Is Trouble Brewing for the Refiners?

American refining has certainly seen its share of ups and downs lately.

The industry was the victim of dwindling crack spreads during the early part of 2012 as feedstock costs for Brent crude skyrocketed. Then fortunes in the sector began to sway in the opposite direction. Crude prices have tumbled relatively lower from their peaks, and the glut of natural gas is helping to not only alleviate higher feedstock costs, but also lower refiners’ energy bills as well.

Those factors — coupled with downstream’s newfound love for exporting excess amounts of gasoline to emerging markets — have led to a rebirth of profits and surging share prices in the sector.

Overall, the U.S. downstream players finally appear to be back on surer footing — that is, if global capacity doesn’t get out of hand. But it seems that a global refinery-building binge in key emerging markets could undermine some of the U.S. firms’ recent bullishness.

Twenty-Five Percent Higher

While demand for refined petroleum products has dwindled here in the U.S. and Canada, it has more than tripled in places like China and Brazil. Along with that rise in demand, prices for gasoline and other refined fuels in those countries also have risen by as much. U.S. refiners have been able to use their cost advantage — thanks to shale gas and oil — to export record amounts of gasoline and profit from the spread.

However, the recent refinery rally could be in long-term jeopardy as a global refinery surplus is beginning to emerge.

All across the world — especially in key emerging markets — numerous refinery projects are in the planning stages or under construction. Most of them are complex and technological advanced mega-refineries that are designed to capture economies of scale and squeeze every last drop of refined products out of a barrel. Perhaps more importantly, the vast majority of those planned expansions are national oil company-sponsored entities. That basically means they are less sensitive to return pressures and run off of government mandates.

Those projects could throw a wrench in U.S. refiners’ export plans as they begin to get built. According to a report from Hart Energy, new refinery expansion projects could add as much as 9 million barrels a day to the world’s transportation fuel supply over the next five years.

That’s a big issue considering gasoline demand in the U.S. and Canada is expected to be flat in 2013 before eventually declining even more. As new energy efficiency measures take hold, domestic demand has dropped. U.S. demand for gasoline has fallen nearly 10% in recent years, and that trend is continuing. The U.S. is roughly burning about the same amount of gasoline it did in 2001, with total petroleum products falling back to 1997 levels.

U.S. refineries produce about 17.5 million barrels of gasoline, diesel and other petroleum products a day. While current domestic demand accounts for most of that, the excess has been sent away to Latin America and emerging Asia. However, this is exactly where all the new refineries are being built, and there’s already some evidence that these markets may be reaching capacity.

Indian refinery capacity has increased by almost 50% in the past five years and not only has met rapidly growing domestic demand, but has made the country a regional export hub. The target of those exports: Latin America, Asia and OCED Europe.

All in all, the surge in global refining capacity could mean that some U.S.-based downstream firms could be idled permanently — particularly if they are already less efficient.

Something to Consider

Investors should be wary of the potential for a global refining glut. The appeal of the sector as of late has been the favorable spread between cheaper feedstocks and the ability to export finished products. With refining capacity rising in key emerging markets, much of that appeal goes out the window.

While analysts expect increased EM demand to absorb the new supply and provide a continuing market for U.S. products — at least for the next few years — the longer-term is anybody’s guess. Refining capacity and product demand is an evolving science. However, it looks like the majority of these new facility plans will go through and global refined products volumes will go up.

Already, some of the larger refiners seem to have seen the writing on the wall. San Antonio-based Tesoro (NYSE:TSO) announced last week that it will wind down operations at its Kapolei refinery in Hawaii. That facility did export some of its capacity toward markets in Asia.

Nonetheless, there still is plenty of firepower left in the industry. For downstream investors, playing both the next few years as well as the long-term means focusing their attention toward the stronger names in the sector. Valero (NYSE:VLO), Marathon Petroleum (NYSE:MPC), Phillips 66 (NYSE:PSX) are among the ones with efficient operations that will continue to churn out steady profits this year and beyond. Those profits — and dividends — will be key to surviving the glut.

Ultimately, the bigger guys will be the ones that are able to compete. And that’s where investors should point their portfolios.

As of this writing, Aaron Levitt did not hold a position in any of the aforementioned securities.

Article printed from InvestorPlace Media,

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