Good times ahead in 2003 for US refining

Jan. 31, 2003
While high crude prices have kept a squeeze on margins of late, the stage is being set for a robust recovery for US refiners in the spring.

Is the worst over for US refiners?
That seems to be the growing consensus among analysts and other market observers.

While high crude prices have kept a squeeze on margins of late, the stage is being set for a robust recovery for refiners in the spring.

Merrill Lynch last month noted that fourth quarter 2002 was the first quarter in over a year that consensus estimates for refining earnings were moving up instead of down.

"We believe that the group (of US refiners it tracks) is entering a new phase of positive (earnings per share) surprises, similar to the environment of 2000 and 2001," Merrill Lynch analysts said in a December research note.

Strengthening fundamentals

There are a number of fundamental reasons why the outlook for US refining is improving.

The spreads for heavy sour crude are improving, having returned to average historical levels from the 10 year lows of last summer, Merrill Lynch noted. The Saudis have been particularly aggressive in sweetening discounts for , Arab Medium Sour, with the differential to West Texas Intermediate for January deliveries topping $4/bbl. This trend is likely to continue in 2003, says Merrill Lynch, with rising heavy sour production from Russia, Canada, the deepwater Gulf of Mexico, and the Organization of Petroleum Exporting Countries.

Tightening products stocks are another boon for refining margins. Stocks of gasoline and distillate were already below normal 2 months ago. Since then, the surge in heating oil demand owing to Japan's nuclear plant shutdowns and colder winter weather and the loss of Venezuelan crude and products imports into the US have only exacerbated that situation.

At the same time, overall demand for refined products is growing. For the week ended Jan. 24, US gasoline stocks fell by 3.3 million bbl, and diesel inventories were drawn down by 6.8 million bbl. Given the high crude price-induced cuts in refinery runs squeezing margins together with reduced imports, such draws reflect strong demand.

Increased volatility

Prior to the surge in crude oil prices at the end of 2002 and beginning of 2003, tightening product stocks helped push refining margins to 10 year seasonal highs in all US regions in October-November.

Pointing to that development, Merrill Lynch contends that the US refining market "will be characterized by an increasing frequency of significant margin spikes going forward as the industry is pushed to its effective capacity limit by growing demand."

Even as overall products demand remains strong, US product availability will be weakened by the onset of new regulatory initiatives and refiners' lagging response to them. That lagging response has come in part because so many refiners are reconsidering the viability of retooling their operations to meet new low-sulfur specifications for both gasoline and diesel and the looming phase-outs of methyl tertiary butyl ether. A bumper crop of US refining assets is on the auction block, and the uncertain regulatory and economic climate is inhibiting capital spending by the prospective sellers.

And capacity creep has yet to help refiners catch up to the demand for the new clean fuels.

2003 critical

This year will prove to be a critical watershed for reformulated gasoline (RFG) in the US, says Aaron Brady, senior analyst with Boston-based Energy Security Analysis Inc.

He contends that US refiners are lagging in their RFG production and will have to ramp up output in order to prevent a significant spike in prices this year.

"Refiners in PADDs I-IV have not increased clean gasoline capacity much in recent years, and imports are not making up the difference," Brady said.

RFG inventories continue to decline, he added.

"California will face its first summer with MTBE absent from a significant volume of its gasoline pool, and there will be a strong pull to find clean components from the Gulf Coast and other regions," Brady said, adding that Europe may have a shrinking volume of clean components to export.

So if a jump in US RFG output isn't forthcoming soon, the US gasoline market could be especially volatile this year.

Put that together with the likelihood that the crude oil market will settle down later this year—perhaps post-Saddam Hussein and post-Hugo Ch

OGJ Hotline Market Pulse
Latest Prices as of Jan. 31, 2003

Click here to enlarge image

null

Click here to enlarge image

null

Nymex unleaded

Click here to enlarge image

null

Nymex heating oil

Click here to enlarge image

null

IPE gas oil

Click here to enlarge image

null

Nymex natural gas

Click here to enlarge image

null

NOTE: Because of holidays, lack of data availability, or rescheduling of chart publication, prices shown may not always reflect the immediate preceding 5 days.

*Futures price, next month delivery. #Spot price. @New contract