The oil majors reported some very dismal numbers for the first quarter, but earnings exceeded market expectations largely because of earnings from their downstream units: Refining operations have allowed the large integrated oil companies to weather low oil prices much better than upstream E&P companies.
Refining operations have allowed the large integrated oil companies to weather low oil prices much better than upstream E&P companies.
Although downstream assets insulated some of the oil majors, the first three months of 2016 were not as kind to the refining sector as past quarters. Refining margins shrank in the first quarter, down roughly 30 percent from the highs of mid-2015.
Measuring refining margins is not straightforward, given that different refined products have different costs and sale prices, and a barrel of crude can be turned into an array of refined petroleum products. That said, one popular metric is the 3:2:1 crack spread, which measures the margin a refiner can earn by turning three barrels of crude oil into two barrels of gasoline and one barrel of diesel.
Crack spreads plunged in the first quarter, hurting downstream earnings, but major U.S. refiners believe the sector is starting to rebound.
2015 was a good year, but Q1 2016, not so much
Crack spreads widened last year as a glut of crude oil in the U.S. pushed down WTI prices, while demand for refined products remained robust. A ban on crude oil exports, which was finally lifted in December, led to rapidly rising crude storage levels, depressing WTI relative to the Brent benchmark, which reflects global conditions more so than WTI. Refiners thrived on the disparity between the two benchmarks, buying discounted American crude and selling refined products at higher prices globally. Last year was one of the worst periods in recent memory for oil producers, but it was a banner year for refiners.
Margins began to narrow toward the latter half of 2015, as a result of a variety of reasons. First, U.S. oil production began to fall. After hitting a peak in April 2015 at 9.69 million barrels per day (mbd), output fell to 9.2 mbd by the end of the year. Production has continued to decline, dropping to about 8.825 mbd in the last week of April. Lower production has slowed the glut within U.S. borders and helped compress the WTI-Brent spread.
Also, when the U.S. Congress lifted the more than 40-year old prohibition on crude oil exports, it helped push the WTI and Brent benchmarks closer to each other, hurting refiners’ profits. By early May 2016, the discount for WTI relative to Brent narrowed to less than $1 per barrel, down from as high as $10 per barrel in the first quarter of 2015. While the shrinking difference between WTI and Brent is squeezing refining margins, a mild winter undermined demand for heating oil and diesel, adding to refiners’ woes.
When the U.S. Congress lifted the more than 40-year old prohibition on crude oil exports, it helped push the WTI and Brent benchmarks closer to each other, hurting refiners’ profits.
As The Wall Street Journal noted, the top six oil refiners—ExxonMobil, Chevron, Valero, Phillips 66, Marathon, and PBF Energy—saw their combined downstream profits fall by half in the first quarter of 2016 compared to the same period a year earlier. Exxon’s $906 million in earnings from refining helped it turn a profit, but its downstream unit was still down 46 percent compared to a year earlier. Valero earned $495 million for the quarter, half of 1Q 2015 levels. Not only were earnings down, but they were also much lower than market analysts had expected. Bloomberg found that seven out of eight large independent refiners reported first quarter earnings below consensus forecasts.
Margins begin to rebound
After a rough first quarter, refining margins are starting to improve. The 3-2-1 crack for the Gulf Coast rose $5.19 per barrel in the month of March, and at the New York Harbor, the spread increased by $8.42 per barrel. Refining margins are widening again because of growing demand for gasoline. American motorists are purchasing heavier and less fuel-efficient SUVs on the back of cheap fuel and also driving more miles in these gas guzzlers. U.S. gasoline consumption is on track to break records in 2016, surpassing the all-time high set in 2007.
At the same time, gasoline storage levels are starting to fall at a solid pace, after hitting a record high 258 million barrels in February, the equivalent of nearly 30 days’ worth of supply, the largest stockpile in nearly two decades. Although inventories are still well above the five-year average, strong gasoline demand is helping to burn through some of that excess, which is supportive of higher refining margins.
“The first quarter presented us with challenging markets, with gasoline and diesel margins under pressure,” Valero’s CEO Joe Gorder said recently. “We’re optimistic about product demand. Here in the U.S., distillate inventories have shown favorable reductions recently, and the summer driving season is quickly approaching, which should support gasoline margins. We also expect the strong export demand we experienced in the first quarter to continue,” Gorder said in a statement following the release of the company’s first quarter earnings.
Despite the optimism, a rebound for the refining sector depends on continued growth in demand for refined products—not just domestically, but also around the world.
Despite the optimism, a rebound for the refining sector depends on continued growth in demand for refined products—not just domestically, but also around the world. The industry could run into trouble if demand fails to grow as expected. There are still very large levels of refined products sitting in storage in the U.S., Europe and Asia—the IEA reported in April that middle distillate storage levels in the OECD are 100 million barrels above year-ago levels, and sit at their highest level in years. If global demand doesn’t start to erase this supply overhang, margins could easily fall back again after the market passes peak summer demand.