Oil Refining Update Part II: Increasing Regional Variation
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By Denis Hurley
Part 1 of this article examined the calculation of the crack spread, factors affecting the Brent-WTI spread, and the resulting effect on the crack spread for refining companies like Exxon Mobil (NYSE: XOM), Chevron (NYSE: CVX), Valero (NYSE: VLO), and Tesoro (NYSE: TSO). Part 2 will break down the effects of the WTI-Brent spread on the various PADD regions and possible developments that may affect the spread in the short and medium term.
Breakdown by PADD
PADD 2 and 4: Low Input Prices
On May 16, 2012, the EIA announced that inventories at Cushing had reached record levels despite Midwest refineries running almost at capacity. Without some combination of a significant drop in U.S. tight oil production, decreasing Canadian tar sand oil imports (the majority of which enter the United States through PADD 2), and increased refining and transport capacity in the Midwest, WTI prices will remain depressed compared to Brent crude prices. Recently, the Seaway pipeline was reversed to divert some WTI deliveries to Texas instead of Cushing. Additional transport projects would reduce the extraordinary theoretical profitability of Midwest refineries while benefiting Gulf Coast facilities by reducing the price of their feedstock. With greater transport capacity, barring expansion of PADD 2 refining capabilities, the benefits of growing inland American production will gradually be defused to other regions and the WTI-Brent spread will tighten. However, due to political and regulatory hurdles, the expansion of such facilities to accommodate greater production may require years to complete (the furor over Keystone XL is a case in point). In the short to medium term, the supply glut will benefit refineries in the Midwest and, to a lesser extent, the Gulf Coast.
PADD 5: A Special Case
The West Coast region is something of an outlier nationally in that the special blend requirements of California (one of the largest economies in the world) restrict the refining capacity of the state and limit supply flexibility in the region as a whole. Additionally, the region receives much of its supplies from Alaska and offshore domestic sources. Hence, refineries in the region are insulated by tight capacity for producing California blend gasoline and geographical distance from other regional markets.
PADD 3: Shifting Inputs
The Gulf Coast is beginning to reap to the benefits of abundant crude supplies in Cushing with the reversal of the Seaway pipeline to supply Texas refineries. Yet the Brent-WTI differential has not narrowed considerably, possibly indicating that the Gulf Coast refineries will enjoy a sustained period of low-cost inputs similar that driving profitability at Midwest facilities. As long as a substantial input differential exists among the PADD districts, strategically located refineries will enjoy greater profitability all other things being equal.
PADD 4: Bad Economics – The Losers
When the theoretical, WTI-based crack spread plunged to recent lows in the final months of 2011, numerous East Coast refineries were idled or put on the auction block while others drastically cut utilization at operating facilities. As a result of the sustained Brent-WTI differential, margins on refining at PADD 1 facilities are razor thin compared to those in other PADD regions. The East Coast has significantly increased its consumption of gasoline and finished petroleum products from other regions.
The Wild Cards
Like the crack spread itself, this analysis of the effects of a sustained Brent-WTI price differential is merely a baseline for the theoretical profitability of refineries. All other things being equal, refineries that benefit from low-cost feedstock provided by inland American sources will enjoy greater profitability than their not so lucky counterparts. However, there are several developments that may transpire to stymie this trend of enlarging crack spreads for certain refiners.
First, falling crude prices as a result of deteriorating economic conditions globally could erase the profit margin for upstream producers in the tar sands of Canada and shale regions of the inland United States. Falling production would relieve the supply glut and potentially narrow the WTI-Brent spread, reducing the artificial advantage of inland refineries. Second, greater refining and transport capacity could allow greater inland production and send WTI crude to other PADD districts for refining and/or direct retail sale. The reversal of the Seaway pipeline may be the first evidence of such a trend. Third, there are logistical concerns associated with maintaining the necessary supply levels in PADD 1, despite falling refinery capacity in the region. Although the region is increasingly supplied by other PADDs, a February 2012 EIA report expressed uncertainty about short run hurdles to adequately supplying parts of the northeastern United States. In the short run, lack of adequate capacity in the area could send prices higher. In the long-run, this could result in sufficiently high regional prices to 1) motivate players to reenter the refining sector on location or 2) allow Gulf Coast and Midwest producers, benefitting from higher theoretical margins, to lengthen supply chains in order to meet East Coast demand. The determining factor will be whether or not retail prices in the Northeast spike high enough and the WTI-Brent spread is tight enough to make potential new market entrants in PADD 1 profitable. Regardless, the EIA predicts that WTI will continue to trade at a historically sizeable discount relative to international benchmark prices for the foreseeable future.
Although various other factors can significantly affect a refinery’s cost structure – such as wages, shipping costs, taxes, environmental regulations, etc. – the Brent-WTI price differential is the primary factor supporting the shifting landscape in refining profitability and activity in the United States.
Conclusions: A Shifting Landscape
Four major developments over varying periods of time are affecting the oil-refining sector. First, the entrance of various new players into the sector after several months of tightening production capacity combined with chronic overcapacity in Europe will put pressure on crack spreads for independent Western refining companies. Second, rapidly increasing production in inland North America is creating a supply glut in Cushing, OK, putting downward pressure on WTI prices and sustaining the gap between Brent and WTI prices. Third, the price differential is creating a tiered market for crude inputs at refineries, depressing the ceteris paribus profitability of East Coast refineries while driving profitability at Midwest facilities. Finally, in the next few years, the EIA projects the refining capacity growth will outstrip demand. New, more efficient refineries are being built in the developing world while older, independent OECD refiners will be forced to confront lower margins and regional overcapacity in mature markets. If WTI crude continues to trade at a discount, strategically placed refineries may be insulated from the pressures of greater efficiency while more inefficient, less fortunate companies must accept lower margins. Individual investors should choose wisely. For more information on this topic and others, visit WealthLift to connect with a vibrant community of investors and finance enthusiasts.
This article is written by Denis Hurley and edited by Jake Mann. They don't own shares in any of the companies mentioned above. The Motley Fool has no positions in the stocks mentioned above. Motley Fool newsletter services recommend Chevron. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.