"With these measures still in place, pure refining companies, which were far more affected by the deep trough in refining than integrated oil and gas companies, are now better prepared to cope with a potential extended period of volatile profits on a path to firmer recovery in the medium term. However, Fitch also notes that for those companies which have already made meaningful operating cost and capex reductions there may be little room left for further cuts if market conditions worsen," added Wicik.
Although European refining margins and refiners' cash flows improved in H110 versus H109, refining margins softened in July-August 2010 and remained below the mid-cycle levels for Q3. This poses a threat to the still fragile sector recovery in the past two quarters from the cyclical trough of 2009 when profits reached multi-year low points - EBITDA of complex refineries often fell by 40% or more in 2009 (excluding the inventory holding result), while many simple refineries reported losses. Although 2010 is shaping up to be a moderately better year for European refiners than the very weak 2009, it should be noted that margins and cash flows remain well below the multi-year average.
In terms of Fitch's global coverage of oil refiners, rating affirmations were prevailing in 2010-to date as many companies reduced their capex plan and focused on free cash flow generation. However, the ratings of three US refiners, Sunoco, Inc ('BBB-'/Stable), Tesoro Corporation ('BB'/Stable) and CITGO Petroleum Corporation ('B+'/Stable), were downgraded by one notch in 2010 mainly due to the weak cash flow generation environment for the US refining sector, which was also burdened with weak demand and subdued utilisation rates. The most recent rating action for European refiners was a change in Outlook to Stable from Negative for Poland's largest refining and marketing company Polski Koncern Naftowy ORLEN S.A.'s (PKN, 'BB+'/Outlook Stable) due to improved cash flow and the company's efforts to increase financial flexibility. Currently, out of the 13 refining companies rated globally by Fitch on an international rating scale, 11 companies have a Stable Outlook while the remaining two are on Negative Outlook.
In its rating-through-the-cycle approach, Fitch uses mid-cycle assumptions for its projections of rated refining companies. The agency assumes in its central case for projections that refining margins will be gradually improving and will reach long-term average levels around 2012. However, volatility is expected to remain in place, which requires sufficient financial flexibility and a liquidity buffer for higher-rated names.
Weak demand in Europe is particularly concerning, as refinery utilisation rates remain depressed (about 80% in 2009 and 81% for H110), well below the 2004-2008 average of almost 90%. This has increased fixed cost per barrel and reduced company-specific refining margins. Although global oil demand, moving closely in line with demand for oil products, is expected to grow this year by 2.2% (according to International Energy Agency data) primarily due to growth in Asia, European demand is expected to continue to shrink by 1.4% in 2010, following a steep 5.5% decline in 2009. Further pressure on weak supply-demand fundamentals in Europe comes from additional refining capacity being put on stream as a result of projects initiated several years ago (including projects in Spain, Poland and Greece). Fitch believes that European refineries may see only a slow improvement in refinery run rates on the back of anaemic economic growth expected for 2010-2012, which is considerably weaker than the global economic growth projected by Fitch in this period (see Fitch's latest Global Economic Outlook, published on 1 July). The improvement in run rates will also depend on the closure of less efficient refineries or conversion to storage facilities.
Fitch notes that the continued structural weakness of European refining and much better conditions and prospects for oil and gas production has caused many integrated players to increase their strategic focus on the oil and gas upstream segment and reduce capex for the downstream segment and redeploy downstream assets. In particular, the recent trough was difficult for refiners with a high share of middle distillates in their production output. Despite long-term expectations of structural growth in European demand for diesel at the expense of petrol - resulting in expectations of better diesel crack spreads than for petrol - the crack spread on diesel performed much weaker than petrol crack spreads in the recent trough. This was mainly driven by higher exposure of diesel demand to the economic crisis than in the case of petrol.
