Sandy Fielden (RBN Energy)
Recent third quarter earnings reports from US refiners have reflected lower refining margins squeezed by higher feedstock prices for inland crudes like West Texas Intermediate (WTI) rising to the same level as coastal crudes like Light Louisiana Sweet (LLS) while product prices stood still. In the past two weeks domestic crude prices have fallen below $100/Bbl in the face of a Gulf Coast supply glut. But despite lower crude costs, refinery margins have continued to weaken. The primary culprit has been sharply falling gasoline prices. Today we review what Gulf Coast refiners could do to improve margins.
RBN Energy analysis of refining margins uses a simplified approach known as “crack spreads” to identify overall trends in refinery performance rather than getting into more complex refinery economics. Recall that the term “crack” does not refer to something a wayward crude trader might ingest in the bathroom but rather to breaking down or “cracking” crude oil. The term “spread” means the difference between the sales price of the refined products and the raw material cost of crude i.e. the refining margin. A 3-2-1 Crack spread for example approximates a refinery that produces two barrels of gasoline and one barrel of diesel for every three barrels of crude input. In other words the refinery yield is two-thirds gasoline, one-third diesel.
Back at the start of August we looked at how the NYMEX 3-2-1 crack spread (based on NYMEX futures contracts) cratered 56 percent between March and August this year (2013) after the NYMEX benchmark West Texas Intermediate (WTI) crude discount to Brent narrowed close to parity in July 2013. WTI prices had previously been discounted to Brent for almost three years as a result of crude supply disruption in the Midwest. The 3-2-1 crack spread was squeezed when rising WTI crude prices this year were not matched by refined product prices that stayed more or less static. As a result refiners paid more for their crude but didn’t get higher revenues from refined product sales - reducing their margins.
Two months ago in September we looked at the impact of the Syrian crisis on refining margins at the US Gulf Coast . Back then the threat of war caused international crude prices to increase temporarily, pulling US crude prices along with them but leaving product prices behind. That put further downward pressure on refinery margins – showing how refiners are frequently impacted by events beyond their control.
Any time that crude and refined product prices get out of whack – and it happens quite often - refiners experience volatile margins. Sometimes it works out in refiners’ favor. Over the past three years the WTI discount to Brent crude meant that refiners with access to lower priced “advantaged” crude (for example refineries in the Midwest) were able to enjoy very favorable margins, because generally speaking, product prices continued to be set higher by international markets even as crude feedstock prices for these refiners were discounted.
Back to the present and - as we discussed a couple of weeks ago, crude prices have come under pressure at the Gulf Coast as more supplies reach refineries there from US and Canadian producers and seasonal refinery maintenance reduces demand for feedstocks . But even as crude prices are falling, refinery margins are not responding positively. That is because refined product prices – particularly gasoline are falling faster than crude. And as we shall see, the resulting margin squeeze encourages those refiners that have the flexibility, to cut down their gasoline output and increase their diesel production.
Taking a look first at crude prices, the chart below shows WTI (green line) Gulf Coast benchmark Light Louisiana Sweet (LLS – red line) and international benchmark Brent (blue line) since the start of July 2013. After increasing to over $110/Bbl in early September under the influence of international tensions in the Middle East, crude prices have fallen back below $100/Bbl. As we noted a moment ago an increasing surplus of light sweet crude supplies at the Gulf Coast has caused WTI and LLS prices to fall. Meanwhile Brent prices have become detached from the Gulf Coast market because supplies of imported light and medium sweet crude that use Brent based pricing are not currently needed to meet refinery needs. The two black dotted arrows on the chart show the divergence between Brent and WTI/LLS prices. The current supply surplus has caused crude inventories in the Gulf Coast region to increase by over 17 MMBbl from mid September to the beginning of November. LLS prices have fallen 13 percent from $110.63/Bbl on September 13, 2013 to $97.89/Bbl on November 8, 2013. WTI prices fell 13.6 percent over the same period from $108.21/Bbl on September 13 to $94.6/Bbl on November 8.
Source: CME data from Morningstar (Click to Enlarge)
Next take a look at refined product prices for gasoline and diesel at the Gulf Coast. The chart below shows ultra low sulfur diesel (ULSD - green line) and reformulated gasoline (orange line) priced at the Gulf Coast since the start of July 2013. You can see that the price of diesel has remained relatively stable since the start of September while gasoline has fallen sharply (blue dotted circle). The strength of diesel prices results from continued strong demand for exports from the Gulf Coast, to Latin American and European markets. Also demand for heating oil (used primarily in the Northeast during the winter) is high at this time of year in the run up to winter. Because New York State now requires the use of lower sulfur spec heating oil, the demand for low sulfur diesel from Gulf Coast refineries is higher –underpinning ULSD prices.
In contrast gasoline prices are falling because of continued weak domestic demand. Gasoline demand in the US fell by 3 percent between the end of August and mid October according to data from the Energy Information Administration (EIA). We have previously discussed falling US gasoline demand. Increased ethanol blending in gasoline to meet Renewable Fuel Standards and more efficient engines under CAFÉ regulations have reduced US consumption since 2005. Gasoline demand is traditionally weaker at the end of the summer driving season and Gulf Coast gasoline inventories remained high this fall. Early October inventories were essentially the same as those in late July because summer demand did not soak up supplies (source EIA). As a result gasoline prices at the Gulf Coast fell 22 percent from $2.96/gal on September 2nd 2013 to $2.32/gal on November 1, 2013 although in the past week falling gas prices at the pump have encouraged increased demand and a slight uptick in prices that you see at the end of the chart.
Source: CME data from Morningstar (Click to Enlarge)
In this situation where crude prices are down 13 percent and gasoline prices fell 22 percent, refining margins are once again under pressure. However, stronger diesel prices afford some hope that refiners can bolster their margins by increasing their output of diesel and reducing their output of gasoline. We can see how this works by looking at two crack spread calculations that reflect different gasoline output volumes. The chart below shows two Gulf Coast crack spreads calculated since July 2013 . The blue line on the chart is a 3-2-1 crack spread – modeling a refinery that processes 3 barrels of LLS crude to produce 2 barrels of gasoline and 1 barrel of diesel. That 3-2-1 crack spread represents a traditional US Gulf Coast complex refinery configuration designed to produce twice as much gasoline as diesel. The red line on the chart is a 2-1-1 crack spread modeling a refinery that processes 2 barrels of crude to produce one barrel of gasoline and one barrel of diesel. The 2-1-1 configuration matches gasoline and diesel output at 50 percent each. You can see that in the period since the start of September the 2-1-1 crack spread with less gasoline has been more profitable than the 3-2-1 with more gasoline (green circle). In fact between September 2 and November 1, 2013 the 2-1-1 crack spread averaged $3/Bbl higher than the 3-2-1. In other words reducing gasoline output at the expense of diesel increases the potential margin by $3/Bbl.
Source: CME data from Morningstar (Click to Enlarge)
Easy enough to do that with our crack spread models but is it something that refiners are able to accomplish in practice? The answer to that question is not so simple because refineries are complex operations that cannot be reconfigured overnight. Most complex Gulf Coast refineries that process light sweet crude were designed to meet market needs 10 years ago when US gasoline demand was growing and domestic demand for diesel was weaker. These refineries still produce more gasoline than diesel. Not surprisingly, when diesel demand and prices are stronger than gasoline - which is the situation today – those refinery configurations produce lower margins. And if those refiners produce more diesel then they get more unwanted gasoline along with it – adding to the downward pressure on gasoline prices.
But refiners are not blind to these economics and they are responding by investing in processing units that produce more diesel. Back in July we covered investments by Valero and Marathon in hydrocracker units designed to bring their refinery production closer to a 50/50 gasoline/diesel output like a 2-1-1 crack. Expect to see more investments along these lines among Gulf Coast refiners with an eye to the strong diesel export market.
However, as we have frequently detailed, the flood of new shale crude showing up at Gulf Coast refineries are very light – meaning that they contain a lot of gasoline components. These crudes do not have so many middle distillate components that are needed to produce diesel. So whatever refiners do to adjust their configuration to produce more diesel, they are still going to be left with a lot of gasoline range material. Since the US market demand for gasoline is static or falling, that material will likely have to be exported. If international and domestic demand for gasoline are both weak then gasoline prices will fall. Good news for US motorists but bad news for refiners.
Summing up, as Gulf Coast refiners get ready for the flood of new crude coming their way, the downward pressure on crude prices offers the prospect of improved refinery margins through lower feedstock costs. But that is not guaranteed because refining margins also depend on product prices staying higher as well. So far healthy demand at home and abroad for diesel has made that product quite profitable for Gulf Coast refiners. Gasoline margins are less robust and could threaten to spoil the refining party.
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