Refining margins have been absolutely decimated, especially for refiners of heavy, sour crude like Valero Energy (VLO) and Tesoro Petroleum (TSO).  This is taking a toll on profits in the oil and gas sector, with both oil majors highly leveraged to downstream operations like ConocoPhillips (COP) and independent refining outfits showing steep falloffs in operating margins.  I see this as a proxy for the underlying economic demand in the U.S. economy.

Refiners

Refining is a cyclical business and this same pattern has been repeated for decades. When times are good, refining margins are high.  But, margins crash down at a moment's notice, leaving some flat-footed and generating the waves of oil-sector busts of yesteryear. The desire of large firms to move away from Refining and Marketing reflects their desire to be insulated from these swings.

Independent refiners like Tosco, Valero, Premcor, Tesoro, and Giant grew up because of this vacuum left by the majors. Because the world's refineries are leveraged to light sweet crudes like West Texas Intermediate (WTI), heavy and sour crudes like Maya and Alaska North Slope (ANS) normally sell for large discounts on the spot market. This generated a demand for complex refining capacity capable of processing these crude varieties and offers the independents a natural area of competitive advantage.

Refiners as a proxy

However, this cycle has been especially severe for refiners leveraged to heavy, sour crudes, with WTI-Sour Crude margins averaging $1.34 a barrel for all of 2009. Valero, the largest independent refiner had never had layoffs until now. Below is the beginning paragraphs of today's VLO press release.

Valero Energy Corporation (NYSE: VLO) announced today that the company is continuing to take action to improve its profitability by rationalizing underperforming operations.