Chevron (CVX) and other vertically integrated oil majors like Exxon Mobil (XOM) and British Petroleum (BP) could begin to see margins from their struggling downstream businesses rise in Q1 2012 as independent refining plants across the U.S. and Europe close down. Dropping margins have resulted in the closure of Petroplus, the largest refinery in Europe, and other key refineries, and this should tighten the industry surplus situation. Chevron and other oil companies reported a drastic fall in refining margins in Q4 2011 and lower volumes because of high crude prices.

We have a $109 price estimate for Chevron, which is at a 5% premium over its current market price.

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Capacity reduction

Analysts estimate that almost 1.2 million barrels a day (M b/d) of refining capacity has closed down since the beginning of 2012 because of low crack spreads. Refining margins have improved to $11/barrel in Europe and touched $26/b in the U.S. after touching a low of $11/b in early January. Crack spreads also widened in Asia, touching $19/b from $9.5/b a month ago.

Analysts at Deutsche Bank estimate that industry surplus would fall from 3.4% to 3% in 2012, which is healthy for the industry. The closure of all of Petroplus' refineries could reduce the industry surplus to 2.7%. Refineries are making a profit of $0.16/b on fuel oil because of strong demand for the product from end-customers. Fuel oil is a loss-making product for refiners that resulted in losses for refineries ranging from $5 and $15 per barrel over the last three years, according to some estimates.

Along with closing capacity and strong fuel oil demand, cold weather in Europe is also helping refining margins. Chevron reported a loss in its refining business last quarter because of falling margins and lower demand. With smaller players going out of business and further consolidation expected, the company's downstream business is expected to be a major source of value for the company.