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Oil Firms' Margin Woes Spread

Three big names in two days say margins will contract, but investors don't seem to mind.

Grim profit forecasts by a trio of major oil players citing shrinking margins are pointing to tough times for the energy group heading into the upcoming round of earnings announcements.

Key sector members

Valero

(VLO) - Get Report

,

Marathon Oil

(MRO) - Get Report

and

Chevron

(CVX) - Get Report

have all indicated that low refining margins will likely hurt their bottom lines in the third quarter of 2007.

Valero was the latest to warn, saying Wednesday that its throughput margins will likely be $700 million less in the quarter than in the same period last year as a result of higher feedstock costs.

Similarly, Chevron said on Tuesday that its earnings will be "significantly below" its second-quarter profits due to a "sharp decline in refined-product margins for the downstream business," according to a press statement.

Just hours before Chevron's remarks, Marathon said its quarterly refining and wholesale marketing gross margin would be about half the 32.7 cents a gallon earned in the prior year.

Valero's stock overcame early weakness, though, and late in the session it was up 3% on the day to $74.35. Marathon gained 0.8% to $58.82, but Chevron slipped 0.7% to $92.17.

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The Dow Jones U.S. Oil & Gas index, a tracker for the energy sector, was higher by 1.5%.

At any rate, the predictions are striking because refinery crack spreads for products like motor gasoline were near record highs just a few months ago. Refinery stocks performed well last spring, as consumption figures showed strong demand for energy leading into the summer driving and cooling seasons.

For its part, Chevron reported record profits of $5.4 billion in the second quarter.

According to John Parry, senior analyst at energy-research firm John S. Herold, companies are facing difficult comparisons, both sequentially and year over year. He says this year's second quarter and the third quarter of last year are both poor benchmarks by which to measure the recent progress of refinery firms.

Last spring, geopolitical tensions in Iran and Nigeria allowed refinery crack spreads to reach as high as $30 a barrel, but the numbers were unsustainable, says Parry. "Those prices were driven by fear, greed and hedge fund speculators" rather than reasonable market fundamentals.

Likewise, the third quarter in 2006 contained its own market anomalies, Parry said. In the first storm season after hurricanes Katrina and Rita, traders had bid the prices of crude and petroleum products well above normal levels because they were scared of another catastrophic storm.

Refineries were also experiencing an abnormal number of shutdowns as they raced to adhere to new government requirements for gasoline and ethanol blends.

Sheraz Mian, an energy analyst at Zachs Financial, says that third-quarter refinery throughput figures are always lower than those from the second quarter because demand for gasoline and other petroleum products declines after the summer driving season.

Analysts usually account for this seasonal drop in their financial models. However, this year has been different than most. While demand, and thus the price, for petroleum products has fallen in the third quarter, crude oil has continued to trade at record high prices. This relationship has cut deeply into refining margins.

The low profit margins are not spread uniformly across the U.S., though. Spot crude has been selling at higher prices in the west than in the rest of the country, as the refineries there tend to process heavy Alaskan crude.

"Refineries' performance levels will differ depending on where their operations are most heavily concentrated," said Mian. "West Coast refiners like Valero, Chevron and

Tesoro

(TSO)

will probably be worse off than those in the central U.S. like Marathon because their feedstock is more expensive."

While weak third-quarter earnings announcements will likely affect refinery stocks in the short term, it's important to remember that seasonality is a key factor in any moves. As the demand for heating oil changes, so could the financial strength of the refinery industry.