Valero Can Keep Pumping Profits; An exceptional 2022 has raised the bar for U.S. oil refiners, but conditions still look favorable

The good times aren't over for U.S. oil refiners.

Refining giant Valero Energy's results released Thursday showed how exceptional 2022 was for the sector, especially in the U.S. On an annual basis, the company made a gross profit of $21.82 per barrel of refining throughput, more than two times what it commanded prepandemic.

The company's net income for the fourth quarter was 10% higher than what analysts polled by Visible Alpha expected, resulting in its best annual profit on record. Valero's shares, already up 13% year to date, rose another 1.8% after the earnings call.

A number of factors converged to make refining profitable last year globally, but especially so for the U.S. market. Capacity shrank globally after the pandemic decimated fuel demand, which meant there wasn't enough to match the gasoline and jet fuel demand rebound when normal travel patterns resumed.

Meanwhile, sky-high natural-gas prices in Europe meant there was a higher floor on refinery margins since the rising input cost supported higher diesel and gasoline prices globally. High European natural-gas prices also gave U.S. refiners using relatively cheap domestic natural gas a cost advantage.

Additionally, high energy costs in Europe led refiners there to use light, sweet crude oil that is less energy and hydrogen-intensive to process. That widened the usual discount for the harder-to-process heavy, sour crude, which U.S. refiners tend to use as feedstock. New regulations that require ships to use low-sulfur fuel—known as IMO 2020—further contributed to the discount in sulfur-heavy sour crude.

Richard Joswick, head of near-term oil analytics at S&P Global Commodity Insights, said that if 2004 to 2007 was the "golden age" of refining then 2022 was a "platinum age."

While an exceptional 2022 has raised the bar for refiners, conditions still look favorable. Valero Chief Executive Joe Gorder said on Thursday's earnings call that the company continues to see "large discounts" for heavy sour crude oils and fuel oils.

Valero is scheduled to finish construction on a coker and sulfur refinery unit in Port Arthur, Texas, during the second quarter that should improve its ability to process heavy-sour crude oil. And, while natural-gas prices in Europe have come off their peak, the U.S. still has a huge cost advantage: the Dutch benchmark price is almost seven times that of U.S. Henry Hub futures at the moment.

More refiners are also scheduling maintenance on facilities this year after going full throttle last year: In 2022, U.S. refineries ran at an average of 91% of their capacity. That should also support margins.

Meanwhile, distillate fuel (diesel and jet fuel) inventory remains low globally and Europe's pending February import ban on Russia's petroleum products could further tighten the market. Europe is heavily dependent on Russia for distillate imports and will have to shift its sourcing to other places like the U.S. and the Middle East.

Moreover, unlike crude oil, where so-called "dark" tankers have been able to successfully shift Russian oil to places outside Europe, there aren't as many "dark" product tankers to move Russia's diesel around. The market for product tankers also is already tight, wrote Matthew Blair, equity analyst at TPH & Co., in an email.

Refining margins are looking healthy so far this year. The monthly WTI 3:2:1 crack spread, a proxy for refiner profitability, was $38.30 a barrel on average so far in January, according to data from S&P Global Commodity Insights. That is about two dollars a barrel higher than the average fourth quarter spread. And it gets better: China's reopening should start contributing to "significant demand recovery" starting in the second quarter, according to Valero.

America's refiners could well end up maintaining their platinum status.