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The analysis utilizes information reported annually to the Energy Information Administration's (EIA's) Financial Reporting System (FRS) by the two dozen or so U.S.-based major energy-producing companies.91 The FRS contains financial data and associated measures of energy-related operations by line of business, including U.S. refining/marketing. Over the past ten years, the FRS companies accounted for 72 percent of U.S. refinery capacity. The FRS data are complemented by financial information drawn from annual reports for non-major domestic refiners.
Income from refining operations primarily depends on the spread between refined product prices and raw material input prices (termed, the gross refining margin), operating costs, and volumes processed and sold. The gross refining margin is an important determinant of short-term refining profitability. For example, an examination of the gross refining margin reveals the sources of increased U.S. refining profits in the context of the gasoline price runup in the First Half of 1996 (see the section "Petroleum Price Rises Yield Profit Gains in First Half of 1996").
In the longer term, though, the relationship between refining profitability and the gross refining margin attenuates. For example, the correlation between the FRS companies' annual U.S. refining/marketing profitability and a somewhat broader definition of the gross refining margin 92 is not significant by the usual statistical conventions.93 The reason for this weak relationship is that the gross margin excludes operating costs such as refinery energy expense and maintenance of marketing networks. Operating costs may not typically vary much from quarter to quarter, but in a longer term context they are a key component of profit change. Of particular importance is the strong relationship between U.S. refining/marketing profitability and the net refining margin based on FRS data (i.e., the gross margin less out-of-pocket operating costs) ( Figure 104).94 Thus, examination of the components of the net refining margin should provide insights as to the level and volatility of U.S. refining profitability. Table 17 presents the components of the net refining margin and measures of U.S. demand for the FRS companies' refined products, and refinery utilization for the peak and trough years of refining profitability.
The profitability story in the 1980's is largely told by the dynamics of demand, capacity rationalization, and reductions in operating costs, as gross margins were fairly stable over the period. Following full deregulation of petroleum prices in 1981, refining profitability in the United States reached its lowest point in 1984. The U.S. refining industry was plagued by a falloff in demand and massive amounts of excess crude oil distillation capacity. The net margin on the FRS companies' U.S. refining and marketing operations was only 1 penny per barrel in 1984. However, the gross margin changed little from the previous peak profitability year of 1979. What did change was demand (down 19 percent), capacity utilization (down 9 percentage points), and operating costs (up $1.80 ($1995) per barrel). Moving to the peak profitability year of 1988, most of the factors that devastated the bottom line in 1984 turned around: demand was up 17 percent, capacity utilization noticeably improved, and operating costs declined by more than $2 per barrel. Again, the gross margin changed little.
The FRS companies' return on U.S. refining and marketing investment fell from its post-embargo peak in 1988 to zero in 1992. Demand for the FRS companies' refined products fell 7 percent over this period. Unlike the 1980's when gross margins held fairly steady, weak demand squeezed the spread between product prices and the prices of crude oil inputs. Overall operating costs also increased owing to a rise in marketing costs. The increase in marketing costs was widespread, with 16 of 18 FRS refiners reporting higher unit marketing costs between 1988 and 1992. The reasons for higher marketing costs are not altogether clear. Advertising outlays were up, reflecting a resurgence of growth in gasoline marketing in the wake of the oil price collapse of 1986. Also, the added costs of complying with leaking underground storage tank requirements were a contributing factor to higher marketing costs.
The profitability of the FRS companies' U.S. refining operations recovered slightly in 1993 and 1994, but remained low by historical standards (Figure 102). This recovery is remarkable since it occurred while the gross margin fell by nearly $1.30 per barrel. Growth in demand of about 2 percent helped the bottom line but most of the improvement in earnings came from operating cost reductions, mainly marketing costs. Nearly all of the FRS refiners reported lower marketing costs between 1992 and 1994, citing restructuring and efficiencies gained through greater retail outlet productivity. Also, the FRS companies reduced their advertising outlays, at least for television. On the refining side, cost cutting by the companies and higher capacity utilization contributed to improved profits.
In 1995, increases in refined product prices did not match the rise in crude oil costs. The consequent squeeze on margins was in part due to the effects of unusually warm winter weather on first-quarter heating fuel demand and to complications arising from the introduction of reformulated gasolines. As a result, the FRS companies reported a 1.0-percent return on their U.S. refining/marketing investment base, the third poorest financial performance in nearly two decades. Despite jumps in distillate and gasoline prices in 1996, U.S. refining operations fared only slightly better in terms of financial performance than they did in 1995. For example, major petroleum companies that separately disclosed quarterly financial results for their U.S. refining and marketing operations reported that income from these operations in 1996 was 15 percent above the comparable total in 1995. 95
Examination of the FRS companies' U.S. refined product margins is thus seen to reveal the sources of volatility in rates of return to U.S. refining and marketing. The volatility of U.S. refining/marketing profitability over the past decade or so reflects a combination of swings both in the spread between refined product prices and crude oil input prices and in marketing costs, which, despite the massive restructuring of marketing networks, have shown a varying pattern over time with a tendency toward long-term decline only recently evident. Further, the low level of refining/marketing profitability in the 1990's is largely traceable to lower gross margins which were only partly offset by reductions in operating costs. However, there are other developments that have contributed importantly to the longer term course of U.S. refining/marketing profitability. These developments are not directly observable in the data on margins, but, instead, are best understood in the context of capital deployment.
In the 1990's, U.S. refining was hit by lower gross margins following the peak years of 1988 and 1989. Also, over the same period, the capital intensity 96 of U.S. refining increased by 50 percent or so after remaining nearly unchanged for several years (Figure 105). Together, these developments underlie the generally low rates of return to U.S. refining and marketing in the 1990's. Examination of investment patterns in U.S. refining proves useful for understanding why capital intensity rose in some periods and was unchanged in other periods.
The past 20 years saw several distinct phases of capital deployment in U.S. refining (see "Perspectives on Petroleum Profitability" for a more detailed discussion of this topic). Investment patterns during this span had the effect of increasing the capital intensity of these operations. Beginning in the late 1970's and continuing through the early 1980's, the FRS companies led U.S. refiners in making investments to upgrade their capability to utilize heavier, more sulfurous crude oils. The companies premised these investments on expectations that the composition of world supplies would shift toward lower quality, lower priced crude oils. Led by the FRS companies, many U.S. refiners invested in specialized plant and equipment in order to profit from the expected growth in the wedge in prices favoring lower quality crudes. Also, market adjustments made in the context of the crude oil price escalations of the 1974-1981 period signaled a shift in the composition of petroleum demand toward gasoline and distillates and away from heavier products. Domestic refiners, again led by the FRS companies, added light product capacity to accommodate this shift.
Increased environmental standards further heightened the capital intensity of U.S. refining during this period. Implementation of major Federal environmental quality legislation in the 1970's confronted refiners with stringent standards for airborne emissions and effluents discharged into waterways. Compliance resulted in added capital expenditures for U.S. refiners (Figure 106). Upgrading and environmental quality measures led to a surge in capital expenditures for U.S. refining over the 1978 through 1983 time span with an attendant rise in capital intensity.
Responses by energy consumers to oil price escalations, together with the deregulation of U.S. petroleum prices in early 1981, made much of U.S. refining capacity uneconomic. While petroleum price regulations were in force, U.S. refining operations yielded moderate rates of return. However, starting in 1981, profitability declined sharply. Narrowing of the price differential between high and low quality crudes during the first half of the 1980's further eroded rates of return. Investments for upgrading refinery input capabilities were premised on a widening of this differential. Therefore, a narrowing tended to impair rates of return.
By 1986, U.S. refiners had shut down or otherwise disposed of plant and equipment representing over 3 million barrels a day of refining capacity. The FRS companies accounted for 75 percent of this reduction. Investment fell off in part because upgrading projects were completed, in part because refiners massively consolidated capacity, and in part because the capital markets were repelled by the poor returns to refining investments. The winding down of pollution abatement expenditures and redeployment of assets gained in the mega-mergers among the FRS companies in the 1981 through 1984 time period also contributed to a falloff in U.S. refining investments. All of these developments flattened the growth in capital intensity.
Capital intensity remained level through most of the 1980's. During this period, net refining margins improved, as did petroleum product demand, leading to increased profitability for U.S. refining and marketing. A widening of the price spread between crude oil qualities also contributed to higher earnings (see Figure 91 from Chapter 7 (PDF format)). The buoyant rates of return in U.S. refining during the latter half of the 1980's were short lived. In the 1990's, lower margins, due in part to the narrowing of the crude oil price-quality differential, eroded U.S. refining and marketing profits. The adverse effects on profitability were exacerbated by a renewed rise in capital intensity beginning in 1990. Refinery upgrading, in part undertaken to satisfy mandates for reformulated fuels, was the major source of this most recent upswing in capital intensity. Expenditures for pollution abatement played a key role as well.
Growth in motor fuel demand, spurred by the low level of petroleum prices following the oil price collapse in 1986, encouraged investment in light-product capability. The earlier shift in the price-quality spread favoring the use of heavier crude oils encouraged investments in processing capabilities. What differed in the 1990's from the earlier surge in U.S. refining investment was the role of environmentally-related capital expenditures. Starting in the mid-1970's, refiners' environmentally-related capital expenditures trended downwards as the requirements of the Clean Water Act and Clean Air Act were met. By the mid-1980's, environmentally-related outlays were less than 10 percent of overall capital expenditures of U.S. refiners.
In 1990, the Clean Air Act Amendments were enacted by Congress and signed into law. This legislation presented U.S. refiners with added requirements for motor fuels to be met by the end of the decade, including the production of oxygenated gasolines by late 1992, lower sulfur diesel fuels by late 1993, and reformulated gasoline by January 1, 1995. To comply with these measures, FRS refiners stepped up their capital expenditures for the necessary facilities. Environmentally-related capital expenditures quadrupled, accounting for nearly 40 percent of U.S. refining capital expenditures by 1994. The additional capital expenditures raised the capital intensity of U.S. refining.
Examination of the path of capital intensity thus completes the story of U.S. refining profitability over the past 20 years or so For the 1990's in particular, capital intensity grew but refining margins diminished while growth in refined product demand was nearly flat. As a result, the returns to investment in U.S. refining have been low, compared with the rest of U.S. industry.
Petroleum Price Rises Yield Profit Gains in First Half of 1996
Higher petroleum prices in the first half of 1996, particularly gasoline prices, raised concerns
about the profits of petroleum
companies. In fact, profits from U.S. refining and marketing operations were up sharply. In the
first quarter of 1996 (Q196),
major integrated refiners (the "majors") reported income from their U.S. refining operations of
$223 million (Table 18), which
was a turnaround from losses in the first quarter of 1995 (Q195) their worst first-quarter
performance in the past 10 years
(Figure 107).97 Similarly, smaller, non-integrated refiners (the "independent
refiners") made a substantial
recovery from a very poor first quarter the year before. The majors registered a $0.5 billion gain
in their U.S. refining profits
in the second quarter of 1996 (Q296) while the independent refiners' net income was up 55
percent. For the first half of 1996,
both groups of companies more than doubled their earnings compared with the very poor results
in the first half of 1995.
The spread between product prices received by refiners and the cost of raw material inputs for their refineries (termed, the gross refining margin) is an important determinant of refining profits, in the short term. For example, there is a strong positive relationship between second-quarter U.S. refining/marketing income and the second-quarter gross refining margin.98 Although the gross refining margin in Q196 was low in comparison with the general level of margins in the 1990's, it was well above the first-quarter margin of the year before (Table 19). In Q195, the refining margin fell to a 6-year low, squeezed by a combination of a slight rise in crude oil input costs and downward pressures on gasoline and distillate prices. The modest recovery in the overall refining margin largely reflected the effects of an especially cold winter in 1995-1996, particularly in March. Distillate prices were up 17 percent and the price of propane rose 22 percent between Q195 and Q196. In contrast, gasoline prices were up 6 percent, just matching the rise in crude oil input prices.
Demand growth also favored higher refining profits in Q196 relative to Q195. The quantity of total refined products supplied was up 4 percent over this period, mainly reflecting the greater demand for space heating fuels. Improved economic conditions also contributed to overall petroleum demand, with real GDP growing 2 percent between Q195 and Q196. The total amount of distillate fuel oil and propane supplied was up 5 percent. Residual fuel oil volumes were up 7 percent, fed by electric utility demand. However, growth in gasoline demand was nearly flat.
In the second quarter, the rise in gasoline prices outpaced the rise in crude oil prices compared with Q295, $2.91 per barrel vs. $2.21. However, overall distillate product prices registered a steeper rise of $4.65 per barrel over the same period. Similarly, while motor gasoline demand rose nearly 1 percent, distillate demand was up nearly 5 percent, reflecting strong demand for diesel and replenishment of inventories.
It is probably worthwhile to note that second-quarter profits in 1996 exceeded expectations based on the estimated relationships between profits and the gross refining margin noted above. Based on these relationships, the actual value of Q296 refining/marketing profits were 1.7 times the predicted value for the majors and 1.3 times the predicted value for the independents. One source of higher profits in this quarter not accounted for by the above relationships appeared to be a wider spread between wholesale prices paid and retail prices charged for gasoline by retailers. The retailer margin in Q296 was up 2 cents a gallon (15 percent) from the previous year (Table 19). Since most of the refiners that reported second-quarter financial results have gasoline marketing networks, an increased spread in the retailer margin would contribute to improved bottom-line results.
Text last modified: November 3, 1997
File last updated: January 22, 2008
Author:
Jon Rasmussen
Contact:
Neal Davis
neal.davis@eia.doe.gov
Phone: (202) 586-6581
Fax: (202) 586-9753
URL: http://www.eia.doe.gov/emeu/perfpro/pi&t97/ch8.html
