U.S. refining margins reached nadir in 1995, upturn expected

Refining margins in the U.S. will improve over the next few years after reaching a low point in 1995. This is the view expressed by Salomon Bros., New York, in a July report titled, "Refining Industry-Light at the End of the Tunnel."

U.S. refining margins have been weak since the early 1990s.

"We attribute this weakness to the excess investment in conversion capa city...prompted by the passing of the 1990 Amendments to the Clean Air Act, and by the industry's view that heavy crude oil will become more abundant and cheaper," says Salomon Bros.

Conversion capacity has increased 1.6% over the past 5 years, while light products demand has risen only 0.8%/year. Because of the rapid increase in conversion capacity, it may take some time before demand increases enough to put upward pressure on margins, concludes the report.

Conversion capacity

Between 1980 and 1989, U.S. conversion capacity increased an average 1.2%/year. By contrast, during the 1990-95 period, conversion capacity grew at an average 1.6%/year.

The Clean Air Act Amendments (CAAA) sparked this increase in U.S. capacity of processes such as coking, catalytic cracking, hydrocracking, visbreaking, and thermal cracking.

At the time, U.S. refiners thought the CAAA would increase earnings for plants sophisticated enough to produce the new fuels by driving out of business those refiners with older, less-sophisticated hardware. But the expected level of shutdowns, sometimes estimated to be as much as 2 million b/d of distillation capacity, did not occur.

One contributing factor to the less-than-expected level of shutdowns is that the costs and liabilities associated with closing a refinery acted as a deterrent.

According to the Salomon Bros. report, only 605,625 b/d of U.S. refining capacity was shut down in the 1992-95 period. When combined with small increases in crude capacity at the remaining refineries, total U.S. crude capacity continued to creep upward during the period.

During the period of preparation for making oxygenated, reformulated, and low-sulfur fuels, U.S. refiners also increased conversion capacity.

"They may have done this in anticipation of improving margins," says Salomon, "or to help expedite the recovery of their investments in the units required to make fuels that meet CAA standards. Another possibility is that the legislation prompted refiners to carefully assess their operations and to make improvements and perform debottlenecking operations while they were at it."

Conversion vs. demand

Fig. 1 [17423 bytes] shows that, in the early 1990s, U.S. conversion capacity increased while demand for gasoline and distillate decreased. This, says Salomon Bros., resulted in an oversupply of these light products and depressed refining margins.

The conversion capacity buildup is especially important because, in contrast to crude distillation units, refineries typically operate conversion units at maximum throughput to increase return on investment.

Contributing to Salomon's predicted rebound in refining margins are:

Gasoline demand growth of 1.7%/year, compared to 1.5%/year during the past 3 years
Distillate demand growth of 2.0%/year, compared to 2.4%/year during the past 3 years.

Increases in gasoline demand will be driven by increased sales of light trucks and by the repeal in the U.S. of the federal speed limits.

The projected decline in distillate demand reflects decreasing demand from nontransportation sources and increasing use of alternative fuels such as natural gas. Diesel fuel, however, will account for a larger share of distillate demand, says Salomon.

Fig. 1 shows that capacity growth, with respect to products demand, will diminish through 2000.

Global demand

The long-term worldwide supply/demand balance also will have a favorable effect on the U.S. refining industry. Salomon Bros. predicts that demand for petroleum products will grow 2.0%/year over the next 5 years, with 2.0%/year growth in gasoline demand and 2.5%/year growth in distillate demand.

Demand for other petroleum products will grow at slower rates, as will crude distillation capacity. This will lead to higher worldwide utilization rates.

"Conversion capacity should be sufficient to absorb the increase in light products demand over the next year," says Salomon, "but from 1997 onward tightness is expected. This trend will help [U.S.] margins, which historically have been mitigated from wild swings partly as a result of petroleum products imports and exports."

Capital spending

Based on the announced capital expenditures of seven major oil companies, Salomon expects refiners to decrease capital spending by 15% in 1996, compared to 1995. This collective decrease in refinery capital spending will reduce the growth rate for conversion capacity and thus bolster the recovery of U.S. refining margins.

Historically, refining industry capital expenditures have shown a strong negative correlation to refining margins. Typically, when expenditures peak, margins reach a trough 3-4 years later, says Salomon.

Fig. 2 [18990 bytes] shows that U.S. capital spending peaked in 1992. This augurs an improvement in refining margins from 1996 through 2000, according to the report.

Salomon Bros. found a similar relationship between European refiners' capital spending and Rotterdam refining margins.

Salomon says its studies of capital spending and margins "paint a picture of an industry that is subject to 8 to 10-year cycles between peak (and conversely, trough) refining margins, which seems to make sense in light of the highly competitive nature of the refining industry."

Beyond 2000

Salomon Bros. sees considerable uncertainty for the refining industry after 2000. This uncertainty is the result of environmental regulations such as the CAAA.

"The 1990 Clean Air Act Amendments is the single most important factor affecting the domestic refining industry, past, present, and future," says Salomon. This is because the CAAA involves several programs phased in throughout the 1990s.

In 1998, refiners must produce reformulated gasoline (RFG) meeting the U.S. Environmental Protection Agency's complex model. And in 2000, Phase 2 of the RFG program will command even stricter gasoline specifications.

"Phase 1 RFG probably had minimal impact on the refiners, most of which could meet the regulation with small investments in refinery units," says Salomon. "However, Phase 2 RFG will significantly impact refiners."

A number of refiners in California were forced out of business by the strict requirements for California Air Resources Board (CARB) Phase 2 gasoline, which are similar to federal Phase 2 requirements. And federal Phase 2 RFG will affect 20-25% of U.S. gasoline demand, compared to about 12% for CARB Phase 2.

"We expect further refinery retrenchment and/or restructuring by the year 2000," says Salomon. "Refiners will have to invest in greater hydrotreating capacity to meet low-sulfur specifications and more alkylation capacity in place of catalytic reformers-both of which are relatively expensive units-in order to meet the octane demands of gasoline."

The report concludes that federal Phase 2 RFG will further reduce U.S. gasoline supplies, much more so than Phase 1. "This time around," says Salomon, "environmental legislation should have a positive impact for the survivors in this highly dynamic industry."

Salomon tempers this somewhat optimistic outlook by adding that there is still considerable uncertainty regarding federal Phase 2 RFG. Given the U.S. government's track record of altering its plans for RFG, refiners have postponed making any major plans for producing Phase 2 RFG. As a result, they are at risk of not being able to meet the deadline.

"The bottom line," says Salomon, "is that uncertainty will continue in the refining industry, as it has throughout the first half of this decade, although evidence exists of an upward turn in margins."