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North American Refiners' Credit Strength Is As Good As It Gets

Investing in the refining industry is not for the faint of heart; a refining and marketing company's creditworthiness is tied to the commodity cycle and consumer demand patterns, as well as the vagaries of geopolitical factors on global prices and regional economies. However, independent refiners' performance in the decade leading up to the COVID-19 pandemic in the first quarter of 2020 belied the industry's inherent volatility. Now, unprecedented strength in refining margins has put the independent refiners we rate in an enviable position in terms of credit strength after almost 18 months of extreme weakness. The companies have more financial flexibility and options as we begin to see demand soften modestly in response to high retail prices; the increased risk of recession in 2023; and industry headwinds related to long-term demand patterns, environmental concerns, and the broader energy transition. We believe that North American refiners will be able to navigate the near-term risks of weaker demand and longer-term changes that should support ratings during the next few years.

Margins Should Decrease But Remain Robust

The industry has benefited from historically high refining margins since early spring 2022, when several factors converged to create a super cycle that refining companies had not experienced previously. What made this particular cycle unique is that demand strengthened beginning in the fourth quarter of 2021 and gained momentum into the first quarter of 2022 around the same time the Russia-Ukraine conflict began in late February. The global supply shock caused by the conflict, coupled with strong demand, sent commodity prices soaring and refining margins followed. For example, the U.S. Gulf Coast 3-2-1 crack spread (see chart 1) shows how margins rose in late February, peaking at almost $60 per barrel (bbl) in June, which is just shy of the peak margin of $61/bbl on April 20, 2020, when West Texas Intermediate (WTI) crude oil futures closed at negative $37.63/bbl due to tight storage and excess crude oil supply at the height of the COVID-19 pandemic. While refining margins have softened since they peaked in June, they remain well above the five-year average of about $15.50.

Chart 1


The pullback in demand is partly due to inflationary pressures and increasing worries about a U.S. recession. The nationwide average retail price for motor gasoline was about $5.40 per gallon in June and has since decreased to about $4.25/gallon, causing cost-conscious consumers to drive fewer miles and the Biden administration to suspend the federal gas tax of 18.40 cents per gallon for gasoline and 24.4 cents per gallon for diesel for three months. Crude oil by far makes up the largest percentage of the price of motor fuel, with various taxes and refining costs making up the difference (see charts 2 and 3).

Chart 2


Chart 3


Refining Utilization Remains Strong And Inventory Levels Are Returning To Normal

Refiners are taking advantage of the strong margins and are again running at pre-pandemic utilization levels (see chart 4). Utilization, which for the U.S. is about 17.9 million barrels per day of capacity, is back to the low-90% area as of the most recent Energy Information Administration (EIA) data from May 2022, with U.S. refiners running at close to full capacity, capturing the strong margins during the summer driving months. Utilization dipped to a historic low of about 70% in April 2020 as the global economy shut down from the COVID-19 pandemic and again in February 2021, as the pandemic effects lingered during what is typically a seasonal low for operating refining capacity.

Chart 4


Fuel inventory levels have begun to recover to pre-pandemic levels, too. Based on recent data from the EIA, fuels inventory levels are generally below five years, which we believe could lead to margins remaining above mid-cycle levels in the next 12 months if demand holds and inflationary pressure subsides. We looked at the time period from mid-March 2020 to late June 2021--the 15-month period where the COVID-19 pandemic in our opinion weakened demand and affected refining operations the most--and then analyzed demand patterns and inventory levels through August 2022 (see charts 5 and 6). Distillate fuel inventories spiked and remained elevated following the global economic shutdown in March 2020 but have been trending below the five-year average since January 2022 while demand has improved.

Chart 5


Motor gasoline inventories show a similar pattern to distillate stocks, albeit with more seasonality. Gasoline inventory typically builds in the fall through the winter months before declining as the summer driving season begins. The second inventory spike in June 2020 was a result of the pandemic, but inventories have continued to trend down since.

Chart 6


The transportation fuel that took the biggest demand hit during the COVID-19 pandemic was jet fuel. Demand hit bottom in the summer of 2020 and has recovered almost to pre-panedmic levels. Inventories are generally more tightly managed and were less volatile through the period we're focusing on.

Chart 7


Independent Refiners Have Tailwinds Heading Into 2023

We believe the North American independent refiners we rate are in the strongest position that they've been in years in terms of credit quality and financial flexibility. While macroeconomic factors, including high inflation and increased risk of recession, present some near-term headwinds, we think the industry drivers remain supportive, which should keep credit ratios strong through 2023.

Table 1

U.S. Refinery Expectations In 2020
Issuer Issuer credit rating Business risk Financial risk Reported debt FYE 12/31/21 Net debt/EBITDA Downgrade triggers
12/31/21 (Mil. $) † Net debt/EBITDA‡ FY22 forecast** Debt/EBITDA; FFO/debt

Flint Hills Resources LLC

A+/Stable/A-1 Satisfactory Minimal N/A N/A 0.1x > 1.0x

Phillips 66

BBB+/Stable/A-2 Satisfactory Intermediate 14,434 2.4x < 1.0x > 3.0x

Valero Energy Corp.

BBB/Stable/-- Satisfactory Significant 13,161 2.3x 0.75x-1.0x > 4.0x

Marathon Petroleum Corp.

BBB/Stable/A-2 Satisfactory Significant 28,034 2.7x 1.0x-1.5x > 4.0x

Motiva Enterprises LLC*

BBB/Stable/A-2 Fair Significant 2,706 1.5x 0.5x-1.0x > 3.0x

HF Sinclair Corp.

BBB-/Stable/-- Fair Intermediate 3,780 3.1x < 1.0x > 3.0x

Deer Park Refining L.P.*

BBB-/Stable/A-3 Fair Aggressive 1,664 (24.7x) 2.0x-2.5x Tied to PEMEX

PBF Holding Co. LLC

BB-/Positive/-- Fair Significant 3,269 4.0x 0.75x-1.75x > 4.0x

Delek US Holdings Inc.

BB-/Stable/-- Fair Significant 2,406 6.6x 3.5x-4x > 5.0x

CVR Refining L.P.

B+/Stable/-- Weak Intermediate 1,589 4.8x 1.75x-2.5x > 5.0x

Par Petroleum LLC

B/Stable/-- Weak Aggressive 650 6.0x 2.0x-3.0x > 4.5x

CITGO Holding Inc.§

B-/Stable/-- Fair Significant 1,859 5.3x 3x-3.5x Included in PDVSA bankruptcy

CITGO Petroleum Corp.§

B-/Stable/-- Fair


2,947 5.3x 3x-3.5x Included in PDVSA bankruptcy

Montana Renewables LLC §§

B-/Stable/-- Weak Highly leveraged 500 N/A 3.9x Tied to Calumet
Total debt 76,999
*Ratings uplift from strategic link to parent. Deer Park (bb-; linked to Petroleos Mexicanos (BBB/Stable/--), Motiva (bb; linked to Saudi Aramco). §Ratings constrained (CITGO's SACP 'bb') due to link with Petroleos de Venezuela, S.A. (PDVSA) . PDVSA's ratings were withdrawn due to the lack of timely information on June 12, 2019. †2021 Reported debt includes consolidated debt of the refiner and its operating subsidiaries, including operating/financing leases. ‡Represents group consolidated leverage metrics. Cash is not netted against debt for companies with a weak business risk profile. **Revised forecast for 2022. §§Montana Renewables (SACP of 'b') is 100% owned by Calumet Specialty Products Partners L.P. (B-/Stable/--).

Better Credit Quality Has Improved Ratings For Some

Stronger refining margins and industry fundamentals over the past year resulted in a reversal of fortune for the industry. Credit measures are at their strongest levels in more than five years. The cash flow windfall benefiting refiners improved credit quality and caused us to revise nine out of 10 outlooks to stable from negative. Also, in the past 12 months, we raised the issuer credit rating on PBF Holding Co. LLC two notches to 'BB-', with a positive outlook, putting the company within reach of the 'BB' pre-pandemic rating. The strong results for the second quarter of 2022 are the pinnacle of several consecutive strong quarters, where quarterly EBITDA at times matched companies' full-year mid-cycle results. We believe the strong credit profiles provide refiners with added financial flexibility as the cycle subsides, and we believe credit quality for some speculative-grade companies could further improve in 2023.

Capital Allocation Will Help Inform Our Future Analytical Views On Credit Quality

Refiners are flush with cash from strong profitability during the past several quarters, providing management with considerable flexibility when making future financial policy decisions. During the global economic shutdown, the independent refiners we rate borrowed more than $8 billion for additional liquidity so the industry could ride out the downturn. Some companies maintained their common dividends based on the belief that a recovery would take shape after a few quarters and over the long-term, demand for refined products would be little changed. Others suspended their dividends to preserve cash or reduce the cash burn. While we understood the rationale for maintaining a dividend for equity investors, in our opinion, it was clearly a negative driver for credit quality. That said, companies are now using their stronger financial positions to repay the debt that was borrowed and in some cases have restarted dividends and are aggressively repurchasing shares. We generally view share buybacks, if done at management's discretion rather than under a predetermined program, as not necessarily harming a company's credit profile. We tend to weigh share repurchases along with overall liquidity, discretionary free cash flow, and overall credit measures in forming our view. The three largest investment-grade refiners--Valero, Phillips, and Marathon--all maintained their common dividend payments (see table 2). Valero and Marathon also agressively repurchased shares, helped by the significant cash flow generation and in Marathon's case, the gross sale proceeds received from the Speedway divestiture of $21 billion in June 2021.

Table 2

Selected Discretionary Free Cash Flow
Cash Share buybacks* Dividends* DCF*
As of June 30, 2022 (in mil. $)
Valero Energy Corp. 5,392.0 1,904.0 1,604.0 5,384.2
Phillips 66 2,809.0 66.0 1,930.3 3,449.8
PBF Holding Co. LLC 2,174.3 0.0 39.1 2,312.5
Marathon Petroleum Corp. 13,319.0 9,847.0 2,720.0 2,122.0
HF Sinclair 1,702.2 132.3 90.2 885.0

CVR Energy Inc.

893.0 0.0 122.0 499.0
Discretionary cash flow (DCF) = operating cash flow minus capex, dividends, and share repurchases. *All figures are adjusted for the past 12 months.

The positive discretionary free cash flow generated provides financial flexibility and options for companies as they look to return money to shareholders, acquire businesses, or simplify corporate structures, much like the HollyFrontier Sinclair Oil Corp. transaction and PBF Energy Inc.'s acquisition of the public units of PBF Logistics L.P. while also redeeming high coupon corporate debt.

Rated Independent Refiners Are Well Positioned To Meet The Challenges Of The Energy Transition And Changing Demand Trends

The North American independent refining industry is among the most competitive in the world. Competitive advantages include high refining complexity, significant feedstock options, and lower-cost natural gas. That said, longer-term risks to the industry include climate change, increased penetration of electric and hybrid vehicles, more regulation, and slower growth in demand for refined products. We think refiners are in a position of strength for the next few years as the industry looks to meet these challenges, as some refiners pivot to converting a portion of their capacity to renewable fuels, which will enable companies to reduce emissions and benefit from various regulatory and tax credits. We believe the refining of hydrocarbons into transportation fuels will be needed for a considerable period and will generally support current ratings. Ultimately, we believe a refiner's financial policy decisions and its ability to adapt its core business of refining transportation fuels to meet changing demand will determine if ratings can remain resilient.

This report does not constitute a rating action.

Primary Credit Analyst:Michael V Grande, New York + 1 (212) 438 2242;
Research Assistants:Michelle Kogan, New York
Joshua Carter, New York

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