Lenders wary of financing ULSD projects, but congress bill might help the 'small'

Diesel Fuel News, April 14, 2003 by Jack Peckham

San Antonio -- Small refiners face special challenges to finance ultra-low sulfur diesel (ULSD) projects mostly because they lack the earnings and balance-sheet leverage of the multinational integrated oils.

"In many cases in the refining industry, capital spending for clean fuels projects will exceed the fair market value of the [smaller-company] refinery," as Jacobs Consultancy director John Jenkins explained in a paper (AM-03-124) to National Petrochemical & Refiners Association (NPRA) annual meeting last month.

In contrast, the major oils can contract general debt (and some may tap cash flow) for such projects. They're able to execute these ULSD projects without even bothering to tell lenders what the funds are for -- often not until after the fact, he said.

But it's a different story for "small" refiners. While some of these companies might look toward some of the "new" technologies to cut capital costs of ULSD projects, "new or unproven technologies cannot be financed unless the borrower (not the licensor or contractor) guarantees the operation," Jenkins explained.

In a post-NPRA conference interview, Jenkins pointed out to us that bankers look at history. In refining, that's often a sad story, so lenders doubt that small refiners can generate enough cash flow to pay back a ULSD hydro-desulfurization project that might cost around $40 million.

The evidence is the feeble returns refiners generated from earlier clean-fuels projects, such as the 500-ppm sulfur highway diesel fuel that U.S. EPA mandated in 1993.

Just as discouraging for "small" refiners: Some of the more innovative financing deals that were available in the 1 990s have disappeared in the wake of the Enron scandal. Project financing is quite unlikely unless the borrower has deep pockets, Jenkins explains.

Bottom line: Lenders are even more risk-averse for clean-fuels projects, despite today's record-low interest rates. What's more, "a bank doesn't want to end up owning a refinery" if that's the collateral on a loan.

So, with debt markets seemingly closed, one of the few alternatives left to small refiners might be the so-called "vulture capitalists" willing to take a gamble on a ULSD project in exchange for high (but risky) returns on equity.

Or maybe the wisest choice for such refiners is to shut down.

However, pending bills in Congress (having passed both the full U.S. House and Senate Finance Committees this month) designed to offset ULSD capital costs for "small" refiners might change this picture (see related story, p1).

The provisions -- destined to be folded into an omnibus 2003 energy bill -- would allow "small" refiners (under 205,000 barrels/day) to expense up to 75% of ULSD project costs and up to 5 cents/gallon tax credit on the other 25%.

However, the 75% expensing assumes a "small" refiner has sufficient income to take full advantage of that provision. On the other hand, the nickel/gallon tax credit "probably will handle the variable cost" of a ULSD project, Jenkins suggested.

"But whether this [tax package] does much for return on investment is still a question," he added. "However, it will get people to re-look at the subject. Maybe there will be enough incentive to not walk away from a refinery that has been making $10-15 million a year. If you could demonstrate to a banker that your investment is solvent across a range of projections, then you might get a bank deal, or a lease, or something."

If these "small" refiners could capture some extra ULSD margin (versus higher-sulfur diesel) in the marketplace on top of the 5 c/gal. tax credit, then the viability of a ULSD capital project would start to look better, he said.

Still, many U.S. refiners predict there won't be any margin spread between ULSD and the 500-ppm sulfur diesels (both highway and non-road). That's because EPA has greatly restricted 500-ppm diesel sulfur availability due to an 80% minimum ULSD mandate during the highway diesel phase-in, and due to "baseline" restrictions tied to the upcoming non-road diesel fuel rules.