Tickers in this Article: VLO, TSO, SUN, XOM, COP
Earlier this week, major Wall Street broker Goldman Sachs (NYSE:GS) decided to turn thumbs down on the oil refining group, stating that it saw "little reason for investors to own the sector." That announcement prompted a mini-selloff in the shares of independent refiners Sunoco (NYSE:SUN) and Tesoro (NYSE:TSO), both of which got whacked with "sell" recommendations by Goldman. While both stocks values have since stabilized since the negative call, the discouraging fundamental realities for this group, which likely prompted Goldman's negative view, remain very much in place, and could get worse. (For a primer on the oil industry, refer to our Oil And Gas Industry Primer.)
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Less Driving Means Lower Margins for Refiners
Problem number one continues to be the sharp rise in crude prices at a time when gasoline demand in the U.S. market remains subdued due to the recession. For operators like Sun, Tesoro and other major independent Valero (NYSE:VLO) that puts pressure on their refining margins. And there appears to be no relief in sight.

Fresh inventory data reveals that gasoline supplies increased more than expected. That prompted a 12% selloff in gasoline futures, dropping the crack spread - the differential between crude oil and gasoline prices - to $8.77, the lowest level in three months. With the summer driving season now half over, and the word "staycation" now having entered the American lexicon, it's hard to see how this situation can be reversed anytime soon.

Refiners Exposed to Higher Pollution Costs
More bad news for refiners came with the House passage of the climate bill, which finally commits the U.S. to reducing its production of green house gasses through the adoption of a cap and trade system. As major carbon producers, refiners will face a higher cost of business in future, and stand a take a bit of a medium term hit as they only qualified to receive 2% of the free carbon permits that will be dolled out in the initial years of the plan to help cushion conversion costs. By comparison electric utilities get 30% of the free permits. While the bill has to be passed by the Senate before it becomes law, a Democratic majority in that body virtually assures passage - albeit with the usual modifications.

Other potential legislative moves designed to curb the production of carcinogenic gases could force refiners to embark on additional costly spending programs designed to cut such hazardous emissions. Operators like Valero, as well as Exxon (NYSE:XOM) and ConocoPhillips (NYSE:COP), have been identified as falling short under the new guidelines proposed by the Obama administration.

The Bottom Line
Traders betting on a late summer rally in refining margins will be disappointed. Longer term investors should recognize that a perfect storm of legislation is on the horizon and promises to crimp this sectors long-term profitability. (See our article, Can Business Evolve In A Green World? for a related read.)

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