The refining sector is the one part of the oil and gas industry that is actually making money in the current low price environment. The good times are slowing down, with demand growth weakening and refined product inventories ballooning. But U.S. refiners are still set to have a strong year in 2016, largely because the industry is typically more flexible than crude producers. “Downstream players are more responsive than those in the upstream,” said John Auers of refining consultancy Turner, Mason & Co. “They can trim back much easier to manage supply based on demand.”
The refining sector is the one part of the oil and gas industry that is actually making money in the current low price environment.
There are dangers for refiners, however: The biggest possible downside is in fact demand—if it underperforms, the excess refined product in storage will weigh on margins. “Gasoline and diesel are now in oversupply,” said Auers. “Demand is not yet soaking up all production. Part of it is seasonal, but refiners are banking on low prices stimulating consumption.”
February, a slightly cruel month
For U.S. refiners, February was a difficult month, relatively speaking, with margins in certain regions turning negative. But benchmark crack spreads—the difference between the purchase price of the crude and the selling price of the refined product—have held up well, and should rebound once demand picks up when motorists hit the road more often in the spring and summer. The NYMEX gasoline crack spread versus Brent has fallen from just above $25 per barrel at the beginning of the year, but fluctuated between healthy levels of $15-$20 per barrel during February. Meantime, the NYMEX diesel crack spread hasn’t been as stellar, but has found support around $10 per barrel, as it contends with a bigger glut.
Both major refined products have seen major inventory gains since the beginning of the year that need to be worked off. U.S. distillate stocks—which include diesel and heating oil—are in a relentless rise upward: 1) they have jumped by more than 10 million bbl since the end of last year 2) they are now above the 5-year average 3) they have increased by 40.6 million bbl, or almost one-third, since this time last year.
The other piece of bad news from a refiner perspective is that distillate fuel demand is .8 mbd lower than year-ago levels, based on preliminary data from the EIA. The relatively mild winter in the U.S. Northeast, the only part of the country that uses substantial amount of heating oil, helped put a cap on demand. Refiners have adjusted accordingly by cutting back distillate output, which is down .2 mbd, and continuing to send large volumes to customers in the Latin American and European markets. Exports of distillate fuel have stagnated but remain high around 1.3 million barrels per day. “We continue to see good demand for both distillate and gasoline abroad,” said an official at Valero, the top refiner in the U.S., on the company’s recent earnings call, noting that it hit record export volumes in the fourth quarter.
“We continue to see good demand for both distillate and gasoline abroad.”
The gasoline market is relatively weak, too, but not as bad as diesel and heating oil. Inventories are well above the five-year range and are up by almost 15 percent versus year-ago levels. At the same time, however, stocks have declined by 3.7 million bbl in the past two weeks and demand is .3 mbd higher when compared to the same time in 2015, getting a continued bump from low retail prices, which should benefit refiners all year long.
The heavy crude advantage
Margins are set to fall this year, but remain at robust levels, signaling that downstream players should indeed perform well while upstream and oilfield services companies will see continued carnage from lower oil prices.
Last year, the Gulf Coast 3-2-1 crack spread versus Light Louisiana Sweet (LLS) averaged $14 per barrel, according to Turner, Mason & Co., but that should fall to $9/bbl this year. Despite the dip, the 2016 level, if realized, would still exceed the 2009-11 average, when demand took hits from the 2008 financial crisis.
Margins are set to fall this year, but will likely remain at robust levels, signaling that downstream players should indeed perform well while upstream and oilfield services companies will see continued carnage from lower oil prices.
Despite the current oversupply in gasoline and diesel, refiners have a lot going for them. Low prices support demand, particularly for gasoline, and they can export excess supply. Just as importantly, U.S. refiners, which have the most flexible plants in the world and run a variety of crude grades, hold a huge advantage now with low-cost feedstock. From 2011-15, they enjoyed wide differentials between U.S. crudes and international prices—they bought discounted crude at U.S. prices and then sold products that were relatively higher at international levels, giving them large profit margins. Although spreads between U.S. crudes and global prices have tightened (LLS, in fact, is at parity with Brent), U.S. refiners are well equipped to run discounted heavy crudes. Wide light-heavy spreads should persist throughout the year, giving them access to cheap grades. The return of heavy Iranian barrels to the global market, along with high production of heavy grades in Canada and Latin America, will depress heavy crudes but the ongoing decline in U.S. light shale oil will likely support light prices, causing differentials to widen, making conditions favorable to many in the downstream sector in the U.S.
Still a good time to be a refiner
“[Refiners] can make just as much money or more with $30 oil or $100 oil but not if you are a producer.”
This past week, Warren Buffett summed up why refiners are darlings for investors even when prices crash. “In the oil production business, it all depends upon the price of oil whether you’re going to make money in the future. In the refining business, it all depends on basically what is the crack spread, which is basically what it costs you to buy oil and sell it,” he said on CNBC. “[Refiners] can make just as much money or more with $30 oil or $100 oil but not if you are a producer.”
The outlook has shifted from last year, but it’s still good to be in the refining business. That’s not to say there aren’t danger signs on the horizon. Demand needs to pick back up, which isn’t guaranteed in the current macro-economic environment, and managing a large refined product inventory overhang will not be easy. But given their nimbleness, U.S. refiners are poised to make current market conditions work to their advantage.