US downstream fundamentals beginning upturn

US downstream fundamentals have gradually strengthened since midsummer, and overall annual product demand is expected to improve by 1.7% next year compared with close to flat this year, a Merrill Lynch analyst said.

By OGJ editors

HOUSTON, Nov. 5 -- US downstream fundamentals have gradually strengthened since midsummer, and overall annual product demand is expected to improve by 1.7% next year compared with close to flat this year, a Merrill Lynch analyst said.

"Several factors are beginning to point towards an improved 2003. These include improving heavy-sour crude oil discounts, strong US gasoline demand, improving distillate demand, and a gradual tightening in US product inventories," Andrew C. Fairbanks said in a research note.

Sour differentials hit bottom in June and are expected to return to average levels next year, he said. The 2003 forecast assumes a normal winter and a stronger economic recovery in the fourth quarter and next year.

"Once in a better total demand environment, we believe the industry will once again run at full capacity under very tight conditions," Fairbanks said. Gasoline imports, though high this year, should be fully absorbed in similar quantities next year with only modest demand growth."

Near-term environment
In the absence of immediate positive overall demand growth in the US, the downstream market will experience minicycles in its inventory numbers and margins, he said.

Poor margins force refinery run cuts that tighten inventories and raise margins. This attracts the offline capacity back onto the market, but it swamps demand and increases inventories again—resulting in a return to lower margins

"We view the February-May 2002 period as the first complete cycle. June-August was the second, and we are now entering the third cycle this year .... We believe the industry will continue to churn through these cycles until a true, sustainable recovery occurs in demand, which we expect will begin during late fall-winter," Fairbanks said.

Merrill Lynch anticipates that the refining industry will "break out of the minicycles tyranny" in the second half of this year and return to full capacity next year. The major risk to our forecast ... would be a double-dip US recession or sustained $34/bbl-plus crude oil prices," he said.

Gasoline imports
Gasoline imports have been a critical issue for the US downstream sector this year and will continue to remain so in the future, Fairbanks said.

US imports are running higher this year than in the high margin years of 2000-01 despite the steep drop in 2002 US refining margins, he said.

"While gasoline demand growth has been strong this year, the market has failed to retighten quickly because rising import levels have effectively offset all the demand growth," Fairbanks said.

Of the 51 countries that exported gasoline products to the US this year, 14 accounted for significant volumes with the biggest share coming from Canada to account for 22% of all gasoline imports.

"The primary growth in incremental imports during the 1999-2002 period has been driven by Western Europe, Canada, and to a smaller extent Russia. These countries have increased exports to the US by 294 thousand b/d over the period," Fairbanks said.

Increasing US imports
Structural changes prompted growing imports from Europe, especially post-2000, he said. "We estimate that the incremental cost to make Eurograde gasoline material into US reformulated gasoline spec material is only about 0.5¢:/gal. This creates a much lower hurdle to transatlantic RFG arbitrage economics, and we think is a key driver," he said.

He said this year's rise in Russian exports to the US stemmed from Russia's agreement with (the Organization of Petroleum Exporting Countries) to withhold crude oil exports from the market.

"Anecdotal reports suggest that the Russians were indeed exporting finished petroleum products instead of crude oil, and it appears some of it even found its way into the US. These volumes are still not large, around 1.7 million bbl so far this year," Fairbanks said.

Future US imports
"Though we are estimating another record year for gasoline imports into 2003, we think the US market will be able to accommodate realistic import levels going forward," he said. "Incremental imports are coming from everywhere, including some unusual places where it should not be economic to export barrels to the US."

Some imported gasoline is expected to drop off the market in 2003, especially if those countries' home markets become more attractive with better local demand, Fairbanks said. This includes Egypt, Brazil, and Argentina.

"Going forward, we believe the US supply demand balance will again return to the conditions of 2000-01 when strong demand and margins in the US pulled in higher imports to balance tight markets (rather than the ... noneconomic barrels being pushed into the market this year)," he concluded.

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