The NYTimes today carries a Reuters Breakingviews column arguing for a break up of the vertically integrated oil majors. The author trots out a number of questionable arguments in favor of a break up. He then voices a counterargument that is directly relevant to the themes of this blog:
“Executives argue that lumping refiners and explorers together offers a natural hedge. In theory, when falling crude prices hurt production, the refining business gets relief from lower input costs.”
Some might claim this is just a straw man, but I hear this thinking often enough that I think it is worth pushing back against it.
First, in its simplest form, this argument just has to be wrong. At a first approximation, combining production with refining in no way hedges production. The oil producer is a natural long. The refiner is neither long nor short. The refiner both buys crude oil and sells refined oil products. It captures the margin between the two. Adding up the exposure of a producer with the exposure of a refiner yields a company that still has the exposure of a producer. There is no natural hedge there.
What I mean by ‘at a first approximation’ is that we assume that the price of crude and the prices of refined products all move together, one-for-one. Of course, this assumption doesn’t hold. When crude prices move, margins on refining often move, too. But the relationship is complicated, and in no way can it be described as a natural hedge. At best, it is like any two distinct operations within a broadly defined industry which have exhibited some negative correlations in the past so that profits from the two divisions seem to hedge one another. Whether the correlation is really there and reliable in the future is a very difficult question to resolve.