Market conditions had been mostly kind to U.S. refiners over the past five years. The massive rise in domestic production gave them cheap feedstock and, in turn, hefty margins. Demand growth picked up once the economy recovered from the 2008-9 financial crisis. When any excess of refined products came about, refiners increased exports, very sharply, to Europe, Latin America and Asia. Inventories remained slim enough to underpin product prices while crude struggled with a growing surplus.
Refiners will continue to struggle for a variety of reasons: Inventories are likely to stay elevated, spreads between U.S. crudes and international grades are poised to remain tight, downstream overcapacity is set to persist, and demand growth is showing mixed signals.
But now their luck is running out. The crude overhang has shifted to a glut of refined products. Moreover, the wide discounts U.S. refiners enjoyed for their feedstock relative to international prices have mostly evaporated as shale output has declined and U.S. producers can now freely export crude. Lastly, demand growth is not as robust as originally thought, while product exports have, for the most part, plateaued.
Refiners will continue to struggle for a variety of reasons: Inventories are likely to stay elevated for some time, spreads between U.S. crudes and international grades are poised to remain relatively tight, downstream overcapacity is set to persist, and demand growth is showing mixed signals. Besides independent refiners, downstream departments in the oil majors will also suffer, bringing about another stroke of bad luck to companies such as ExxonMobil and BP that have already taken major hits from ongoing weak crude prices. Many of the oil majors have been saved by their downstream operations since the oil price collapse, and the end of this lifeline is likely to hit their earnings hard through the rest of the year.
In a reflection of the pressure refiners are now seeing, the gasoline crack spread versus NYMEX WTI—the differential between the price of crude and gasoline—has fallen to under $14 per barrel as of the end of last week, down from over $20/bbl from March-May and some $16 lower than this time last year. At the same time, the crack spread for distillates—heating oil and diesel—isn’t performing well either, down to $12, falling some 20 percent in the past month. Looking back even further, the distillate crack has plunged 35 percent from year-ago levels.
If current crack spread levels are the floor, refiners could say that the worst is over. However, since crude is moving more into balance while refined product stocks are high and downstream capacity has grown sharply, crack spreads could fall further, undermining margins.
The overall supply picture is bearish, and it’s uncertain when stocks will significantly draw down. The Energy Information Administration (EIA) sees gasoline inventories remaining above the five-year range average (see below) throughout the rest of this year and into next. Distillates, meanwhile, are somewhat tighter, but will remain at the high end of the average range, according to the EIA.
Furthermore, the growing evidence that U.S. demand is not rebounding as strongly as analysts anticipated creates more trouble for refiners—low retail fuel prices aren’t enough to create a significant draw in product stocks. Last year, gasoline demand in the U.S. grew by a stronger-than-expected 240,000 b/d. This year, gasoline is forecast to reach 9.29 mbd, essentially tying the record of 2007, but the annual increase would be much lower at 130,000 b/d. Moreover, the outlook may be revised downward, given that the past two months, the EIA adjusted its preliminary gasoline demand figures lower by more than 200,000 b/d for both April and May. For next year, the EIA sees gasoline demand growing by a very modest 20,000 b/d as the stimulus from the low price environment recedes. Total petroleum demand will see the same trend—moving from robust growth of almost 300,000 b/d last year to a modest 160,000 b/d in 2016.
The growing evidence that U.S. demand is not rebounding as strongly as analysts anticipated creates more trouble for refiners—low retail fuel prices aren’t enough to create a significant draw in product stocks.
Against this backdrop, speculators are now net short gasoline by more than 6,000 contracts, versus holding net length of roughly 25,000 contracts about two and a half months ago, a reflection of the sharp reversal in market sentiment.
The distillate fuel market has been weighed down by similar trends, while also hurting from the fact that exports are no longer growing. Exports soared from 2010-13, reaching a peak of 1.4 mbd in October of 2013 as refiners shipped excess supply to regions that were short on distillates, mostly Latin America and Europe. But new downstream capacity, particularly big export plants in the Middle East, has made competition fierce in these markets. As a result, exports have remained stagnant, fluctuating between 1 million-1.3 mbd, unable to revisit the peak reached almost three years ago. Meanwhile, China, the world’s second largest consumer, is now a net exporter of products—another indication how global and competitive the refined products markets are.
Tighter crude spreads
From 2010 through last year, U.S. refiners enjoyed a competitive advantage over their counterparts in other regions because of the cheap crude grades available in the U.S. The shale boom, with crude supply growing by more than 1 mbd for four years in a row, caused U.S. prices to collapse relative to the rest of the world. U.S. benchmark WTI sold consistently under European marker Brent (see below), while other grades, such as those produced in the Bakken in North Dakota traded well below WTI. The low U.S. oil prices inflated margins.
Two main factors, however, have sliced the spreads back to normal levels. First, U.S. oil production has fallen by more than 1 mbd from its peak reached last April. This development has kept the U.S. market, though oversupplied, from becoming even more glutted that the rest of the world. At the same time, with the U.S. government in December having lifted the 40-year ban on crude exports, which refiners lobbied hard to keep in place, U.S. producers can sell cargoes into the international market if the economics justify. While the export flows have been modest, they have kept the WTI-Brent spread from blowing out again and removed distortions in the U.S. market.
Right now, there is simply too much refining capacity. In the longer run, the situation could worsen for the industry.
In order for refined products markets to restore some semblance of balance in the short term, demand has to rise or utilization needs to drop. Right now, there is simply too much refining capacity. In the longer run, the situation could worsen for the industry. In the next five years, according to consultancy Turner, Mason & Co., refiners are scheduled to add a massive 22.4 mbd of downstream capacity (see below), growing by three and half times the pace of global demand, almost guaranteeing global imbalances will continue unless a large number of projects are canceled or delayed.
“Despite the fact that we’ve seen very strong product demand, obviously, the refinery utilization has been such that supply has been able to keep up and even outpace demand,” said Gary K. Simmons of Valero on the company’s most recent earnings call. “So, ultimately, we’re going to need a rebalancing and see lower refinery utilization moving forward.”
Valero, the country’s leading independent, has seen its stock fall by as much as 28 percent this year, before recovering slightly.
“Refining has always been a cyclical industry,” Andrew Lebow of Commodity Research Group told The Fuse. “Right now the situation could go from bad to worse. The products markets are out of balance. There needs to be run cuts or the industry has to rationalize capacity. Europe is the obvious place for this to happen, with its simple inefficient plants. It’s clear there will be some pain ahead.”
Refiners were the bright spot for the industry over the past couple of years, as they were able to still see stellar profits while producers and the service sector had to cut capital expenditures, reduce cash flow, increase debt, and lay off staff. Now the downstream industry is suffering similar misfortunes, and will continue to do so for some time.