U.S. Refiners Lose Crude Price Advantage Performance still holding up.
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1 ? U.S. Refiners Lose Crude Price Advantage Performance still holding up. Morningstar Commodities Research 10 June 2016 Sandy Fielden Director, Oil and Products Research Era of Record Margins Over U.S. refiners enjoyed record margins between 2011 and Two competitive advantages underpinned this stellar performance. First, access to lower-priced crude feedstock, primarily from shale, as well as cheap natural gas fuel for processing kept costs low. Second, increased demand for refined products fueled by an export boom on the Gulf Coast provided an outlet for this supply hitting the market. The first of these two advantages has now all but disappeared, as U.S. crude prices are level with international competitors. The second growing refined product exports has continued and been joined by renewed growth in domestic gasoline consumption. As a result, U.S. refining margins are down in 2016 compared with their peak in 2012, but they continue to outperform international competitors. The Crack Spread There are 137 refineries operating in the U.S. that can process over 19 million barrels per day of crude oil. These refineries vary considerably in capacity and complexity, making it difficult to judge overall performance by reference to simple metrics. However, one basic measure of refining margins that industry watchers use is the crack spread. This is a proxy for a cracking refinery margin reflecting the spread between prices for CME futures contracts for New York refined products gasoline and ultralow-sulfur diesel, or ULSD, and the price of West Texas Intermediate crude oil. The ratio in the crack spread represents three barrels of crude processed to produce two barrels of gasoline and one barrel of ULSD. The average crack spread between 2005 and 2010 was $10.80/bbl. That number more than doubled to $23.70/bbl between 2011 and 2015, peaking at $30/bbl in The crack averaged $15.9/bbl from January to May 2016 (Exhibit 1).
2 $/bbl Page 2 of 6 Exhibit Crack Spreads Source: CME, Morningstar Record Margins Driven by Access to Discounted Crude The greatest boost to refining margins between 2011 and 2015 came from access to cheap domestic shale crude that became stranded inland. During 2011, a dramatic increase in crude production from shale rapidly overwhelmed the existing pipeline system delivering crude from the wellhead to refineries. New shale crude production in remote locations such as North Dakota and the Rockies could not be accommodated on existing crude pipelines in the Midwest, which were already flowing Canadian crude south. Even if the U.S. crude managed to reach the Midwest hub at Cushing, Oklahoma, there were no existing pipelines to deliver it south to the Gulf Coast region, which hosts 50% of the nation s refinery capacity. The result was a buildup of crude in storage at Cushing during 2012 and price discounting by producers to get barrels onto crowded pipelines. During 2012, the average discount between inland crudes priced at Cushing based on WTI and crudes priced at the Gulf Coast based on Brent, was $18/bbl. This forced Bakken crude producers in North Dakota to discount their crude even further below WTI. The result was a windfall for refiners initially in the Midwest and then later in coastal regions as producers used alternative transport such as crude-by-rail to bypass pipeline congestion. At the same time, refined product prices held up because they are set in international markets rather than by domestic crude prices. The combination of cheap crude and higher-valued products caused crack spread margins to jump from $10/bbl in 2010 to $30/bbl in The U.S. refining advantage was cemented by access to cheaper processing fuel in the form of natural gas. Prices for that fuel sank below $2 per million British thermal units in the spring of 2012 as surplus production from shale weighed on the market. Once crude producers and marketers determined new paths to deliver crude past Midwest congestion and as new pipeline networks were built out to deliver supplies to the Gulf Coast during 2013 and 2014, the discount between inland crudes and coastal grades (as typified by the Brent/WTI spread) narrowed to about $3/bbl. That $3/bbl discount remained in place
3 Page 3 of 6 during 2015 because of the artificial barrier created by 1970s-era U.S. regulations restricting crude exports to most countries except Canada. U.S. producers could not export surplus supplies as shale production continued to increase and had to accept discounted prices from domestic refiners even though crude supplies were no longer stranded by transport congestion. The lifting of the export ban by Congress in December 2015 removed the remaining barriers to free movement of U.S. crude. Since then, WTI and Brent have traded in a tight range (see Venezuela Buying U.S. Exports), making it economic for U.S. refiners to process more imported crude at the expense of inland shale supplies. Lower crack spread margins during the first half of 2016 reflect this end to the era of advantaged crude pricing. However, refining margins in the U.S. continue to be higher than those of European and Asian rivals even without access to cheaper crude because of strong demand for refined products. Refined Product Export Boom U.S. refined product exports have been growing over the past seven years. Exhibit 2 shows total U.S. net gasoline and distillate (diesel and heating oil) exports as reported by the Energy Information Administration. Net exports of distillates (exports minus imports) increased by 270% from 360 to 984 thousand bbl/day between 2009 and Exports of gasoline (including blending components) increased by 94% from a net import of 733 mb/d in 2009 to a net import of just 45 mb/d in This year through March, distillate exports were up 27% versus first-quarter 2015 and gasoline exports have increased sixfold over first-quarter 2015 to a net export of 227 mb/d. Note that the U.S. has only just become a total net exporter of gasoline in 2016 but that regionally exports have grown significantly on the Gulf Coast even as the East Coast continues to import gasoline during the summer. This export boom has largely occurred from the U.S. Gulf region with the majority of refined products shipping to Latin America. The U.S. has won this export market share over international rivals by becoming the most cost competitive supplier not only because of lower crude costs but also as a result of more efficient refinery operations.
4 Thousand bbl/day Page 4 of 6 Exhibit 2 U.S. Net Gasoline and Distillate Exports Net Diesel Net Gasoline Jan-09 Jan-10 Jan-11 Jan-12 Jan-13 Jan-14 Jan-15 Jan-16 Source: EIA Gas Guzzlers Boost Domestic Demand In addition to increased demand for refined product exports, U.S. refiners have enjoyed an unexpected surge in domestic demand for gasoline since the crude price collapse began in June U.S. domestic consumption of gasoline had been experiencing what was believed to be terminal decline after 2005 because of the mandated addition of corn-based ethanol to gasoline and increased vehicle fuel efficiency standards. However, falling crude prices in 2014 translated into lower gasoline prices in 2015 and a subsequent jump in domestic gasoline demand that was up 3% in 2015 versus 2014 and is expected to increase another 1.7% in 2016 according to EIA. Owners are driving more miles and purchasing less-efficient gas-guzzling autos at a faster pace. During the same period, demand for diesel has been flat to lower as a result of a warmer winter in (see Heating Oil Contango) and lower commercial driving demand. The combination of higher demand for refined product exports and the more recent boost in domestic gasoline sales have supported refining margins even as refiners lost the advantage of lower crude prices. EIA data shows that U.S. refiners ran their plants at an average 89% of operable capacity over the entire period of high margins between 2011 and This 89% operating rate has continued during the first quarter of 2016, indicating that lower margins have not discouraged operators from processing high volumes of crude. Crack Spread Forward Curve Refiners were one of the main beneficiaries of growing U.S. shale crude production as increased supplies pressured feedstock prices down. Despite losing the advantage of access to low-priced
5 Jul-16 Sep-16 Nov-16 Jan-17 Mar-17 May-17 Jul-17 Sep-17 Nov-17 Jan-18 Mar-18 May-18 Jul-18 Sep-18 Nov-18 Jan-19 Mar-19 May-19 Jul-19 Sep-19 Nov-19 Jan-20 $/bbl Page 5 of 6 stranded domestic crude, refiners have generally continued to enjoy robust margins and to run plants at high levels of utilization. Provided international as well as domestic demand for refined products continues to soak up excess supplies, then strong margins will continue. The current CME forward curve of the crack spread (Exhibit 3) shows a strong seasonal shape, with the crack spread higher during the summer driving months indicating the importance of gasoline demand. Exhibit 3 Crack Spread Forward Curve Source: CME, Morningstar We expect refining margins to remain strong provided that crude prices do not rise too rapidly. Bearish signs for refiners include a return to crude prices over $80/bbl that would choke off demand for gasoline and a collapse in demand for refined product exports resulting from lower economic growth in Latin America. K
6 Page 6 of 6 About Morningstar Commodities Research Morningstar Commodities Research provides independent, fundamental research differentiated by a consistent focus on the competitive dynamics in worldwide commodities markets. This joint effort between Morningstar's Research and Commodities & Energy groups leverages the expertise of Morningstar's 23 energy, utilities, basic materials, and commodities analysts as well as Morningstar's extensive data platform. Morningstar Commodities Research initially will focus on North American power and natural gas markets with plans to expand coverage of other markets worldwide. Morningstar, Inc. is a leading provider of independent investment research in North America, Europe, Australia, and Asia. The company offers an extensive line of products and services for individuals, financial advisors, and institutions. Morningstar's Commodities & Energy group provides superior quality market data and analytical products for energy data management systems, financial and agricultural data management, historical analysis, trading, risk management, and forecasting. For More Information North America Europe commoditydata-sales@morningstar.com? 22 West Washington Street Chicago, IL USA 2016 Morningstar. All Rights Reserved. Morningstar's Credit Ratings & Research is produced and offered by Morningstar, Inc., which is not registered with the U.S. Securities and Exchange Commission as a Nationally Recognized Statistical Rating Organization ("NRSRO"). Unless otherwise provided in a separate agreement, you may use this report only in the country in which its original distributor is based. The information, data, analyses and opinions presented herein do not constitute investment advice; are provided solely for informational purposes and therefore are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. The opinions expressed are as of the date written and are subject to change without notice. Except as otherwise required by law, Morningstar shall not be responsible for any trading decisions, damages or other losses resulting from, or related to, the information, data, analyses or opinions or their use. The information contained herein is the proprietary property of Morningstar and may not be reproduced, in whole or in part, or used in any manner, without the prior written consent of Morningstar. To license the research, call
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