By Ryan Couture and John Auers
While the song bearing the title of today’s blog might not be near the top when most “Parrotheads” list their top Buffet tunes, it came to mind as we ponder the future for refiners, both in the U.S. and abroad. Although the future is always unknowable, developments in the last couple of years have seemingly made the task even more difficult. As oil prices have fallen from over $100 per barrel to less than $30, prices for gasoline and diesel prices have fallen as well, with wholesale prices now hovering around $1/gal for both. While this price decline has had dramatically negative impacts for producers’ bottom lines, refiners have generally fared better. In fact, most have thrived for much of the past year, as the low prices have increased demand, benefiting refiners around the globe. But other aspects of a low price environment have not been so good, particularly for U.S. refiners. In a past blog we talked about how domestic refiners have seen margin premiums above international competitors decline, as the discounts they enjoyed for crude and natural gas have narrowed. But the past is past and what comes next is what is on everybody’s minds. The “Ever Elusive Future” which JB sings about seems to have, “No Reason nor No Rhyme” but industry players have to base plans on something and the Futures Markets can provide a clue. But how good a predictor are those markets? In today’s blog, we take a look at how well they have fared in the recent past.
“For fools and fortune tellers always looking for the cash”
With looming concerns about the health of the global economy, conflicts heating up and cooling down around the world, and government pushing a variety of industry unfriendly policies and uncertainties regarding crude production, petroleum markets are facing increasing volatility. U.S. markets have ebbed and flowed dramatically thus far in 2016, largely in-synch with the price of crude. This volatility has carried over to refining margins, as they have shifted from being very good for much of 2015, to levels that have resulted in refiners cutting crude runs across the U.S. The current bearishness is carrying over to the futures markets as the forward “curve” for product margins looks a bit gloomier than it has been in recent years. This has had pundits talking about what that means; some proclaiming it may even be the early signs of a recession.
Can these forward curves tell us about what the future has in store for refiners, both domestic and international, or do they just reflect short-term market sentiment, meaning little? There are dozens of futures markets looking at benchmark crudes (WTI, Brent, Dubai), as well as products (gasoline, diesel/heating oil, natural gas) for a variety of delivery locations. Looking at crack spreads is a common tool for understanding relative refining performance in the past and present. Applying that crack spread to the futures curves; you can get a glimpse on what the market thinks the future might look like. In order to get an idea of their future, we will look at the benchmark 3:2:1 crack spread using those forward curves. Using NYMEX futures for RBOB gasoline and heating oil (which is ULS grade, akin to ULSD in most places) and using WTI and Brent futures as a crude basis, we can get a relative idea of what the market thinks future refining cracks may be for both domestic and international refiners over the next several years. The latest forward curves for both are plotted in Figure 1, below.
Does the declining trend, evident in the curves, spell a downturn for US refiners? While the curves do predict a softening of crack spreads (which has been seen in the beginning of the year), domestic refiners still maintain an edge and markets predict they will ever slowly (re)gain an edge on their international (Brent-based) counterparts.
The fact is, the crack spread curves alone don’t tell us much about how these compare to historic crack spreads, or how they did (or did not) trend with reality in the past. To get an idea of how the forward curves have performed in the past, historic curves from 2013-2016, 2014-2017, 2015-2018 and 2016-2019 (the one shown above) were overlaid along with the actual crack spreads to give us a clearer picture, as shown below in Figures 2 and 3.
Looking at Figures 2 and 3, the futures cracks have been far from perfect at predicting what the actual market cracks are. Since no one will debate the difficulty in predicting what the spreads might be years out, the first year of each futures crack is the solid bold line to help compare the “near market” futures versus the actual market crack spreads (in grey). One thing is clear, while the futures have directionally trended with the market cracks, none have accurately predicted the market, especially when there have been dramatic movements. The closest was in 2013, a year of relative stability in prices. With the recent instability, it is no wonder the futures markets have not foreseen the shifts in spreads.
“More than the strong survive, who’s gonna be alive …”
This brings us back to the question, “What does this have to do with the ultimate refining margins?” The high margins that some U.S. refiners were making, capitalizing on the difference between stranded U.S. crudes and internationally priced products, has narrowed considerably as the absolute crude price fell in late 2014. At the beginning of this year, we are seeing near parity between the crack spreads, as the WTI discount to Brent became, at times, a premium. While WTI crack spreads have fallen, international Brent-based crack spreads have improved as demand picked up. Moving forward, the futures curves predict shrinking margins for refiners, both domestically and internationally. Figure 4 shows the various annual futures curves for Brent and WTI-based cracks, as well as the latest futures curve extending from January 2016-December 2018.
While the spread between WTI (domestic) and Brent (international) crack spreads has dramatically compressed in the past year, we are only looking at a few years, including some with abnormally high margins for WTI-based crack spreads. If, instead, we step back a few additional years and look at how the curve compares versus 2010-2015 historic crack spreads, we get a slightly clearer picture. Figures 5 and 6 show how the 2016 curve fits versus the maximum, average and minimum actual crack spreads for 2010-2015.
Although we are seeing lower than average futures projections for the WTI crack spread in 2016, this does not necessarily spell “doom and gloom” for U.S. refiners. Given those years of high margins, it is expected that as the spread between Brent and WTI has closed, so would the gap in crack spreads. Low prices have spurred product demand for refiners globally, and global product demand growth is forecast to continue to grow. U.S. refiners remain well poised to supply that need. Futures prices for WTI cracks remain several dollars per barrel above the international counterparts as the projections move out, meaning markets predict domestic refiners still have an edge moving forward. Additionally, crack spreads do not take into account the cost of refining, for which the U.S. will continue to hold an advantage.
Conclusion
While futures markets are a valuable tool for all segments of the energy market, they are by their very nature just a reflection of current thought and sentiment. They currently forecast a difficult environment for the industry and they very well could be correct, but so is the proverbial “broken clock” a couple times a day. As JB sings, “The Ever Elusive Future is a script right from our past.” We all know how quickly things can and have turned around, and it is likely they will again. The key question is in which direction will that turnaround take place, and that is indeed very difficult to predict.
Although Turner, Mason & Company does not possess a working crystal ball, we do possess significant experience and understanding of the industry, and have devoted countless hours in analyzing fundamentals and trends. We have incorporated this analysis into our recently released 2016 edition of The Crude and Refined Products Outlook. The Outlook includes our forecast for crude and product prices through 2030 in the main refining markets around the globe. While unforeseen developments will certainly cause aspects of the Outlook to be “wrong,” the fundamental drivers underpinning the forecasts are consistent and reasonable and provide a good basis for long-term planning efforts. What’s more, knowing that it is impossible to actually forecast prices precisely, we devote significant effort in The Outlook to explaining the key drivers shaping prices and how we expect those drivers to develop in the future. For more information on The Outlook, visit the TM&C web site at turnermason.com or call Shanda Thomas at 214-754-0898.