The US refining sector is enjoying robust margins due to healthy demand growth and relatively tight products markets.
Many analysts expect the prosperity US refiners experienced in 2003 will be repeated—if not improved upon—in 2004. But are markets witnessing the beginning of a longer-term up cycle for US refining? John C. Meloy, analyst with Houston-based Simmons & Co. International, thinks so.
'Sweet spot' ahead
Meloy contends that the US refining industry is poised to enter the "sweet spot" of the refining cycle in coming years.
A number of factors have set the stage for a refining environment in the US that will likely translate into higher earnings, Meloy said in a recent Simmons research report. First among these factors is the result of years of a poor refining environment in the US, as befits an industry cycle. According to Meloy, poor rates of return in the refining sector have led to low levels of capital reinvestment and rising capacity utilization.
"As in any business cycle, excess capacity leads to low returns," he said. "Over the last 12 years, the return on capital (ROC) for refiners has been subpar."
Because a low ROC spawns a lack of investment, extended periods of low returns tends to eliminate the weakest competitors so that only those refiners with the lowest operating costs can compete. And that situation has held in US refining, which has shifted from a long stretch of overcapacity to one of undercapacity. This situation will be further exacerbated by the implementation of new clean-fuel regulations that require significant infusions of capital.
"As a result, many smaller refineries struggle with the economics for compliance, as the costs cannot be amortized over a substantial number of barrels produced," he said. "This Darwinian concept plays itself out during the bottom of most business cycles—the strong survive, and the weak go away." What's coming during the next few years is a situation where US refining capacity utilization will average near maximum capacity of 95%—which entails a minimal number of turnarounds or other disruptions (an unlikely scenario in an aging refinery base). Projecting gasoline demand growth of 1.5%/year means US gasoline demand will reach 9.5-9.6 million b/d in 2004-05. At 95% utilization, US refineries could manage only 8.8 million b/d, leaving imports to fill the gap. While US gasoline imports in 2003 averaged nearly 900,000 b/d, the resulting 1% cushion augurs a truly tight market outlook.
The Simmons analyst also predicts that an equivalent 130,000 b/d of domestic gasoline production will be eliminated via octane loss through new government fuel specifications. And a further supply loss of 100,000 b/d is likely from sources of US gasoline imports that are not willing to make the needed capital commitments to meet new US fuel specs. Meloy excludes from this scenario traditional foreign suppliers such as refiners in Northwest Europe, Canada, and Venezuela, although he notes that this situation could worsen with further turmoil in the latter country.
Rising crack spreads
With demand growth healthy, this leaves US refiners running all out to meet demand and upward pressure on gasoline prices, he said: "It also argues for an upward move in crack spreads."
Meloy notes that US crack spreads have already exhibited this behavior, with the US Gulf Coast crack spread averaging $4.20/bbl in 2000-03 vs. $2.70/bbl in 1992-99. Furthermore, the highs in the crack spread during the recent period are getting higher and more frequent, while the lows are getting higher and less frequent.
Meloy estimates that it would take a crack spread of $9/bbl to justify new grassroots refining capacity in the US—an unlikely scenario, even with recently improved levels. A more likely scenario calls for US crack spreads to rise just enough to give foreign refiners an incentive to upgrade.
"Simply put, refining margins need to climb by at least 47¢/bbl, on average, to induce foreign spending on dedicated, low-sulfur gasoline to the US," Meloy said. "Without a rise in crack spreads to facilitate such spending, we believe the US will not have adequate supply of gasoline in the future."
There are downside risks to his projections, such as federal waivers of environmental rules in response to price spikes, heavier than expected imports, or economic weakness slowing demand growth. But none of those are likely to squelch a fundamentally strong outlook for US refining in the years to come.
(Online Jan. 5, 2004; author's e-mail: [email protected])
