Brent crude oil traded at a 13-month low of USD76/barrel on 10 October 2008, down from an all-time-high of around USD145/barrel in early July 2008. In the past 18 months to June 2008, EBITDA and funds from operations (FFO) of companies operating in R&M were boosted by non-recurring inventory holding gains as a result of the increase in crude oil price since early 2007. In H108 inventory holding gains were particularly high and accounted for as much as 50% of operating profit for some pure European R&M companies or fuel marketers and around 20% for some integrated oil companies.
These inventory gains and losses lead to considerable profit volatility, particularly in quarterly results, given fluctuations in oil prices and the large quantity of inventories of crude oil and oil products (including compulsory stock required by the EU) held by European companies with operations in R&M. Fitch notes the size of inventory holding gains/losses has increased since Q208 as nominal quarterly changes in oil prices have been substantially greater than in 2003-2007.
Fitch's credit analysis adjusts profit and FFO reported by European R&M companies by excluding inventory holding gains and losses and treating them as non-recurring items. Adjusted profit and FFO are primarily driven by changes in refining margins, which in turn are the main driver of a refiner's cash flow. Fitch notes refining margins for complex European refineries remained relatively solid in the first nine months of 2008, though lower than in the corresponding period of 2007, leaving underlying credit quality largely unchanged.
In addition, the fall in oil price has lessened working capital needs of companies operating in R&M because the value of inventories held continues to decrease as companies replace older, more expensive inventory with cheaper stock at current prices. This has enabled refiners and marketers to reduce their drawings under working capital bank facilities and has especially benefited highly leveraged companies given current difficult credit market conditions.
Within the European R&M sector, the cost of inventories is measured by either the "first-in first-out" (FIFO) method or average historical cost method, leading companies to report inventory holding gains in a rising crude oil price environment and losses in a falling price environment. This is because revenue is reported based on current prices of oil products, while cost of sales is calculated using historical crude oil prices. This time lag may be up to 30 days or even more, depending on the amount of inventories held on the balance sheet, the pricing formula for crude purchases, the period needed to transport crude oil to refineries, the processing period of refineries, and the cost calculation method. This contrasts with the "last-in first-out" (LIFO) method used widely by US oil and R&M companies, which is not impacted by the inventory holding result because it calculates the cost of inventories at the current cost of supply.
In a special report entitled "Inventory-Related Disclosure in European Refining and Marketing" published on 27 August 2008, Fitch provided an overview of supplementary disclosure by select European companies with operations in R&M of inventory holding gains/losses and profits on a replacement cost basis. The agency believes that improved and more consistent disclosure of inventory holding gains and losses would be a positive development for the refining sector.
