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US independent refiners get some breathing room, but long-term outlook bleak

Near-term prospects are turning around for the US independent refining sector.

That's the good news. The bad news is that, for the long term, this will still remain an especially tough business to make much money in. Accordingly, market and other, external pressures will increasingly propel US independent refiners into further consolidation-and even that won't help things much.

In a new credit risk rating analysis, Moody's Investor Service notes that US independent refiner-marketers continue to be plagued by high costs, excess capacity, intense competition, margin volatility, and cyclical peaks in refining margins that are of relatively short duration.

When these factors are combined with increasingly stringent environmental regulation, it is easy to see why the US independent downstream sector has experienced such poor returns on investment during the past decade.

"Looking ahead," said Moody's, "we believe independent refiners will continue to face the difficult challenge of improving returns while maintaining sufficient financial flexibility to weather cyclical troughs."

Refining margins started to take a steep dive beginning in late 1998 and lasting through first-half 1999, when the warmer-than-normal winter weather combined with the Asian economic collapse squeezed demand. That circumstance was exacerbated by the stunning drop in crude oil prices, which prompted many refiners to push as much crude through stills as possible in expectations that oil prices would rebound. This swelled even further the glut of gasoline and distillate on the market that was created by flagging demand. The ensuing plunge in margins forced many refiners to take noncash inventory writedowns in response to low product prices as well as low crude oil prices. Of course, as always, the West Coast was the exception to market trends elsewhere during this time, when a string of refinery outages linked to refinery accidents buoyed product prices and margins.

The more-complex refiners among the independents have seen the worst of it during this downturn, as the decline in the heavy crude oil supplies (the result of output cuts by key OPEC and non-OPEC producers such as Mexico and Venezuela in tandem with reduced capital spending in the heavy oil strongholds of Canada and California) caused the differential between light and heavy crude prices to narrow.

Overall, the short-term outlook for US refiners is positive, in Moody's estimation, largely on evidence of long-awaited declines in crude oil, gasoline, and distillate inventories. The inventory drawdowns stemmed from a number of factors: working stocks off amid a rise in oil prices, the drop in refinery utilization as a result of the aforementioned weak margins, and a surge in gasoline demand during the summer. Still, there were some signs of continued pressure on refining margins during the third quarter, owing to the traditional lag period between crude oil and refined product price increases.

Moody's predicted that "...more-normal inventory levels, the strong US economy, and a heavy refinery maintenance schedule will likely cause North American refining margins to remaining at or near historical averages for the remainder of 1999-and perhaps into 2000, particularly if the Western Hemisphere experiences a normal winter (winters have been warmer than normal for the past 3 years).

"A return to excess global crude supplies and/or a dramatic slowdown in US economic growth could, of course, limit margin improvements, but we do not believe that these scenarios are highly likely over the next 6-9 months."

Moody's adds that it thinks the recent tightening in light-heavy crude differentials is only a temporary situation, as higher crude oil prices and a consequent rebound in capital spending by heavy oil producers will spur an increase in heavy crude supplies and thus a widening of the light-heavy spread.

In the longer-term outlook, Moody's thinks that, despite continued increases in demand for petroleum products during the past 5 years and the industry's progress on improving operating efficiencies, returns on investment for refiners will remain relatively low. During the past 10 years, average refining margins have fallen, mainly because of overcapacity and intense competition.

"We believe that excess refining capacity, competition, and environmental compliance costs will continue to limit any sustained widening in average refining and marketing margins," Moody's said.

The same sort of competitive pressure that has led E&P companies and the integrated majors to consolidate to find relief in economies of scale will spur refiners to maximize throughput for the highest possible returns. At the same time, the very efficiencies that refineries have introduced have helped contribute to the phenomenon of "capacity creep," in which, for example, US refining capacity rose by 4% during 1997-98, as a result of debottlenecking and upgrade projects (and this figure excludes the re-start of two existing refineries that had been inactive. While the margin trough of 1998-99 precluded much spending that would have exacerbated this problem, the recent recovery in margins is likely to underpin a return to the kind of spending for projects that aggravate capacity creep. Add to this the expected hike in capital and operating outlays stemming from new environmental rules targeting sulfur levels and phaseout of certain oxygenates, and the picture grows bleaker still.

Moody's also points to the recent expansion of some products pipelines that are allowing low-cast Gulf Coast refiners to penetrate some of the niche markets in which certain of the independent refiners have thrived. And the spreading trend from Europe of gasoline retailing by hypermarketers is going to accelerate marketing competition, with the result that independent refiners are entering into supply arrangements with hypermarketers to preserve market share, only to see the retail margins erode as a result.

The divestment of downstream assets emanating from the megamergers among Exxon, Mobil, BP, Amoco, ARCO, etc., will probably mean a flurry of acquisitions by some of the bigger refining independents, but Moody's thinks this won't do much to eliminate capacity-largely because of the high cost and heavy potential environmental liabilities associated with mothballing a refinery.

This presents a scenario for independent refiners in the next century of continued high costs, limited market expansion capabilities, increasing competitive pressures, and low margins. It's not a pretty picture. Now would be a good time to start looking at innovative approaches to this market: perhaps diversification, supply-for-equity deals, export markets, etc.

One thing is certain: The status quo cannot persist indefinitely; low margins means low returns to shareholders, and if there is anything even more competitive than refining these days, it's Wall Street. Investors vote with their dollars, and undercapitalized, overly leveraged US refining companies could mean idle plants, increasing imports-and most likely, increasing ownership of US refining capacity by foreign entities with vast, low cost crude supplies.

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Latest Prices as of December 3, 1999

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