Atlantic Basin refiners to struggle with gasoline glut before margins rebound next decade

Prospects for profitability in the refining business are looking increasingly positive for later in the next decade, following a short-term period of continued weakness in markets.

Last week, we looked at a new study by Energy Security Analysis Inc. that offered this outlook, focusing on the Asia-Pacific region. This week, let's examine how ESAI views prospects for refiners in the Atlantic Basin.

The Atlantic Basin refiners that will fare best in the next decade will be those with the greatest ability to economically produce the new slate of clean fuels that will be required in the US and Europe.

"Atlantic Basin fuel demand will remain strong, led by gasoline and diesel demand growth in the U.S., where demand will grow faster than increases in refining capacity, implying higher import volumes and firmer product prices relative to crude," ESAI predicted. "While capacity creep and other small refining projects can continue to increase domestic supply, these modest gains are probably no match for another decade of strong gasoline and diesel growth."

But there remains a threat to this brightening outlook: the persistent surplus of gasoline in Europe. As preferential tax treatment has continued to favor diesel over gasoline there, in tandem with a trend toward greater fuel efficiency, gasoline demand growth has languished in Europe. Refiners nevertheless have continued to increase crude runs to meet growing demand for other products, and the result has been more excess gasoline supplies hitting the market.

ESAI warns that this gasoline surplus could grow enough to swamp both the European and US markets. So the outlook for Atlantic Basin will become increasingly dependent on strong demand growth from the US and, to a lesser extent, Latin America.

The prospects are much brighter for diesel in the Atlantic Basin, as the US and Europe both find themselves in an increasingly net short position on diesel, says ESAI. Although the distillate market is weak at present, diesel values should strengthen more in the midterm, buoying margins overall. ESAI projects nominal average Gulf Coast margins increasing by $1.50/year through 2005, leveling off thereafter; European margins will basically follow the same track

Further bolstering Atlantic Basin refining margins in the midterm are the next round of environmentally driven fuel reformulations as Europe, Canada, and the US press efforts to all but eliminate sulfur from gasoline and diesel fuels by 2005. This push will result in the loss of still more refining capacity as more refiners find themselves unable to justify the expensive outlays needed to meet the new sulfur specs. And the overall push in the Atlantic Basin will keep the high-quality diesel and gasoline blending components especially dear. That will be further exacerbated if efforts to ban MTBE in the US are effective, as refiners find another substitute for this prized oxygenate.

"This simultaneous lowering of sulfur levels in both gasoline and diesel in North America and Europe (and other countries around the world) suggests that light/heavy crude differentials will widen in the future, and that refiners should consider investing in upgrading units that can both upgrade low quality feedstocks and desulfurize gasoline and diesel streams," ESAI said.

On the other hand, higher-sulfur fuel oil will increasingly become a drug on the market as it gets displaced more and more by natural gas. The value of fuel oil relative to crude oil will continue to shrink, especially as power utilities begin to factor in the rising cost of emissions controls-especially with climate change initiatives-and turn more and more to natural gas to fire their turbines. This process will be accelerated by the trend toward preferential taxation for lower-carbon emission fuels.

Even the fuel oil that survives will be lower-sulfur in nature, and the higher-sulfur fuel oil will be relegated to the bunker market, so that low and ultralow-sulfur fuel oil will command a significant premium over the high-sulfur grade.

With the prospect of having to dispose more resid into a shrinking market, says ESAI, refiners-especially those in Europe-will reduce their yields of resid still further, via upgrading or destruction (gasification). Without such conversion initiatives, refiners will find their margins pulled down by the poor values for resid.

On a final note for refiners worldwide, ESAI offers a cautionary insight: Any projections must take into consideration the ramifications of global warming concerns at the national level and how they will filter down to the level of local pollution controls.

"The quest to reduce CO₂ emissions is probably the biggest unknowns for refiners," ESAI said. "It is clear that the industry and transportation sectors will be the primary targets of any government strategies to reduce greenhouse gases, as most man-made CO₂ emissions are produced from fuel combustion or industrial processes.

"On balance, any assessment of the future of refining margins must carry an implicit sensitivity for environmental policies that restrain or reduce oil demand. The global interest in CO₂ emissions reductions can only intensify that sensitivity. Beyond that, it is hard to quantify. Oil consumption policies (whether promotion of fuel efficiency technologies or plain taxes), bolstered by CO₂ emissions concerns, are unlikely to shave 10% from global oil demand by 2010. Lopping 2-3% from expected demand in 2010, however, may not be out of the question."

Considering that such a range reflects the average global oil demand growth in recent years, that's a big Damoclean sword hanging over the refining industry's head a decade from now.