Sharply higher crude oil prices in the first half of 2008 and crumbling North American end-user demand have led to substantial weakness among downstream companies' second-quarter results. Significant year-on-year decreases in operating results were seen at bellwether Valero (second-quarter [2Q] net income [NI] of $734 million versus $2.25 billion in 2007, a 67% drop), Tesoro (2Q NI of $4 million versus $443 million in 2007, a 99% drop), Marathon (segment NI of $158 million versus $1.25 billion in 2007, an 87% drop), ExxonMobil (segment NI of $1.56 billion versus $3.39 billion in 2007, a 54% drop), and Chevron (a segment loss of $734 million versus $1.3 billion gain in 2007).

The main factors behind the decreases are the sharp run-up in crude oil prices; declining crack spreads; demand destruction for key refined products, especially gasoline (currently estimated in the negative 3% to negative 5% range); higher operating expenses created by surging natural gas and electricity prices; and lower capacity utilization, as the industry has been forced to cut runs to match declining North American demand. For the first half of the year, U.S. refinery utilization averaged just 86.8%, versus a long term-average of 92.4%, according to EIA data. In addition to these factors, rising oil prices have significantly elevated liquidity needs across the industry, as refiners have been forced to finance more expensive crude and refined product inventories.

With the traditional U.S. driving season a bust so far, the earnings outlook for the rest of the year remains weak. Looking forward, we expect near-term credit metrics across the sector to decline relative to last year. If sustained, the current high crude/low crack spread environment is expected to result in lower operating cash flows and additional pressure on the ambitious capex budgets announced across the industry last year. At this point, several companies have announced cuts in discretionary capex to accommodate this near-term stress including Valero (2008 budget revised down from $4.5 billion to $3.8 billion) and Tesoro (2008 budget revised down from $1.1 billion to $870 million; further cuts possible pending a capital review).

Refiners still have a number of levers they are able to pull in order to maintain credit quality - including further cuts in discretionary capex, reductions or suspensions in share buyback programs, liquidation of inventories, and asset sales. However, the weak environment has also created several constraints on refiners' financial flexibility. The sharp downturn in refining margins means that sellers may not get the record proceeds received for brownfield refineries over the last few years. Similarly, the challenging credit environment may limit the ability of non-strategic buyers to obtain financing on acceptable terms, which could also shrink the pool of potential bidders. In addition, the steep drop in share prices across the refining sector - many of which recently touched multi-year lows - make share buybacks relatively more attractive at this point and could limit managements' desire to tap into equity financing at what are perceived to be very dilutive levels. Fitch will continue to closely monitor operating results and any revisions in capital spending plans across the sector.