The key reason behind the lackluster performance of oil and gas companies, including the likes of Exxon Mobil (NYSE:XOM), BP Plc. (NYSE:BP) and Chevron (NYSE:CVX) last year, was thinner refining margins. Almost 80% of the year-on-year decline in Exxon’s 2013 full-year operating earnings (earnings adjusted for divestment gains in 2012) can be attributed to thinner downstream margins.  This was primarily due to industry overcapacity amid sluggish demand and higher crude oil prices. There were certain bright spots as well, such as refineries in the Midwest U.S. that gained from lower crude oil prices due to the fast-growing supply from unconventional plays in the U.S. and a lack of midstream infrastructure. However, the sharp decline in international crack spreads more than offset this advantage. Here’s why we believe that global refining margins might continue to remain under pressure in the short to medium term.
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Gasoline demand in the developed world, which declined with the sluggish economy, continues to remain weak as more hybrids and electric vehicles enter the market and biofuels become more competitive. Under these circumstances, the developing world is slowly becoming the center of gravity for the refining industry. Gasoline and diesel prices, which were long dependent on demand in developed nations, now fluctuate with the developing world’s rising thirst for crude oil and fuels. However, demand growth from the developing nations, especially China has slowed down over the last couple of years.
At the same time, governments in different parts of the world continue to expand their existing refining capacity, which is already operating at very low or no returns, just in order to sustain employment and reduce their reliance on imported fuels. As a result, a lot more refining capacity has been recently added globally than what has been retired. This has put a downward pressure on the profitability of refining business at a time when high crude oil prices and environmental costs are already weighing on margins.
Most of the recent refining capacity addition has taken place in the Asia-Pacific and Middle East. In Asia-Pacific, China has led the growth in refining capacity. At 12 million barrels per day, the country’s refining capacity already surpasses its domestic demand. However, the country continues to add new capacity. Recent capacity additions have been enough to turn the country into a net exporter of refined products with new capacity expansions still due to be completed this year and the next. Other fuel-importing Asian countries are also planning refining capacity expansions.
In the Middle East, Saudi Aramco Total Refinery & Petrochemicals Co. (SATORP), a joint venture between Saudi Aramco and Total, started shipments from the 400,000 barrels per day Jubail refinery in September last year. This is just one of the three such massive facilities planned by the Kingdom. Other Middle Eastern oil producing countries are also adding refining capacities, including United Arab Emirates, Kuwait and Oman. 
This could potentially lead to a scenario wherein Asian refiners would have to export gasoline and diesel to the European nations, which are already reporting a decline in fuel demand. Realizing that there could be limited scope for exports, China is taking a hard look at some of its refinery expansion plans. Earlier this year, PetroChina announced that it had put off starting up two new refineries with a total capacity of 600,000 barrels per day and delayed the expansion of another one to scale back its aggressive plans amid slower than expected demand. Most recently, BP dropped its plans to invest in a 200,000 barrels per day refinery in China.  While these cut backs do signal a decline in margin pressures in the long run, in the short to medium term we expect the global refining market to remain oversupplied.
Shrinking WTI-Brent Spread
The shrinking WT-Brent crude spread in the U.S. is not helping refining margins either. Since 2011, increased crude oil production, primarily from the unconventional plays in the U.S. coupled with infrastructural bottlenecks due to limited pipeline capacity from Cushing, Oklahoma, the delivery point for WTI crude, to refineries situated on the Gulf Coast drove WTI prices lower as compared to the Brent crude. This allowed refineries in the U.S. to earn a much higher crack spread, as the prices of refined products did not decline as much. Last February, the spread between these two benchmark prices crossed more than $23 per barrel, which has shrunk to just around $10 now. 
This sharp move can be attributed to the impact of expanding infrastructure, increased refining capacity in the Midwest and Middle East supply concerns. The expansion of the Seaway pipeline in January last year increased its capacity to transfer crude from Cushing to the Gulf Coast by 250,000 barrels of oil per day (BOE/d). The Magellan Longhorn pipeline that began flowing 225,000 BOE/d from the Permian Basin in West Texas to Houston further eased storage capacity shortfall at Cushing. More significant pipeline capacity addition that recently came online is the Keystone XL Gulf Coast Extension (700,000 BOE/d). This will not only reduce piling inventories at Cushing, but would also provide Gulf coast refiners with an access to the Canadian oil sands crude oil. Going forward, we expect the WTI-Brent crude spread to decline further as oil inventories at Cushing, Oklahoma eventually normalize.
Increasing Focus On ULSD
In an over supplied market with razor-thin margins, International oil companies are investing heavily in ramping up their capacity to produce more of premium products that have higher crack spreads such as ULSD or ultra-low sulfur diesel, a diesel fuel with sulfur content as low as 10 parts per million. Demand for ULSD is expected to rise sharply in the coming years as countries all over the world try to reduce particulate emissions from diesel engines. As of 2006, almost all of the petroleum-based diesel fuel available in the U.K., Europe and North America is of ULSD type.
Exxon Mobil recently commissioned a new hydrotreater unit at its Singapore refinery, which increased its ULSD capacity by 57,000 barrels per day. The company has so far invested almost $3 billion in upgrading several refineries around the world for higher ULSD production. This is expected to slightly offset the impact of global overcapacity on its operating margins. 
- Exxon SEC Filings, sec.gov [↩]
- Satorp ships first products from Jubail refinery complex, ogj.com [↩]
- BP Drops Plans to Invest in China Refinery Project, IEA Says, bloomberg.com [↩]
- Price difference between Brent and WTI crude oil narrowing, eia.gov [↩]
- ExxonMobil’s New Singapore Hydrotreater Begins Operation, exxonmobil.com [↩]