Evidence mounts of a secular recovery under way in refining

The evidence continues to mount that a secular recovery is under way in the world refining industry.

As always is the case in refining, any recovery-or downturn-varies widely by geographical region. But the case is clear for a rebound in the refining business with the strengthening of margins across the board.

Refining margins were already starting to look much better a year ago at this time, and they jumped sharply in the first quarter vs. the same period a year ago.

According to Merrill Lynch, average first quarter 2001 refining margins for all of the major North American and European refining centers have outstripped those for first quarter 2000.

In the US, first quarter US refining margins were up almost 35% from a year ago, with margins on the Gulf Coast and West Coast each posting gains of nearly 50% year-to-year.

In Northwest Europe, complex margins in the first quarter were running 10% above those of first quarter 2000.

Merrill Lynch expects a continuing "stellar performance" from Mediterranean refiners, where leading indicator complex margins posted a gain of almost 80% in the first quarter vs. a year ago and where simple margins are expected to move above the line of profitability after posting losses in first quarter 2000: "Here, the widening of the light-havy spread has been a major boon."

US woes

But because the US market continues to be plagued with a refining-transportation infrastructure that cannot keep up with the complex welter of "boutique" fuels in various regions, as mandated by federal air quality rules, market tightness remains a constant, it will again set the pace for high refining margins this year.

That is borne out by the continuing bad news on inventories, underpinning prospects for a repeat of last summer's market disarray. That situation saw refinery and pipeline outages and a scramble for supply that spiked gasoline prices in the US Midwest high enough to spur yet another fruitless federal investigation into charges of collusion and price-fixing by refiner-marketers.

The reason there is likely to be a repeat of last summer's supply and price woes in the US-and the most compelling evidence of why this worldwide refining recovery is secular and long-lasting in nature-is that the underlying trends are entrenched, Merrill Lynch notes, and they include:

An overall lack of refining capacity.
Reduced gasoline yields as a result of accommodating more-stringent product standards.
A reduced level of imports owing to the creation of de facto "barriers" erected against products that don't meet these more-stringent standards.
Depleted product stocks.
An inability to sustain "capacity creep"-the process of gradual, incremental growth in refining capacity owing to revamps and debottlenecking. (A surge in capacity creep came with an earlier round of revamps geared toward changing market needs and changing products specifications, but that one has largely run its course. Whatever capacity creep is revived with the round of revamps that will come as US refiners scramble to meet new lower-sulfur limits in gasoline and diesel, as mandated by the US Environmental Protection Agency, will be offset by the number of refineries that are shuttered because meeting the new standards will render them uneconomic.)
A heavy round of maintenance turnarounds that is long overdue, taking a good deal of capacity offline.
Structural improvement in Europe's refining sector-specifically a long-overdue consolidation of capacity and companies.

Slight cooling

While the overall fundamentals suggest the global refining sector will continue to remain hot, Merrill Lynch nevertheless sees some cooling from the overheated state of the market last year.

This cooldown owes largely to the slowdown in both the US and overall global economies. Still, the analyst holds to margin forecasts in 2001 and 2002 that are likely to range, respectively from $0.95 and $1.00/bbl in Northwest Europe to $10.63 and $10.25/bbl on the US West Coast. If anything, Merrill Lynch, there is a strong likelihood that these forecasts may be on the low side.

An exception is Asian refining, where the analyst estimates first quarter 2001 margins averaged 30% below year-ago levels. This region still suffers from overcapacity and less-cohesive markets, and the kind of structural consolidation and streamlining seen in Europe is overdue in Asia-albeit more problematic in the latter because of the preponderance of state involvement in products pricing and refining capacity operated by state-owned firms unresponsive to shareholder concerns over financial returns.

Still, the continuance of the bullish trends points to the view that "refining has been on the cusp of a major secular improvement," Merrill Lynch said.

"Central to this was the combinatin of tightening environmental standards and capacity constraint worsening an existing structural product imbalance in the Atlantic Basin. Evidence that this was already occurring was gleaned in 2000, but further analysis has only served to strengthen this conviction."

There is likely to be a severe contraction in capacity in the Atlantic Basin over the next 3-5 years, the analyst contends: "New environmental standards are set to remove already scarce gasoline and diesel through lower yields. Closures are a separate issue that also look set to shrivel capacity, as many small refiners are unable to justify investment."

Merrill Lynch reckons the amount of capacity likely to be closed in the Atlantic Basin as a result of lower yields and closures spawned by new fuels specs could total as much as 1.7 million b/d. This works out to 5.5% of capacity in North America and Western Europe combined.

We need look only as far as California after the introduction of CARB II reformulated gasoline, where massive investments were made to accommodate the new fuels specs-the most stringent in the world at the time-and a number of smaller refineries were closed because they could not justify the investment. It is thus illustrative to note that the world's strongest refining margins are now on the US West Coast.

As always, California is the leader on matters involving tradeoffs on energy and the environment. Judging from the current energy predicament facing that state, one can only speculate with a shudder where Lotusland will take us next.

To borrow and modify a colleague's joke:

What's the difference between California and the Titanic?

At least the Titanic went down with its lights on.