All is not rosy for inland oil refineries in North America

Robert Campbell

Published — Saturday 15 December 2012

Last update 15 December 2012 5:37 pm

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NEW YORK: Inland oil refineries in North America are having their day in the sun. Captive supplies of cheap crude make life easy and profitable. But all is not rosy for these plants. A shrinking market will eventually doom many.
Inland oil refineries are like large land animals: they can only survive as long as they have enough territory to support themselves. A shrinking market brings with it a wave of extinction.
Refiners elsewhere have a solution when their domestic market shrinks: exports. But inland refineries face a unique set of challenges when it comes to exports.
Firstly, they may lack the infrastructure to move products to export markets. And even if they do have access to the pipelines or waterways needed to reach the coast, these facilities add extra costs.
Extra costs are a death sentence for export-oriented refineries. The brutal logic of arbitrage economics means no one has pricing power and competitiveness arises solely from low-cost operations.
The International Energy Agency highlighted these issues in its latest Monthly Oil Market Report.
A sidebar on inland German gasoline stocks explores the dilemmas facing German refineries due to their geographic position.
German gasoline stocks have risen by 2.3 million barrels since the end of June and were 1.5 million barrels above the 5-year average by the end of October, according to the IEA.
The agency concluded much of this stockbuild, which has come in the teeth of shrinking German gasoline demand and an unfavorable market structure, is due to the fact that German refineries simply cannot access foreign markets due to logistical constraints.
Ultimately, this situation could prove fatal to inland refineries. The inability to sell all of the gasoline being produced imposes huge costs that can either be tackled by costly investments to reduce gasoline output or through refinery closures.
Yet many refineries will struggle to justify the expense of major capital expenditures when faced with a shrinking market.
Unless market trends change, closures become more likely.
A similar situation could well play out in the Midwestern US.
For now, Midwestern oil refineries are reaping bumper profits, largely because they inhabit a market big enough to support them all.
Indeed, when demand peaks in the summer, the Midwestern market still requires imports of supplies from the Gulf Coast, keeping product prices high even as input costs stay cheap.
But this situation may not last for ever. The market for transportation fuels in the US is declining. Biofuels and efficiency mandates will almost certainly cut into the share now held by petroleum in the regional fuel mix.
Already regional refiners are getting a taste of the future in the so-called shoulder months of the year, when lower fuel demand eliminates the need for imports of gasoline from the Gulf Coast.
Regional fuel prices fall rapidly, wiping out the windfall profits associated with buying cheap crude oil priced off of West Texas Intermediate crude.
This is a situation that will undoubtedly worsen as improved fuel efficiency standards and other conservation measures continue to penetrate the regional fuel market.
As such, Midwestern refiners could well find themselves needing to move some of their production into new markets if they are to continue to operate at full capacity.
Fortunately for regional refineries, some measures are being taken to expand markets.
Sunoco Logistics, for instance, is building a new refined products pipeline system to take an initial 85,000 barrels per day of fuel from refineries in Ohio to points as far east as Pittsburgh in Pennsylvania by early 2014.
But the question remains: will markets expand fast enough to allow the Midwest to continue to support all of the refineries currently operating there?
For those who gain access to infrastructure to export to new markets, cheap crude will probably guarantee a long a profitable life.
For those unable to move surplus fuel to market, a fate similar to inland German refineries looms, especially if competition for inland crude oil begins to erode the price advantage for feedstocks these facilities now enjoy.
Ultimately what is emerging in the US is a series of unintended consequences arising from America’s infamously incoherent energy policies.
Crude oil production is booming just as conservation measures aimed at cutting oil demand are set to really start to bite. There’s no real problem with these two outcomes: rising energy production and lower demand could well give the US a boost through lower energy costs and higher investment.
Except other policy elements are at play here. For instance the Jones Act restrictions on coastal shipping essentially entrench some coastal oil refineries regardless of their competitiveness due to pipeline capacity shortages.
In many ways the shipping restrictions now function as a “tax” on East Coast residents in support of a handful of companies and other vested interests in the US domestic shipping industry.
But ultimately this ban could well prove troublesome for the domestic refining sector as domestic demand contracts.
Similarly, the ban on crude oil exports is probably stunting the growth of pipeline infrastructure that will be needed to efficiently move inland crude oil production to market.
Biofuels mandates originally conceived when oil demand was assumed to be in perpetual growth are set to become increasingly onerous as petroleum demand contracts.
What the US needs is a complete revision of the way it looks at liquid fuels policy in order to ensure the benefits from the shale boom are maximized rather than being captured by a few rent-seeking firms.
This sort of revision seems a long way off. For too long energy policies have been conceived and sold to voters as some sort of panacea for costly fuel. So far there is little sign that an evolution in the debate is in the offing.
— Robert Campbell is a Reuters market analyst. The views expressed are his own.

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