Refining business undergoing structural shift to good times

Refining business undergoing structural shift to good times

The refining business is soaring today, and the current fundamentals of the business suggest that this is not a short-term phenomenon.

Refining margins in the Atlantic Basin have reached record levels at some points during the year, propelled by strong products demand, low stocks, and a slowdown in the incremental capacity growth in the US that the market dubs "capacity creep."

At the same time, most analysts are forecasting crude oil prices will be higher than the historic average trend in the next few years. Contrary to the simplistic view of the oil industry that much of the public holds, high crude oil prices do not automatically spell good times for all sectors of the oil industry. While refiners can typically pass through some of the higher crude costs to the prices of refined prouducts, there is typically a point where consumer resistance to higher prices kicks in, and the product price begins to soften even while crude costs remain relatively high. That means a shrinking margin for refiners. This was the case during the Persian Gulf crisis following Iraq's invasion of Kuwait. Facing political pressure to keep gasoline prices low when crude prices were their highest in a decade, US refiners saw their margins obliterated.

Conversely, low crude oil prices don't automatically translate into bad times for refiners. The reduced feedstock costs can help lower product prices enough to add stimulus to demand. Again, if product stocks are not bulging and capacity utilization is not too low, product prices can outperform crude and thus bolster refiners' margins even in a depressed crude oil market.

Refiners' fortunes rise and fall with the timing of crude and product price changes. A market in backwardation discourages stockbuilding, which reinforces the factors that keep oil prices buoyed. But a sustained surge in stockbuilding coupled with lower-than-expected demand creates a contango situation that depresses oil prices. It's all part of the cyclicality of the business.

But, every now and then, there emerges a new paradigm, a dramatic alteration of the underlying outlook for the physical balance of oil markets. Such paradigms emerged during brief periods of supply crisis in the 1970s and early 1980s-even briefer still in 1990-91.

All signs point to a new such paradigm emerging today, only the difference this time is that it seems to be spreading across the entire energy spectrum: crude oil, refined products, natural gas, and electric power. This new shortage mentality is seeping into the global consciousness for a variety of reasons and from a confluence of trends that have their roots in the Asian economic crisis, the oil industry collapse, and the overweening environmental regulatory zeal in the US, all during the 1990s.

It's because the aftermath of these trends is well-entrenched even as the robust US economy continues to pace a strong global expansion (and unexpectedly strong Asian recovery) that energy markets look to be strong for the next few years and perhaps well into the coming decade.

(An early caveat in this prognostication: A US presidential win by Al Gore could easily translate into a "back-door" implementation of the Kyoto Protocol on global warming that, if carried to its logical extreme, could derail this economic recovery worldwide by mid-decade and make the 1998-99 oil collapse look like a walk in the park.)

US refining

For now, we'll look at the US refining sector and how such a structural shift is playing out there.

The combination of ever-tightening environmental strictures and growing capacity constraints has created a basic imbalance in the market structure. Following on the heels of a market downturn, US refiners last year had little incentive to build stocks of either crude or products. At the same time, the bewildering welter of gasoline specifications designed for certain regions of the country according to those regions' particular air quality regulations spawned a number of "boutique" gasolines that exacerbated the problems that already existed with the fungibility of US refined products. So when gasoline demand growth surprised everyone this year while crude and gasoline stocks were low, any supply difficulties-such as pipeline or refinery outages-were complicated dramatically. That created a situation where refining margins reached on average 6-year highs in the US and even record levels in some areas.

Nothing has changed to alter this bullish outlook significantly, other than the fact that the greatest concern over stock levels and possible price spikes has shifted from gasoline to heating oil. Even if winter weather does not live up to expectations of a return to normal temperatures in the US, the fragile situation with heating oil stocks cannot be relieved in time to meet even a modest uptick in demand. There is likely to be a strong program of refinery maintenance in the US this fall and winter, because such work was postponed in the spring because of concerns whether there would be adequate gasoline supplies. So a few big refineries in turnaround will mean a strong drawdown of heating oil stocks at a time when they are already low. If the expected return to normal winter weather materializes early in the US and Europe, then heating oil markets will be stretched to the breaking point, and prices and margins could rocket to new highs.

The turning point really came with gasoline, however, early this year. With gasoline stocks already low at a seasonally slack time of the year, a stretch of maintenance turnarounds and belated demand for heating oil with a late cold snap helped reduce gasoline stocks still further. This situation was worsened by the introduction of the latest specifications for reformulated gasoline in certain US air quality nonattainment areas. With a limited capacity for making the new gasoline on top of the meager stock levels, concerns mounted over adequacy of supply for the summer driving season, and refining margins begin to expand. On the Gulf Coast, second quarter refining margins shot up almost two-fold, or by almost $2/bbl, with the gasoline crack spread there reaching the highest level in 10 years. But the real shocker emerged in the Midwest, where a heavy reliance on ethanol blendstocks created the nation's "boutiqueiest" gasoline. There, the quarterly refining margin hit a record high of $7.77/bbl, and the gasoline crack spread in Chicago peaked at a whopping $22.60/bbl the week of June 16.

This situation underpinned the highest nominal retail gasoline prices in more than 5 years and the highest, in inflation-adjusted terms since the Persian Gulf war (see chart). Not only did pump prices top $2/gal in the Chicago and Wisconsin markets, but regional outages caused many independent marketers to run out of the gasoline for the first time in more than 2 decades.

What's important to note here is that while prices and margins that high are anomalous, the structural trend is not: the underlying fundamentals of the refining business worldwide bespeaks an upward trend for the foreseeable future. The effects of continually tightening environmental strictures, the switch to ethanol from MTBE as an oxygenate, the slowdown (and perhaps disappearance) of capacity creep, and other factors will keep a prop under gasoline prices and refining margins for at least several years to come.

Subsequent columns in the weeks to come will examine this structural shift for refiners in the US by region and elsewhere in the world.

And remember: a Gore presidency acts as an accelerator on this forecast.

Latest Prices as of October 27, 2000

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