US independent refiners enjoying record margins

It's a good time to be an independent refiner in the USarguably the best in many years for a segment of the industry that has seen more than its share of difficulties in the past couple of decades. At least one analyst expects US refining earnings to more than triple this year vs. last year.

US refining margins have rocketed to an average $5.55/bbl this year, according to Prudential Securities, the highest annual margin on record and an incrase of 45% from a year ago and 35% from the previous 5-year average. That happy circumstance results from a combination of strong economic growth, reduced investment in new capacity, low products stocks, industry consolidation, and more-stringent product specs.

"The fact that this remarkable margin improvement was achieved against a backdrop of surging oil prices is further evidence that the underlying economics of the business have improved substantially," Prudential Securities said.

The analyst forecasts that US refining margins will drop by 7% next year, but that still means a high levelabout $5.15/bbl. Even if margins trend downward, the analyst expects them to remain "well above normal" for the next 12-18 months.

The reasons for this cheery outlook include:

A decline in crude oil prices, which Prudential Securities forecasts at $25/bbl in 2001 vs. almost $30/bbl this year-in large part because more crude is being put on the market and demand is declining. But because product stocks remain lean, the likelihood is strong that refiners could roll back product prices at a slower pace than the crude price drop, thus enjoying some margin expansion.
Margins will remain strong this winter because of the unprecedented low levels of heating oil stocks. Correspondingly, if refiners are scrambling to produce more heating oil during the next 4-5 months, that effort will come at the expense of gasoline production. So that increases the likelihood that gasoline inventories will be low at the start of the next driving season, carrying on the margin strength just as crude oil prices continue to decline.
There is likely to be a greater incidence of unscheduled downtime and supply disruptions because refiners have had to postpone a significant amount of refinery maintenance this year in an effort to make enough gasoline early in the year and enough heating oil late in the year.

Capacity changes

One of the key reasons that the US refining industry is getting better is that there is less of itjust as demand for products is stronger than ever.

Ironically, that came as an indirect result of the huge wave of spending by the industry in order to comply with the provisions of the Clean Air Act amendments of 1990. This push to modify and add facilities to produce lower-emission fuels coincided withand in large part propelleda gradual, incremental expansion in US refining capacity. This "capacity creep" offset the effects of refinery capacity that was closed down and of modest growth in products demand, resulting in pretty lousy margins for most of the 1990s.

But capacity creep has slowed down. Prudential Securities estimates that capacity creep average only 0.9% in 2000 and is likely to reach only 1.4% next year and 0.5% in 2002. That works out to an average growth in capacity of only 0.9%/year for the 3-year period.

The slowdown in capacity creep results in large part from the downturn in the oil industry in 1998-99, when the collapse in oil prices slashed cash flow and forced a rollback in capital spending. This, of course, will be relatively short-lived, as the next wave of capital spending will come with the new specs for gasoline and diesel that are looming on the horizon. Of course, if these new sulfur levels are to be effected in gasoline and diesel within the timeframe currently being discussed at the Environmental Protection Agency, then a lot of capital spending won't happen, because some refiners will not be able to accommodate the schedule. A lot won't happen, anyway, as some of the more-marginal refineries won't be able to make the economic justification for it. That means more US refiners will get out of the gasoline and diesel business altogether, which will reduce US capacity still further, rather than continue the growth trend under the capacity creep phenomenon. Would any new US grassroots refining capacity get built under such a scenario? Would any non-US refiners attempt to meet this shortfall and comply with the tough new specs in the time available? Neither looks like a likely proposition, so the longer-term outlook for US refining margins looks pretty healthy at this viewing as well-at least for the refiners that have managed to survive.