Judging by the challenging fundamentals now facing the company, it wasn't overly surprising to see a flurry of insider selling earlier this month in the shares of refiner and distributor Sunoco Inc (SUN).

While some of the transactions were related to the exercise of year-end options, the selling was notable in the fact that seven senior officers of the company offloaded a grand total more than 430,000 shares.

So what sort of concerns might have prompted the insiders to head for the exits at this juncture?

For starters, refining margins in the U.S. East Coast region, where Sunoco sells the majority of its refined products, have been dropping of late, and could go lower.

In the fourth quarter of 2005, the regional refining margin, or "crack spread" stood at $8.90 per barrel. During the third quarter of this year, the margin had declined to $5.87 and some analysts now expect it to hit $3.50 this quarter.

Lower than expected prices for furnace fuel in the Northeast, due to higher than normal temperatures, are blamed for much of the decline.

In as cyclical a business as refining is, such wide swings in the crack spread are to be expected. However, in Sunoco's case, this comes at a time when the company is engaged in a significant multi-year capital spending program designed to put it on par with other players in the U.S. refining industry.

Some time back, Sunoco made the strategic decision to stick with refining premium priced light sweet crude while the rest of the industry was busy tooling up to process the lower priced grades of sour and heavy crude. Refining light sweet crude is less capital-intensive, which boosts return on capital, but it lowers operating margins.

However, earlier this month, the company announced a massive multi-year US $2.28 billion capital expenditure program designed to convert a significant portion of its heating oil capacity to the production of new ultra-low sulfur diesel and to expand capacity in other high value distillates like jet fuel and kerosene Since its introduction last June, ultra-low sulfur diesel has largely replaced low sulfur diesel for on-road vehicle use.

Until recently, it has always looked like the company's net earnings would be sufficient to fund these expenditures. Now, the double-edged sword of lower profits due to slumping refining margins and escalating construction costs due to rising raw materials and labor costs is putting that assumption to the test.


The price-tag to upgrade the Philadelphia refinery has already jumped by $100 million, or 30% to over $400 million and the second phase of the Toledo, Ohio refinery upgrade has been pushed back until 2008. Concerns are rising that the final construction bill could go much higher.

If Sunoco can't cover these capex costs from operating income, there isn't a lot of slack funding capacity on the balance sheet to borrow on. If you include off balance sheet liabilities such as operating lease obligations and certain pension benefit obligations Sunoco's total debt/capital ratio stands at 65% -- well above the rest of its peer group.

All of this makes Sunoco a fairly risky bet at this point, despite the fact that it's trading at only 9x next year's consensus EPS of $7.11. As soon as the reality of a much lower crack spread is taken on board by the analysts covering the company, next year's consensus forecast should go lower. That, combined with any further announcements of cost overruns, which I believe are likely, should work in tandem to keep the stock price in check during most of next year.

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