Marathon Oil’s (MRO) midyear spinoff of its refining operations to shareholders and a similar pending move by ConocoPhillips (COP) have raised questions as to whether the integrated approach to the oil business is being relegated to the dustbin of history. The answer is: On a selective basis, yes, but not entirely. The industry’s traditional business model involves combining oil drilling, petroleum refining, and chemicals manufacturing under one roof. That lineup has delivered big returns for investors over time, and has helped to provide a relatively safe group of stocks that generally offers good dividends and modest long-term upside potential.
But problems have arisen with the low returns that refining has delivered in recent years, following a short-lived "Golden Age" in the mid-2000s. One major difficulty is consistently turning a profit on products whose major input cost, crude oil, has risen notably in the past decade. Fuel demand has not fully recovered from the deep 2007-2009 recession, either, and the economic slowdown at hand further dampens prospects for consumption. There is also the ongoing threat of legislation calling for tougher emissions standards that periodically require significant capital spending. The federal mandate that more renewable fuel, mainly corn-based ethanol, be produced could also displace gasoline and lead to refinery closures.
Taken together, these hurdles are driving some diversified petroleum companies to part ways with their refining and marketing businesses. In addition to Marathon and ConocoPhillips’ initiatives, Murphy Oil (MUR) recently sold the last of its U.S. refineries to Valero Energy (VLO). BP (BP) has also put two of its stateside facilities up for sale, and may be tempted to make further moves, including potentially spinning off its refining segment, to reinvigorate operations following its disastrous 2010 oil spill.
One of the common problems encountered by companies exiting refining is that they are not geographically broad enough. All of Marathon’s refineries, and nearly all of Conoco’s, are based in the United States. The regional limitations are in contrast to the greater global exposure that Exxon Mobil (XOM - Free Exxon Stock Report), Chevron (CVX - Free Chevron Stock Report), and Royal Dutch Shell (RDSA) have in refining. The added scope allows them to benefit when industry conditions are better in a given part of the world. These industry leaders also tend to have greater integration between refining and chemicals operations. Not that these companies don’t suffer when refining margins are squeezed, but their global reach and the refining segment’s contribution to complementary businesses can help to mitigate the downside.
The major oil companies also use their non-oil producing operations to forge alliances that could lead to more business down the road. For instance, France’s Total (TOT) is partnering with Saudi Arabia to construct a large refinery in the desert kingdom by 2013. Having a successful joint venture with the Saudis doesn’t guarantee Total any extra work, but it may give it an edge over competitors if any projects needing technical or financial assistance were to come up.
In conclusion, companies opting to change from an integrated business model to specializing in oil producing or refining will enjoy enhanced flexibility to pursue tailored strategies. Their shareholders will be able to invest in specific segments of the oil and gas industry, and capital gains possibilities are enhanced for stocks of companies focused on a single business when their particular line is doing well. On the whole, the switch to a specialized approach appears more suitable for smaller integrated companies with more regional refining and chemicals operations.
The flip side is that companies lose a measure of stability when they break up. Oil producing and refining are complementary lines that, to some degree, balance each other out over the course of an industry cycle. Financial strength may also be reduced with the loss of overlapping businesses. And dividend growth could be more restrained at specialized oil companies, given the large capital requirements of drillers and the volatility of profits from refining. In all, there is still something to be said for the shares of companies that offer safety, stability, and rising dividend payments over time.
At the time of this article’s writing, the author did not have positions in any of the companies mentioned.