US oil refining faces biggest shake up since 1980s

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Massive discounts for West Texas Intermediate (WTI) and other landlocked crudes in the U.S. Midwest compared with Brent are the result of structural changes that have been building for more than five years and are now producing the biggest shake up in U.S. refining since the 1980s. Three factors have come together to alter the economics of the U.S. oil industry and reverse the direction of crude and product flows:

(1) Domestic oil production has risen in both 2009 and 2010, the first annual increases since 1985. Output is up more than 160 million barrels per year (8%) since 2008, according to survey data from the Energy Information Administration and projections for the final months of 2010.

Rising output from the Outer Continental Shelf in the Gulf of Mexico and North Dakota's Bakken Shale accounts for all the increase, offsetting continued decline at other fields. High prices, intensive exploration and development, and new technologies for deepwater drilling and unlocking oil from shale have all combined to reverse the previous slump in U.S. oil output (see Chart A workbook below).

(2) Increased pipeline imports from Canada to the Midwest (PADD II) have combined with Bakken output to reduce midcontinent refiners' consumption of other foreign crudes, cutting the need to bring oil up from terminals along the Gulf Coast and trimming volumes on northbound pipeline systems such as Seaway (Chart B).

(3) Rapid growth in ethanol blending as a result of federal mandates enacted in the Energy Policy Act (2005) and the Energy Independence and Security Act (2007) has replaced an increasing volume of petroleum-derived gasoline, with the biggest displacement in the Midwest and along the East Coast, where most ethanol refineries are located (PADD I) (Chart C).
MIDWEST CONFLUENCE

These three trends have come together most powerfully in the U.S. Midwest, where Bakken oil, Canadian imports and plentiful ethanol from local distilleries have produced a glut of crude and products, and started to reverse the normal direction of flows.

Instead of being a big net recipient of crude and products from other regions and abroad, as it was in the past, PADD II requirements have fallen sharply. Regional refiners have taken advantage of cheap local oil to boost throughput, seize market share in the midcontinent from Gulf Coast rivals, and dump surplus production into the East Coast.
THE MERCHANT REFINERS

One result is a reduced flow of crude and especially refined products into PADD II from PADD III, which has left northbound crude and products pipelines with low volumes and under-utilised, according to one operator (Charts 1 and 2).

Deprived of traditional customers in the Midwest, Gulf Coast refiners have been increasingly forced to find markets overseas. In the last three years, the United States has become a substantial exporter of gasoline and diesel to Europe and Latin America; almost all the increase has come from refiners in PADD III.

The supply crisis in PADD II and reversing oil and product flows have contributed directly to the rise of a new breed of "merchant refiners" along the Gulf Coast producing for export markets (Charts 3 and 4).
EAST COAST REFINERIES SHUT

The other major result is that refiners on the East Coast have faced mounting competition from rivals in the Midwest and the Gulf, as well as Europe. Imports into the East Coast from across the Atlantic have fallen while several uneconomic East Coast refineries have now closed.

Imports of finished products into the East Coast have shrunk from an average of 380 million barrels a year between 1981 and 2006 (and as high as 400-500 million in 2004-2006) to less than 240 million in 2009 and 2010.

But arrivals of products from the Midwest and the Gulf Coast have remained steady, as PADD II and PADD III refiners have captured market share from both European refineries and East Coast refiners themselves. Record spreads between WTI and Brent are just one part of a much bigger realignment changing the face of the U.S. refining industry.

Structural transformation is replacing the traditional flow of crude and products from the coasts to the midcontinent with a more outbound orientation that sees crude and products flow from the Midwest to the coasts and from the United States to export markets.

Record Brent-WTI spreads and high refining margins for Midwest refiners are both reflecting and driving that shift.

By John Kemp, Reuters market analyst – for Commodities Now.