By John Auers and John Mayes
Ever since the crude price collapse in the second half of 2014, the petroleum markets have been consumed with doom and gloom. And, with the exception of a few good days like yesterday, the news has just seemed to get worse and worse for the industry thus far in 2016. The oil rig count continues to plummet, capital programs are being slashed and massive layoffs have been announced. As the pricing environment continued to worsen, talk has even shifted to possible bankruptcies. So far, only small production companies have filed for protection from their creditors, but if the current market prevails for much longer, larger companies will become increasingly threatened. Despite yesterday’s 6% bump above $30 per barrel for WTI, it remains at levels not seen for 12 years, and the prevailing sentiment is firmly in the “lower for longer” category.
In an effort to brighten things up, let us use the title words from the 1970’s Stevie Wonder penned and Rufus/Chaka Khan performed hit, “Tell Me Something Good” to discuss the one segment of the industry that has thrived – the refiners. While the producers and even the midstream have suffered as prices have fallen, the downstream segment has prospered for much of the past 18 months. With consumers responding to pump prices they thought would never return, they are driving and buying gasoline like they haven’t in many years. This strong demand led to excellent gasoline margins and boosted refiner’s earnings across the globe in 2015. But more recently, even this downstream boom has begun to hit some roadblocks, as demand growth has slowed and refining margins (particularly in the U.S.) have fallen, resulting in relatively poor 4th quarters and slow starts in 2016. Are these roadblocks permanent or will refiners return to saying “Something Good”?
Since the deregulation of the U.S. refining industry in the early 1980s, and continuing through the late 1980s and 1990s, U.S. refining margins have been challenged. In the beginning of the new millennium, margins began to improve as the supply/demand balance became tighter, peaking during the so called “Golden Age of Refining” in 2005 through mid-2008. The ensuing Great Recession put an end to these good times, but things really got going again for many refiners in 2011. In that year, margins in the midcontinent and PADD IV exploded to levels, which put the Golden Age to shame by comparison.
The primary driver for this surge in earnings was the rapid growth in crude production, which created stranded crudes. These grades did not have adequate access to exit pipelines and, therefore, became heavily discounted in price. Bakken was often bottlenecked in North Dakota, while the Permian Basin was constrained on several occasions. This situation caused even higher margins in 2012 before a buildout of pipeline capacity allowed for a return to more typical margins in 2015.
All the other regions of the U.S. saw some advantage by the distressed crude-pricing, but to a lesser degree. Bakken flowed to PADDs I and V by rail, while PADD III was benefited by the stranded WTI in the Permian Basin. By 2015, margins on the West Coast led the U.S., which benefitted from the curtailment of the Torrance refinery following an explosion in February of that year.
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The recent spike in U.S. refining margins appears even stronger when compared with other markets (Figure 2). Margins in the U.S. have been well above other refining centers for many years. In addition to being assisted by often distressed crude prices, U.S. refiners have enjoyed very low natural gas prices (generally the largest component of a refinery’s operating expenses) as well as a significant complexity advantage compared to other global refiners.
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Since 4Q 2015, and extending into early 2016, there has been a downturn in U.S. margins. This can be attributed in part due to the increased level of refinery runs in the second half of 2015, which caused inventories to build. The growing global crude inventory build kept crude prices low, which encouraged the high refiner run rates. We also believe a lot has to do with the seasonal slowdown in demand. Regardless the cause, refiners have responded by trimming rates, but we can expect both demand and rates to pick up again as we move into the summer driving season in our current low price environment.
The strength of refining margins can also be seen in stock valuations, which have steadily risen for independent refiners in recent years. When crude prices began to decline in 2014, so did the stock prices for independent producers and even for the international majors (Figure 3). By the middle of 2015, this divergence had become substantial with the stock prices of the producers and majors falling below levels at the beginning of 2013. Even midstream companies have been hit hard, but to a slightly lesser degree. With the recent dip in margins, refining stocks are beginning to take the hit as well, showing modest declines, albeit still above their 2013 base unlike the other industry segments.
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While the market devaluation of independent producers is understandable, the fate of the international majors has been just as severe. This is in spite of the earnings announcements of the majors which indicated their earnings were being supported by their own relatively strong refining results. It was clear that the lower results of their upstream segments were weighing heavily on the minds of investors.
Figure 4 details the sharp contrast in the earnings of the majors in recent years. Between 2007 and 2014, 83% of the earnings of the majors were brought in by their upstream divisions while the refining segments only contributed 17%. In 2015 however, there was a significant reversal of this pattern. The refining divisions of the international majors for the last year produced 84% of their earnings, while the upstream contributed only 16%.
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The future of refining margins is clouded as usual. The low price environment produces impacts on refiners, which are more complex than for other market segments. On the positive side, the low prices stimulate demand and lessen competition for products from alternative sources. On the negative side, however, low prices decrease the relative crude and natural gas-pricing benefits.
The ending of the crude oil export has received considerable attention in recent months, but is not likely to have a substantial impact on the market. Over the longer term, the end of the export ban will keep the large domestic discounts from developing by better linking U.S. grades with world crude prices. East Coast refiners will be the primary loser in that they will become more disadvantaged by the Jones Act. Crude can be tankered to Europe in foreign flag vessels but must go to the East Coast in more expensive Jones Act ships.
The industry will continue to be plagued with a plethora of environmental and regulatory concerns in the next decade. From alternative fuels mandates and carbon taxes to permitting issues and rising octane requirements, the industry will face a steady barrage of challenges. The key to healthy margins, however, will likely remain with strong product demand. This should remain solid, driven by reasonable economic growth and low oil prices.
Even with the challenges of the next decade, the U.S. should remain a dominant force in the global refining industry, but the ability to maintain and grow product exports will be critical. The benefits of strong domestic production will remain (along with the natural gas price advantage), which should keep the U.S. competitive in global markets. Continued rationalization in Europe and OECD Asia, however, should continue.
Turner, Mason & Company has just released its 2016 edition of the Crude and Refined Products Outlook. With special topics discussing the effects of the low crude price environment, a decline in the global dieselization trend and the rising values of octane in gasoline, the Outlook provides a crude and product-pricing forecast through 2030 in numerous market regions. For more information, visit the TM&C web site at turnermason.com or call Shanda Thomas at 214-754-0898.