REFLECTIONS ON U.S. DOWNSTREAM: A MARKET IN TRANSITION

March 13, 1995
From remarks to the Middle East Petroleum and Gas Conference, Muscat, Oman, Jan. 16, 1995. Even in an industry as accustomed to twists and turns as the oil industry, the decade of the 1990s is shaping up as a period of unprecedented change. An ancient Greek proverb declares, 'You cannot step twice into the same river" because the flow creates a new river with each passing moment. That's an apt description of the U.S. downstream, the swiftly flowing marketplace in which my company

Paul W. Chellgren
President and Chief Operating Officer
Ashland Inc.
Ashland, Ky.

From remarks to the Middle East Petroleum and Gas Conference, Muscat, Oman, Jan. 16, 1995.

Even in an industry as accustomed to twists and turns as the oil industry, the decade of the 1990s is shaping up as a period of unprecedented change.

An ancient Greek proverb declares, 'You cannot step twice into the same river" because the flow creates a new river with each passing moment.

That's an apt description of the U.S. downstream, the swiftly flowing marketplace in which my company operates.

The floodgates were thrown open with passage of the Clean Air Act (CAA) amendments of 1990, and since that time the industry has operated in a constant state of change.

With total processing capacity of 346,500 b/d, Ashland is one of America's largest independent refiners.

As an independent refiner, we do not have material crude oil production of our own. Instead, we are a major purchaser on the world market, buying nearly 330,000 b/d of crude oil. While a significant percentage of our daily supply comes from the U.S. and Canada, more than half is acquired from sources outside North America. So we are well qualified to talk about the issues facing the U.S. downstream.

DOWNSTREAM SIGNIFICANCE

Why are changes in the U.S. refining sector relevant to this audience, an international gathering assembled in the world's preeminent producing region?

The simple answer is this: Crude oil is only fundamentally valuable when transformed into useful products such as gasoline, jet fuel, distillates, and petrochemicals. It is the refining sector that makes the products that create value and consumers purchase. And it is the refining sector that provides the conduit through which revenues flow back to the producer.

Industry participants today share a single marketplace, a vast web linking the world's producing and refining centers. Across this web information travels at dazzling speeds, carried by sophisticated instruments such as computerized trading, options, forward contracts, and 24 hr crude and product markets.

Clearly, then, the dramatic changes reshaping the U.S. downstream, consumer of roughly a quarter of the world's oil supply, have far reaching implications for international oil markets. Three trends in particular stand out.

MAJOR TRENDS

First, U.S. refiners are becoming more competitive. Spurred by massive recent investments related to new transportation fuel requirements, U.S. refiners have enhanced their ability to source and process a wide range of crude oils. At the same time, they are seeking greater control of their own destinies through increased integration in the retail marketing sphere.

Second, the needs of the downstream are changing. Meanwhile, higher conversion capacity worldwide and shifting crude oil supply patterns are exerting an influence on world oil markets. The upshot is a world production picture out of step with the needs of its single largest customer, the U.S. refining sector.

Finally, new fuels specifications are leading to a massive realignment in U.S. product markets, generating ripples that are certain to rock crude and product markets across the globe.

U.S. SITUATION

U.S. Oil Consumption, Production, and Imports (19901 bytes)

Before we examine these three developments further, let's review the current state of affairs in the U.S. oil industry.

U.S. production of crude oil has declined steadily since 1970, the year of peak production. In 1994, domestic production averaged roughly 6.7 million b/d of crude oil.

Higher U.S. drilling costs, restrictions on the most promising land, and diminished prospects in known producing areas indicate this decline will continue for the foreseeable future. In 2000, U.S. production is projected to average around 5.7 million b/d of crude oil.

Meanwhile, demand is once again climbing after a setback in the early 1980s related to sharply higher crude prices and slower growth rates. While robust U.S. economic growth spurred a 3% gain in consumption in 1994 to an estimated 17.7 million b/d, growth of 1-5%/year is projected for the remainder of the decade.

Consequently, the gap between U.S. production and U.S. consumption will continue to widen, and a growing volume of imports will make up the difference.

Total imports are projected to climb 3% /year, reaching 10.7 million b/d, or 57% of demand, in 2000.

The U.S. refining sector is comprised of 179 refineries with operable capacity of 15.1 million b/d. U.S. refineries are among the most complex and sophisticated in the world, capable of processing a wide variety of crudes.

Despite this high level of sophistication and the related capital employed, downstream earnings have languished during the 1990s. In response to a difficult operating environment, U.S. refiners have made numerous moves during the 1990s to strengthen their already sophisticated supply, manufacturing, and distribution systems.

On the crude oil sourcing side, U.S. refiners have pursued greater and more economical access to foreign crudes. A key factor in this effort has been the push for improved infrastructure, especially in the Midcontinent.

Not only will refiners have access to a wider array of crudes, they also have increased their ability to process a heavier, more sour slate. Heavy oil upgrading and sulfur removal capacity has increased dramatically, spurred by addition of processing equipment necessary to produce cleaner-burning fuels.

CHANGING CRUDE OIL NEEDS

Having invested significant capital to add conversion capacity, U.S. refiners are seeking a heavier crude oil slate. Unfortunately, production trends favor lighter grades.

The narrowing of crude oil price differentials has undermined the efforts of U.S. refiners to earn a reasonable return on investment.

The U.S. refining industry has invested heavily to add coking capacity in recent years, increasing its ability to crack vacuum bottoms into lighter products. But a differential of $3-4/bbl between the lightest and heaviest grades is necessary before this investment can earn an attractive return.

Higher average complexity naturally boosts demand for heavier and more sour crudes and pushes their price up vs. lighter and sweeter grades. But other factors are equally important.

Squeezing the sweet/sour and light/heavy differential from the supply side, for instance, is increased production of the lightest, sweetest crudes, especially North Sea Brent.

In the past 5 years, North Sea volumes have climbed by more than 50%, or roughly 1.9 million b/d, spurred by advances in seismic, horizontal drilling, and other aspects of recovery technology as well as improved tax structures in Norway and the U.K.

European market cannot absorb these additional barrels, and Brent is therefore discounted for movement to U.S. markets. Significant discoveries of light, sweet crudes in other regions of the world suggest such supply fundamentals could continue over the near term.

Moreover, countries with excess capacity operating under Organization of Petroleum Exporting Countries' quota constraints are emphasizing sales of lighter, more valuable grades in their production portfolios, primarily as a means of maximizing revenues.

In short, current crude production trends and objectives run directly counter to the needs of the U.S. downstream.

We expect compression of sweet/sour and light/heavy differential to have a long-term impact on the marketplace. Few U.S. refiners now expect a reasonable return on their recent investment in conversion capacity. Given that forecast, it is unlikely the buildup of such capacity will continue.

NEW FUEL SPECIFICATIONS

The third major trend that is reshaping the U.S. downstream carries perhaps the most far-reaching consequences for upstream and downstream interests. I'm talking, of course, about increasingly stringent environmental regulations related to the 1990 CAA amendments, including mandates for cleaner burning fuels.

These mandates require refiners to change the basic composition of gasoline sold in certain parts of the country four times during the 1990s. They also cut the allowable sulfur content of diesel fuel used in over-the-road applications by 90%.

Just recently the industry entered the reformulated gasoline era.

On the first day of 1995 reformulated gasoline, or RFG, was required in nine U.S. metropolitan areas designated as severe ozone nonattainment It is also now available in areas of the country with less severe ozone problems that choose to opt into the federal program.

At present, the new fuel is required in parts of 17 states and the District of Columbia, areas that account for roughly 33% of U.S. gasoline consumption. California has its own stricter standards that go into effect in 1996. If all nonattainment areas were eventually to opt into the program, RFG would total roughly 52% of the U.S. gasoline market.

The RFG program will be implemented in a three-step process: the simple model, which took effect Jan. 1; a first phase complex model, which will be required Jan. 1, 1998; and a Phase II complex model, which will take effect Jan. 1, 2000.

To make matters more complex, RFG is not the only option available to meet local air quality goals. Many other areas of the country have rejected RFG in their compliance strategies in favor of less expensive but also less-effective fixes such as gasolines with very low vapor pressures.

A study by the National Petroleum Council concluded that the refining industry will spend nearly $37 billion during the 1990s just to meet CAA stationary source and clean fuel requirements. That compares with a 1990 net book value for all refining fixed assets of $31 billion.

Despite that considerable commitment by the U.S. refining sector, it is not entirely apparent that these requirements will stand still long enough for refiners to meet them and begin to earn an adequate return on their investment.

GLOBAL IMPLICATIONS

What do increasingly stringent U.S. environmental requirements mean for world crude and product markets?

Environmental regulations are known to have a particularly eastward migration pattern. They tend to originate in California, leap to the East Coast, then spread to the remainder of the U.S. before spilling into the Atlantic basin and points east. Consequently, refiners around the world may have to deal with increasingly stringent product specifications even as they expand capacity to meet demand growth.

The new requirements could also affect product imports.

A recent ruling confirmed that countries selling gasoline into U.S. markets must use the domestic refining industry's average baseline, rather than their own, in meeting RFG and antidumping provisions. That may make it more difficult for foreign refiners to export their gasoline to the U.S.

Crude oil export markets could also change as refiners seek out crude slates that will help them meet new specifications. ln particular, given the high cost of desulfurization, low sulfur fuel requirements could reduce demand for high-sulfur crudes. Finally, higher costs related to environmental requirements could cause demand to fall and result in lost market share to other fuel sources, particularly natural gas.

Copyright 1995 Oil & Gas Journal. All Rights Reserved.