“King of All the World” – U.S. Refiners Still on Top, but for How Long?

By Ryan M. Couture and John R. Auers

Over the last several years, U.S. refiners have climbed to the top of the global refining mountain, facilitated by both new developments and advantages that have been decades in the making.  This has allowed the U.S. to move from being the world’s largest importer of refined products to the largest exporter, and allowed domestic refiners to operate at high utilization rates even while plants in other developed economies are shutting down.  Being the king is not always easy, though.  There are always those looking to dethrone you.  While some of the advantages U.S. refiners have are hard to replicate, others can be snatched away, returning U.S. refiners to a “window ledge” with some of the competition.  In recent months, the market has shifted, and low oil prices have begun to rebalance refining power.  What will that mean for U.S. refiners?  Will U.S. refiners’ reign be challenged, or will they continue to be, as the Old 97’s would say, “King of All the World?”   We’ll discuss some of the factors that will drive those dynamics in today’s blog.

“Everything was upside for the moment”

U.S. refiners have maintained leading refining margins over much of the last decade.  Even during the financial crash of 2008 and 2009, when many international refiners were struggling with red ink, U.S. refiners were able to squeeze out at least passable margins.  This has been made possible by developing competitive advantages, both within and out of their control.  U.S. refiners benefited from strong, growing domestic demand throughout the 1990s and into the mid-2000s.  Thinking the future was in heavy crude production, U.S. refiners invested in increasing levels of upgrading capacity in order to process Venezuelan and Canadian heavy crudes.  As crude prices spiked in the run-up to the great recession in 2008-2009, crude spreads widened, and so did margins.  Those refiners that could take advantage of heavy crudes benefited, most of whom were in the U.S.

With the recession came a fall in both demand and crude prices.  This put increasing pressure on refiners across the globe, and the world quickly went from a shortage to an excess of refining capacity, leading to the closure of many facilities.  At the same time, significant advances in upstream technologies such as fracking and horizontal drilling were taking place.  This led to the ability to economically develop vast “tight” gas and oil reserves in the U.S.  Prices for energy fell across the board during the recession, but as crude prices recovered, natural gas prices in the U.S. stayed low due to the rapid growth in tight gas production.  Since energy is one of the largest expenses a refiner has, these low prices gave U.S. (and Canadian) refiners a growing advantage vs. their overseas competitors.

Figure 1 - Sel Nat Gas Crude Prices

While fracking was first applied to natural gas, it was soon after used for crude production, and the rest is history.  U.S. production of light tight oil took off, supplying initially the mid-continent and Gulf Coast, but eventually many PADD I and V refiners with domestic crude.  This light, sweet crude was unlike what many refiners had anticipated in the run-up, and it began to trade at a discount.  As production increased further, the limits on exports coupled with oversupply of light, sweet crude with limited logistics options made for localized crude discounts and some rather sky-high margins.

Figure 2 - US Intl Refining Margins

As the global economy recovered after the great recession, Latin American petroleum demand continued to grow.  Demand soon outstripped refining capacity, and due to the challenges associated with building refineries in Latin America (corruption, mismanagement, lack of skilled labor and government bureaucracy to name a few) increasingly greater percentages of their clean products came from U.S. refiners.  This helped to balance the U.S. crude market by creating an outlet for U.S. refined products, allowing U.S. refiners to run larger volumes of the stranded domestic crude oil despite the relatively flat domestic demand.

Figure 3 - US Prod Exports to LASA

“I was in a real bad way”

But a lot has changed in the last two years.  Crude prices have fallen, and with it, so have the price differentials for both crude and natural gas that gave U.S. refiners the edge.  Globally, there have been pockets of economic cooling.  China is not the growth engine it once was, and key Latin American economies have stumbled (in part due to the low crude prices).   The crude export restrictions that helped create a “domestic discount” for crude was removed at the end of last year.  At the same time, low prices have cut into U.S. domestic crude production, further impacting the discount and returning it to a premium in recent months.

Figure 4 - US Crude Oil Prod

On the refined product supply side, some developments have also eaten into demand for U.S. products.  While most of the ambitious refinery expansion projects in Latin America to reduce their dependence on imports have stalled, there have been two that were completed in the last couple of years, albeit at very high costs and after significant delays.  These refineries directly impact U.S. market share, displacing a portion of U.S. product exports from key south of the border markets.  Petrobras, who has been mired in scandal in recent years, did complete Phase 1 of their Abreu y Lima refinery.  It was started up in December 2014, and is processing around 100 MBPD of crude oil, but this came at a steep price tag with expenditures running $10+ billion over the original budget.   Phase 2 of the project (an additional 115 MBPD of capacity) is on indefinite hold as is the Comperj refinery project (despite billions in spending).

In Colombia, the Reficar refinery modernization project faced delay, budget overruns and scandals of its own.  While not as extreme as the overruns in Brazil, it ran nearly $5 billion over for a host of reasons (including a $16 million prostitution bill).  While the refinery had its struggles, it did finally start up at the end of 2015, doubling its capacity to 165 MBPD.  This has given U.S. refiners competition in the region.

“Can’t count me out, ‘cause I’ve got your number”

All of this sounds like the tipping point has come, as the advantages that seemingly propped up U.S. refiners are starting to evaporate.  But there are several other key advantages that were not a result of good timing and being in the right place at the right time.  The figure below may look familiar to some of our readers – it is a breakdown of the factors that have kept U.S. refiners exceptional, and as you can see, only some of the factors have changed, while others are as indelible as the American spirit.

Figure 5 - Drivers of US Competitiveness

One of the things that have hampered refiners elsewhere has been the workforce.  Having a strong, smart, dynamic workforce is essential to maintaining competitiveness in the global marketplace.  Operating refineries requires a large cadre of specialized workers, and the U.S. has that covered.  This has given the U.S. an edge over Latin America, and enabled U.S. refiners to become a large supplier to the region.

A similar, highly educated workforce does exist in other developed countries, such as those in Europe and developed Asia/Pacific.  The difference is that U.S. companies are not tied down by the same rules and regulations that make the cost of labor so expensive in many of those regions.  Labor laws are strong in many places throughout Europe, Australia, Japan and elsewhere.  This has limited the region’s competitiveness, tying refiners to job structures and employment models that are difficult in today’s environment.  The proximity to the workforce that U.S. refiners enjoy is a major advantage from both a cost and flexibility standpoint.

The U.S. is also a remarkably stable place to do business.  Stability and security are key factors that companies consider when looking where to invest.  Unlike in Latin America, the Middle East or Africa, there is limited risk of your investment being nationalized by the government, commandeered by rebels or terrorists, or destroyed amid conflict and war.

The stability has been one of the key strengths of the U.S. economy for many decades.  While the U.S. economy may be slowing in recent months, it still remains stronger than many economies elsewhere.   As the global economic engine slows, refiners in the most vulnerable regions are the most susceptible to closure.  In Europe, where low oil prices spurred demand and helped create a short term “stay of execution” for many refiners, as demand begins to moderate and fall again, the clock is ticking.  Another recent example was Angola’s national oil company, Sonangol, who announced on August 19 they were suspending construction indefinitely of their Lobito refinery and associated terminal due to low oil prices and the “economic reality” of the project.  While the energy industry remains an important part of the overall U.S. economy, low oil prices and low tax revenue will not bring our government to the edge.

Conclusion – “And you made me feel so right at home”

U.S. refiners have benefited from a variety of factors, both in and out of their control in the past decades, that has helped them to become “King of All the World” when it comes to refining excellence.  While some of those factors were out of their control, many were the result of actions taken to improve their competitive position in the global market.  Several key factors have changed in recent years, with the opening of crude exports and expansion of new refining capacity in key product markets, but U.S. refiners still hold many cards that will help them maintain their reign on the global refining industry.  The U.S. workforce plays one of the biggest parts in allowing U.S. refiners to adapt to changing situations.  This is a topic that will be covered in greater detail next week as part of our post Labor Day blog.

We, at Turner, Mason & Company, believe that U.S. refiners will continue to maintain a systematic and sustainable advantage over international counterparts, despite the changing landscape.  While current margins may not be as high as they have been as recently as last year, different dynamics are taking hold that will impact the domestic refining industry moving forward.  These factors are discussed in greater detail in our Crude and Refined Products Outlook which we publish biannually.  Our most recent edition was published last month, and provides an analysis of the key market factors that impact U.S. refiners.  The Outlook also contains a forecast of both crude and refined product prices and demand, taking into account the factors that are discussed.  If you are interested in learning more about our Outlook, or if there are other products or services with which we may be able to assist, please visit our website, send us an email or give us a call.

Executive VP with Turner, Mason & Company