cash flow volatility. We typically focus on adjusted debt to EBITDA as the main financial ratio to assess a company's financial risk. Our debt-to-EBITDA downgrade trigger generally reflects our expectations for financial leverage during a period midcycle margins, which smooths out the peaks and troughs refiners experience throughout a commodity cycle.

While key credit drivers for refiners have not changed, given this unique economic stress, we see a need to be more transparent about our expectations of refiners. We may start publishing our downcycle financial ratio expectations in addition to our midcycle expectations.

For IPPs, we think the impact of the economic slowdown has been relatively muted so far, especially when compared to sectors such as oil and gas, as well as refining. Even during an unprecedented shutdown such as this, it takes time for the energy juggernaut to slow. Operational diversity and countercyclical retail operations that provide a native hedge certainly can make a significant difference to the credit quality, in our view.

Given their focus on reducing leverage in recent years, the IPPs on positive outlook are in much healthier shape from a balance sheet and liquidity perspective. Only Exelon Generation has near-term maturities; some companies have their nearest maturity stretched out as far out as 2023 or 2024. Moreover, all companies generate free operating cash flow under our base-case scenario, even after the COVID-19-related sensitivities. Arguably, the cash flow will be lower and the financial ratios a trifle weaker than what we had estimated for 2020. Still, that may not affect the credit profiles of these companies because they could simply change their capital allocations to keep reducing leverage. For an upgrade to 'BB+', we would expect companies such as NRG Energy and Vistra Energy to sustain adjusted debt to EBITDA of below 3x and adjusted funds from operations to debt of above 25%. We expect to start reviewing the positive outlooks by year-end as the economic recovery materializes.

An investment-grade rating would require some confidence that the forward power markets are structurally sound and will not witness an erosion in price because of a decimation of load. Based on forward curves and current hedges, there is the possibility of a 10%-15% decline in wholesale EBITDA of IPPs in 2021 in isolation, before hedging and mitigation. However, IPPs have shown their ability to hedge into the volatility, despite a backwardated forward curve. In fact, we think IPPs are likely hedging in ERCOT right now for 2021 because the forward curve is still structurally strong and holding up well. For example, in its first-quarter 2020 earnings call, Vistra indicated that it is about 57% hedged for 2021, noting that nearly 70% of its EBITDA comes from the ERCOT market.

Yet, we see the ability of IPPs to preserve future cash flow as a material risk if a second wave of coronavirus cases emerges, or if the actual path of the recovery is much slower than anticipated.

There are two paths for IPPs to achieve investment-grade ratings. They could continue on their leverage-reduction path such that they can sustain adjusted debt to EBITDA at or below 2.5x, which would result in an improvement in the financial risk profile category to intermediate from significant. Alternatively, a relatively stable performance through the recession and some visibility on the resilience of the forward power curve could result in a category improvement in their business risk profiles.

Related Research

• Cure For Pandemic's Spread To North American Refining Is Time, May 29, 2020
• Unregulated Power Update: Independent Power Producers Navigate Falling Demand And Credit Risks In Wake Of Economic Shock, May 6, 2020