Published on Tuesday, November 26 2019
Authors : John Auers

As I was enjoying another college football Saturday this weekend, I got to thinking about the similarities between the BCS landscape and U.S. regional refining competitiveness.  Just as the SEC is again the big dog on the college gridiron, with Gulf Coast power LSU leading the way (so far) this year, PADD 3 is also the powerhouse in refining, and due to IMO impacts it appears likely to be a winner overall over the next couple of years.  The Big Ten (led this year by championship contender Ohio State) is certainly positioned in a solid second place among the Power 5 conferences. So too, we believe PADD 2 refiners, which share the same geographic footprint, will be next in line for good results, also benefitting from IMO driven price movements.  While PADD 4 in far and away the smallest refining region, just as the Rocky Mountain region has the fewest and most overlooked Division 1 football teams, we expect refiners in that region to continue to perform well, just as surprisingly enough the Mountain West Conference trails only the SEC in all time bowl winning percentage.  PADDs 5 and PADDs 1 will continue to be challenged and perhaps have the least positive outlooks, again a similar situation to the BCS environment for those regions.  However, we can draw another very important parallel between the regional outlook for the refining industry and college football, and that is the fact that there will be significant variation between the performances of individual players in each region.  Just as Clemson in the East and Utah in the west could very possibly compete for the BCS trophy, we can see certain refiners in PADD 5 and even PADD 1 achieve good results, while there will be those in PADDs 2, 3 and 4 which will struggle (as do the bottom feeders in the SEC and Big 10).  In today’s blog, I’ll discuss some of the other regional specific dynamics which can be expected to drive refining prospects in each of the five PADD regions (I’ll refrain from mentioning my thoughts on the BCS outcomes).

PADD III – Exports key/midstream buildouts change inter-regional economics

As I noted, PADD 3 is certainly the big boy in not just the U.S. but also globally.  As a result, its fortunes have become more and more dependent on export markets with over 40% of the middle distillates and almost 20% of the gasoline produced in the regions refineries headed to foreign destinations.  With no short term expectations of improved refining prospects in key export markets, especially Latin America, we expect export opportunities to remain strong and the closure of PES provides some additional market in PADD 1.  Heavy crude capable deep conversion plants, especially those with significant hydrocracking capacity, will be the biggest winners from the IMO impacted widening of heavy crude differentials and distillate margins.  With those benefits declining somewhat over time as markets equilibrate.  On the supply side, the start-up of several pipeline projects, including Bayou Bridge, the Diamond Expansion, and the Capline reversal are improving Louisiana refiners’ access to mid-continent and Canadian crudes, alleviating some of the crude supply disadvantages they have experienced in the past vs. their Texas counterparts.  On the other hand, the rapid expansion of capacity out of the Permian is significantly reducing the supply advantage that led to superior results for several inland PADD III refineries due to the now shrunken Midland discount.  Certainly the prospects for Keystone XL are important to Texas Gulf Coast refiners as well.   

PADD II – Midstream developments key for both supply and demand

Over the last decade PADD 2 refiners have benefitted significantly from feedstock cost advantages simply because of their proximity to growing crude production from the prolific Western Canadian and Bakken regions.  This has resulted in regional feedstock discounts, which grew particularly large when major takeaway constraints were hit a few years ago before the buildout of midstream infrastructure connecting to the USGC. The earlier good times led to regional refinery capacity expansion and with limited local demand growth, margins were negatively impacted by a deteriorating product supply/demand balance.  Some recent developments, notably the PES shutdown and the subsequent approval of the Buckeye Laurel bi-directional operation, will improve the situation, providing access to product markets in PADD 1.  On the supply side of the equation, while PADD II refiners will continue to experience some crude cost advantages, these will be reduced as the Capline reversal, combined with the Diamond expansion and expected DAPL expansions improve Gulf coast access for mid-continent and Canadian crudes.  Enbridge Line 3 and Line 5 developments will also be important on the supply side, with refiners on the eastern side of region particularly impacted if Michigan shuts down Line 5 (something we don’t expect). 

PADD IV – Small, Market Advantaged, Volatile

On a dollars per barrel basis, a case can be made to put PADD 4 refineries on top as they enjoy advantages in regards to both crude and product pricing much of the time.   On the supply side, this is the only PADD in the country where in-region production is greater than refining capacity.  Ready access to neighboring production from Canada and the Bakken has added to this supply advantage and led to sometimes very significant crude discounts.  A recent return to growing production in the Uinta Basin is a particular advantage to the Salt Lake refiners, especially in today’s environment where the ability to move those waxy barrels out of the region is limited and very expensive.  Product demand growth in PADD 4 also has generally been the strongest of any region with 2019 growth picking up after sluggish 2018 results.  Logistical supply barriers have and should continue to serve to keep product margins high much of the time, although volatility can be significant in this isolated market as we see regularly on a seasonal basis and when demand slows as it did in 2018.

PADD V – High Regulatory Risks/Potentially High Rewards

Just as it’s often difficult to know just how good PAC-12 teams really are, PADD V’s refining prospects are also the most difficult to assess.  As is PADD IV, the West Coast is pretty self-contained with limited connectivity to other parts of the country and is probably one or one and a half refineries long.  Combined with the high operating cost environment, margins are relatively skimpy when all plants are running at capacity.  However because of limited and expensive alternate supply options, when one or more refineries are down or experience operating issues, California can experience shortages and margins can grow sky high as we’ve seen during a number of circumstances over the past few years.  In those situations PADD V has been a great place for the unaffected plants, something PBF certainly considered when they doubled down in their purchase of the Martinez refinery from Shell earlier this year.  But the regulatory environment is only getting tougher, new and potentially costly Process Safety Management Standards have recently been enacted, LCFS impacts will be ramping up, particularly in regards to the ability to market diesel, and the state wants to do away with petroleum altogether.  The two refineries with HF alkylation units, Valero and PBF’s Los Angeles area facilities, will be particularly impacted if onerous legislation significantly increases costs or even requires a phase out – which by the way we do not expect.  Another notable unique characteristic of PADD V – particularly California, but also more and more impacting the Washington refiners – is the difficult regulatory environment that often prevents new capital investment.  This can be a challenge to some refiners that have, and will continue to have, difficulties adjusting to a changing supply and demand environment, notably declining California crude production and an increasing reliance on product exports.  Conversely, this dynamic also provides a notable relative advantage to regional refiners that already have the hardware in place and logistics capability to better adjust to these changes.  This situation might come particularly in play if the TransMountain expansion is completed, which would allow California refiners to access heavy Canadian crude as a replacement for diminishing in-state heavies, with some positioned better than others to handle the higher sulfur barrels.

PADD 1 – Challenges Abound/PES Shutdown Helps

As for PADD 1, it’s hard not to rank it at the bottom.  It is a very competitive market, with refiners from the USGC, Canada and Europe all fighting for a share of a shrinking product pie, with the emerging threat from PADD 2 making things worse.  With essentially no regional crude production or pipeline connections to producing regions, PADD 1 facilities are also disadvantaged from a crude supply standpoint.  Then you also have the Jones Act, which represents yet another important crude supply disadvantage for PADD I refiners relative to their peers in Eastern Canada. The PES closure certainly improved the environment for the remaining plants and further rationalization of European refinery capacity, which should speed up post IMO, could be the best upside opportunity for the PADD 1 guys.

Turner, Mason & Company, continues to monitor developments in the U.S. and global refining industry, including those that impact regional competitiveness.  Our latest views are being incorporated in our Crude & Refined Products and World Refining Construction Outlooks.  We published our most recent versions of these reports in September and our next editions will be completed in February 2020. If you would like more information on these, or for any specific consulting engagements with which we may be able to assist, please go to our website and send us an email or give us a call at 214-754-0898.  Of course I am always happy to talk college football as well – enjoy the games over the Thanksgiving weekend and the time spent with friends and family.