THE WALL STREET JOURNAL: Oil Refining: “This has prompted speculation that big integrated oil companies like Royal Dutch/Shell Group or BP PLC might float their refining and marketing portfolios. After all, Shell has already started a big program of disposals in other areas, including its liquefied-petroleum-gas business.”: Thursday 7 July 2005

Downstream has long been the poor relation of upstream in the oil and gas industry. Exploration and production was always far more glamorous-and profitable-than oil refining. Indeed, downstream has underperformed upstream in 12 of the past 13 years, according to Goldman Sachs Group Inc. estimates.

But thanks to soaring refining margins, downstream is enjoying a remarkable renaissance. Neste Oil, an independent refiner, is up nearly 40% after pricing at the top of the range in April. Alon Energy in the U.S. will debut soon. This has prompted speculation that big integrated oil companies like Royal Dutch/Shell Group or BP PLC might float their refining and marketing portfolios. After all, Shell has already started a big program of disposals in other areas, including its liquefied-petroleum-gas business.

It's easy to see why these companies might be tempted. Refineries are now valued at close to replacement cost, twice as much as the level they normally trade. Neste is now trading on 15 times 2006 earnings, a premium to both BP and Shell. On this basis, Shell's European refining portfolio might be worth as much as $10 billion.

Are such valuations sustainable? Much depends on how quickly new capacity can be brought onto the market. It takes about three to five years to build a new plant, but Morgan Stanley estimates that demand for refined products will grow twice as fast as capacity over the next two years. What's more, most of the extra oil being pumped into the market to meet the demand needs a lot of processing. This heavier oil is cheaper to buy than the lighter version. Refineries that can extract more sulfur from crude oil are able to cash in on higher margins. The forward curve for refining margins shows even higher returns for the next three years.

That suggests refining margins will stay high for at least the next few years. On the other hand, a slowdown in demand from China or the U.S. could put pressure on margins. So if oil groups such as Shell want to lock in today's high downstream valuations, they should move while the window of opportunity remains open.

Fiona Maharg-Bravo and Chris Hughes 

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