Consolidation In The Oil Industry: Valero/premcor

Lynne Kiesling

The Valero purchase of Premcor announced Monday is another interesting, if not surprising, step in the industry consolidation that started in the mid-1990s. The press on the Valero/Premcor deal seems to hit all of the right notes; I would add to this article on demand continuing to outstrip refining capacity that one of the stated drivers of the acquisition is the less-than-efficient utilization of Premcor’s major refineries. Premcor’s two largest refineries, in Delaware and in Port Arthur, Texas, could deliver more throughput with some reworking (according to some of the sources I’ve read). In fact, the Delaware facility has had some safety and process problems in the past. Thus part of the value proposition in the merger is Valero’s expectation that they can re-optimize the processes at the Premcor refineries. So it may create some additional capacity by increasing the load factor within the existing capacity. But, the last refinery in the US was built in 1976, and it doesn’t look like another one will be built any time soon.

Another angle that enters here is that this acquisition creates a better portfolio from which to produce the variety of fuels that are used to meet myriad federal and state enviromental regulations. The Premcor refineries, in addition to having the ability to process (cheaper and more plentiful) sour crude, may enable the merged firm to specialize more at each refinery in the production of particular types of fuels. Refining is an incredibly technically difficult process, and there are lots of ways to get different combinations of products out of a given stream of crude oil; when you combine that complexity with the complexity of fuel oxygenate requirements etc., the production process gets even more challenging and expensive. Bringing additional refineries into a merged firm may enable the merged firm to eke out some efficiencies by loosening one dimension of that complexity. [NOTE: a former student and I wrote a paper a couple of years ago with the hypothesis that the complexity of the federal fuel oxygenate requirements contributed to the consolidation of the industry through horizontal mergers. Unfortunately the data we would need to test the hypothesis are private, although the publicly-available financial data did not falsify the hypothesis.]

One of the things I find most interesting about this transaction is that it is a horizontal merger of two refining-only firms. The mergers of the mid-1990s were horizontal mergers of vertically-integrated firms. In this high-demand market firms are not using vertical integration to reduce costs, but are instead are consolidating within the specific part of the supply chain that they already inhabit. I continue to think that this merger pattern is consistent with the fact that environmental regulation has broken apart the economies of scale in petroleum refining, making it more costly, and that the mergers are a way to recapture those economies of scale.