This article was authored by Michael J. Remsha, Managing Director and Vice President
In the later years of the 20th century and now in the 21st, oil refineries have become more and more complex in order to process higher sulfur and heavier crude oils into “boutique” types of gasoline and diesel fuel. These reformulated gasolines and diesels are required by governments to clean the air and protect the environment.
An oil refinery is simply an intermediary between crude oil and a refined product. It takes dirty, low-value oil from the ground and distills it under atmospheric pressure into its primary components: gases (light ends), gasolines, kerosene and diesels (middle distillates), heavy distillates, and heavy bottoms. The heavy bottoms go on to a vacuum distillation unit to be distilled again, this time under a vacuum, to salvage any light ends or middle distillates that did not get separated under atmospheric pressure; the heaviest bottoms continue on to a coker or an asphalt plant. Other product components are processed by downstream units to be cleaned (hydrotreating), cracked (catalytic or hydro cracking), reformed (catalytic reforming), or alkylated (alkylation) to form gasolines and high-octane blending components, or to have sulfur or other impurities removed to make low-sulfur diesel. Depending on the process units in a refinery and the crude oil input, an oil refinery can produce a wide range of salable products: many different grades of gasoline and gasoline blend stocks, several grades of diesel, kerosene, jet and aviation fuel, fuel oil, bunker fuels, waxes, solvents, sulfur, coke, asphalt, or chemical plant feedstocks.
Every refinery basically does the same thing. The first primary process unit is the atmospheric distillation unit, and for some refineries, that is the only unit. Called topping plants, these very simple refineries top off one or a few product streams that are easily marketable, and then sell the intermediate streams to other refineries for further processing. Typically, topping plants are very small, processing 5,000 to 10,000 barrels per stream day (“BPSD”). A refinery’s BPSD is the maximum amount the refinery would be expected to process in a day under perfect conditions. Barrels per calendar day (“BPCD”) is the amount a refinery would be expected to process, on average, in a day, deducting for maintenance and other anticipated downtime. Typically, BPCD is around 90% of BPSD.
As refineries include more process units, they become more complex; they then can process heavier (lower API rating) and more sour (higher sulfur content) types of crude and produce more types of products and feedstocks for other chemical plants. Simple refineries have low complexity factors. Complexity is simply an indication of the magnitude of a refinery’s processing capability. The complexity factor for a topping plant would be in the low single digits, say 1 to 3, and a larger, more complex refinery would have a complexity factor around 10 or 12. Some refineries have complexity factors as high as 18; this type of refinery has many process units and has the capability to process some of the heaviest, dirtiest, and most difficult-to-separate crude oils into a wide range of valuable products.
Another indicator of the refinery’s processing capabilities, equivalent distillation capactity (“EDC”), is calculated by multiplying the refinery complexity by the size of the atmospheric distillation unit. The concept of EDC allows for refineries to be compared in a meaningful manner based on their processing capabilities.
Additional process units are used to maximize the value of the barrel of crude oil or are required to meet state or federal environmental requirements. Because environmental requirements are constantly changing, refineries must constantly change the way they do business. Every change costs a refiner millions of dollars. One of the ongoing changes is the way they make and blend gasoline and diesel. A seemingly simple requirement to remove more sulfur from gasoline or diesel may require the addition of another hydrotreater (which could be considered a giant filter). However, if the hydrotreater removes more sulfur than the refinery’s current sulfur plant can process, another sulfur plant will need to be built. Then, because the new hydrotreater needs more hydrogen than the reformer produces or the current hydrogen plant can provide, another hydrogen plant would be needed. Off-sites (support units) also may have to be modified and expanded. So, we can see how easily what began as a $50 million hydrotreater addition could become a $200 million project. Nothing is simple or inexpensive at an oil refinery.
The basic economic principles that determine the value of oil refinery products and raw materials are supply and demand, and competition. As demand increases and supply of products remains constant, the price of the product rises. Because of higher profits, competition grows, which results in an increase in supply. When supply meets demand or possibly creates an oversupply situation, prices fall. Profits decrease and competition declines. This scenario basically represents the roller coaster of prices and values of the products produced at an oil refinery. As a result, refinery management must constantly monitor the prices of the products produced and also the types and prices of the crude oil they process. If the price of jet fuel increases, the refinery may make more jet fuel but less diesel. When the price of jet fuel decreases, diesel may be more desirable again. As a result of such factors, the slate of products produced at a refinery is not constant. These products are always being “tweaked” on the basis of pressures and performance of the market, the requirements of reformulated gasoline (“RFG”) legislation, and summer/winter fuel oil/diesel fuel demands.
In the 1990s, many refineries in the United States had to invest hundreds of millions of dollars to meet the requirements of the Clean Air Act Amendment of 1990 (“CAAA”) and, in California, the California Air Resources Board (“CARB”). Refineries made the investments, expecting an increase in the prices of their products and a commensurate return on their investment. However, it did not happen. Too many refineries were modified, resulting in an overcapacity in the industry. In 2001, the overcapacity situation was normalized, but with the increase in crude oil prices, the refineries are still in a very competitive market.
Environmental expenditures are still required today. Over the next few years, refiners will have to make investments to reduce emissions; reduce sulfur in gasoline and diesel; replace methyl tertiary butyl ether (“MTBE”) with another high-octane blending component (primarily ethanol); and reduce benzene, aromatics, and cetane concentrations in certain products.
The future restrictions placed on refineries will force more refineries (primarily small ones) to shut down, which will drive up the price of gasoline. The United States government supports the need for more refinery capacity and currently is reviewing future environmental mandates to remove more sulfur from gasolines and diesels. Even with the improvement in 2007 in the profitability of the refinery industry due to increasing demand and a limited supply, additional increases in cash flows are still required to support the building of a new refinery.
Approaches to Value
The basic economic principles discussed above interact with the three valuation methods appraisers use to estimate value: the sales comparison approach, the income approach, and the cost approach.
Sales Comparison Approach
The sales comparison approach uses the analysis of actual transactions in the marketplace to derive a value for a refinery based on the actions of buyers and sellers. This approach is a very powerful tool to use in a refinery appraisal because every refinery starts with the distillation of a barrel of crude oil, every refinery is operated to maximize the production of gasolines, and most refineries are relatively complex. To account for differences between comparable refineries and the subject refinery being appraised, the sales can be adjusted using the basic appraisal tools discussed in any valuation text. Adjustments are made for the following factors:
Size - The capacity of the atmospheric distillation unit
Complexity - The magnitude of refining or processing which the refinery can perform
Time - Differences in refinery economics between the appraisal date and the time of the sale
Age - Determining if the sale is physically of a similar age and level of technology as the subject
Location - Accounting for the subject being in a better or worse location concerning its ability to receive raw materials and to ship products to a market
Several other adjustments may be made depending on the circumstances. In addition, any inventories, intangible assets, marketing assets, or other assets must be removed from the transaction price to result in only the price of the tangible plant assets under review.
The market in refinery sales has seen a roller-coaster pattern over the last two decades caused by changes in profitability and environmental requirements mandated by governmental agencies. The market had been relatively predictable until 2006 and 2007. During the mid- to late 1970s, refinery values were higher because of the high level of profits in the industry and the continuously increasing demand for refined products in the United States. Then, in the early 1980s, refinery values began to decline because of a change in the federal small refiner bias, an overcapacity in the industry, and major industry restructuring. Refinery values peaked in 1988 and 1989, when capacity and demand equalized and profits increased. In 1990, the United States government passed the Clean Air Act Amendment, which required most refiners to decrease plant emissions and to modify the way diesel and gasoline were made. This led to the advent of low-sulfur diesel and reformulated gasoline.
Through the early to mid-1990s, few refineries were sold in the market; those that did sell sold for very low prices. As the industry implemented the requirements of the CAAA (which required investments of hundreds of millions of dollars with little or no increase in profits), more and more sales took place. By the late 1990s and through 2001, the sale prices of refineries, on a per-unit per-complexity-point basis, continued to increase (although they still were not as high as in the late 1980s). By 2007, sales prices of oil refineries had reached an all-time high, supporting what some call the “Golden Age” of refining. The consideration of these changes is critical to an analysis of a refinery’s value using the sales comparison approach.
The next indicator to value on our list is based on future income realizations. To develop these future income realizations, the income approach is the tool most frequently used by buyers and sellers in the marketplace. However, the primary difficulty of this method is the necessity to forecast the future. To accomplish this step, buyers and sellers use a matrix of income approaches to test their forecasts in as many different ways as possible. Thus, for negotiating sessions, buyers and sellers will know the high and low ends of their negotiation range.
Items to be forecast in the income approach include throughput and production, prices of the products produced, refinery gain, raw material costs, operating expenses, future capital expenditures and sustaining capital requirements, and the capitalization or discount rate.
Often, forecasts for prices of products and raw materials are available from various published sources. Throughput, production, and refinery gain can be forecast by reviewing past performance, the future budget for the plant, and the plant’s material balance. Operating expenses can be projected by reviewing operations over the past three to five years. Future capital expenditures are commonly budgeted by plant management for three-, five-, or ten-year periods. Beyond the budget, 2% to 3% of the replacement cost will be necessary for sustaining capital, just to keep the plant in safe operating condition. It is especially important to review environmental requirements in the future and make sure they are included in the budget.
The forecast is typically projected over a period of at least 10 to 12 years, sometimes 20 to 30 years, or even into perpetuity if the market is strong and the subject plant has a long economic life. It is most common to develop a discounted cash flow (“DCF”) rather than just capitalizing one year. The industry typically is not stable enough to forecast a one-year normalized income stream. Participants in the market develop after-tax, debt-free cash flow (or free cash flow) streams that reflect the income level received by equity and debt holders. Depreciation is calculated using tax schedules, often accelerated schedules, to reflect the buyer’s new tax basis.
The discount rate that is to be applied to an after-tax, debt-free cash flow stream is developed using a weighted average cost of capital (“WACC”). This requires an investigation of publicly traded common stocks to develop a typical capital structure (equity and debt weightings) and beta (a measure of the volatility or risk inherent in the industry). The capital asset pricing model or the build-up method is used to derive an equity investor’s required return on an investment in the subject refinery. Adjustments must be made for risks inherent in the single plant being valued and the additional risks of equity ownership. Debt cost is high because of the risk of the single-plant nature of the investment; thus, BAA or BBB industrial bonds (higher risk but not junk) are utilized. The WACC is then calculated on an after-tax basis and applied to the forecasted cash flow stream.
The result of the income analysis is the business enterprise value associated with the operating plant. To determine only the value of the tangible assets, deductions must be made for working capital and intangible assets. A normal level of networking capital is estimated based on a comparable company analysis. The intangible assets, which may include the trained and assembled workforce and management team, operating manuals and procedures, software, emission credits, and many others, also must be valued. The resulting income indicator of value for the tangible assets includes the real estate comprising land, buildings, and land improvements; and the personal property, both battery-limit process units and off-sites or support assets.
The last method to be investigated here is the cost approach. This approach in particular requires a certain level of knowledge about the economics of, and the technology utilized in, the industry. In applying the cost approach, the appraiser must calculate the current cost of the plant, using the reproduction cost new of an exact replica and/or a modern replacement. The difference in the two costs is a form of functional obsolescence or a loss in value from within the property due to excess capital costs.
A deduction must be made for physical depreciation. This deduction is based on wear and tear experienced by the property.
At this point in the cost approach, economic obsolescence, or a loss in value from an external economic factor, is investigated. Knowledge of industry economics is necessary for this investigation. This may include a study of industry margins, supply/demand relationships, competition, return on capital, or a comparison of refining industry returns with a benchmark such as the S&P 500.
The next deduction is for another form of functional obsolescence - operating obsolescence caused by changes in technology. New or different technologies frequently result in better control systems that increase yield, and reduced labor and energy requirements make the new modern plant more valuable. Major forms of operating obsolescence are typically found in the catalytic reformers and in the catalytic cracking units. The subject plant’s performance must be compared to that of the modern replacement plant to derive a penalty the subject must endure over its remaining life. After developing the present value of the penalty, a deduction is made for operating obsolescence.
The last deduction is a form of both functional and economic obsolescence that is sometimes called a necessary capital expenditure. This capital expense is required by a government agency primarily for environmental reasons. Again, based on the plant budget forecast, the present value of these capital costs is developed, then deducted.
After all these deductions are made, the value of the land is added after deducting any known and budgeted clean-up costs from the land value as if clean. The result is the cost indicator of value.
Correlation – Concluding a Value
At this point in the appraiser’s process, three indicators of value have been developed for the subject assets. The sales comparison indicator can be a strong indicator of value because it reflects the actions of buyers and sellers in the market. A buyer put money on the table and actually purchased a plant, and a seller actually sold it. Even in a market that has few sales, the appraiser cannot ignore the market. Of course, the sales must be investigated to ensure the sale data used reflect a refinery similar to the subject. The sales do not have to be exactly the same, since they will be adjusted to the subject, but they should be as similar as possible. By using even one, two, or three sales, the appraiser will have at least a range of value in which the subject property should fall.
The income approach, as mentioned above, is the method on which buyers and sellers rely to make a decision. They make the market. But it should be remembered that appraisers reflect the market; they do not make it. Participants in the market generate many income approaches because they cannot forecast the future with any degree of certainty - no one can! They are preparing to negotiate a price. Appraisers use the results from buyers and sellers in the sales comparison approach and try to copy them by developing an income indicator of value based on projections into the future and an industry-based discount rate. The income approach can be very volatile because of even very minor changes in the forecast. While it is a useful valuation tool, the income approach must be supported by either the cost or sales comparison approach to increase its reliability.
The cost approach is especially useful for unique or special-purpose property where comparable sales are not available and an income approach is not possible. It is, simply, the development of the current cost of the property being valued, less all forms of depreciation and obsolescence, plus land value. To develop the cost approach, the appraiser must be knowledgeable of the economics and technology in the industry. A complete and detailed cost approach analysis is very time consuming, but of the three indicators of value, it is the one that produces the most subject-specific detail.
The most supportable appraisal, a complete appraisal, utilizes all three indicators of value. All three indicators reflect the market: the market as defined by refinery buyers and sellers; as defined by the buyers and sellers of refinery products, raw materials, operating expenses, the current cost of equity and debt; and as defined by current construction costs, new technology, and industry economics. In a perfect world, all three provide the same value conclusion, or at least define a narrow range. In reality, correlation of the values indicated is often required.
When deriving a conclusion from the investigation and analysis of the market, the appraiser must use judgment, experience, and common sense to correlate the final conclusion of value for the subject refinery. The correlation and conclusion must be based on the market, not some “pie in the sky” forecast. When the market speaks, appraisers listen.
Previously published in "Appraisaing an Oil Refinery in the 21st Century," Machinery & Technical Specialties Journal, Volume 17, Number 4 (2000-2001 Fiscal Year)
About the author:
Michael J. Remsha is a Managing Director and Vice President with American Appraisal Associates, Inc., in Milwaukee, Wisconsin. In this capacity, he provides direction and technical support on the valuation of special-purpose and personal property. He has been a full-time appraiser since 1977. Mr. Remsha has valued over half of the operation refineries in the United States and many in Europe and Asia.
About American Appraisal:
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