US integrated refiners (refining, pipeline, retail/marketing) have enjoyed positive returns the past several years due to favorable crack spreads. In the future, industry headwinds (e.g. reduced demand, increased crude oil exports) will put pressure on crack spreads and require refiners to win through efficient and effective operations, while still generating enough cash flow to maintain commercial agility (e.g. ability to process a wide variety of crudes).
To do this, refiners will first have to better understand all of the levers that impact profit (e.g. market, configuration, availability, scale, complexity, effectiveness), and how their strategic decisions shape each lever.
Most refiners have enjoyed strong returns over the last 5 years - typically beating the S&P 500. (Figure 1)
However, returns are directly tied to crack spreads, as most refiners saw lower returns when crack spreads dipped in 2016 and 2017. It appears that the market is rewarding firms for the overall profit delivered and not considering how hard the firm had to work to achieve those benefits. (Figure 2)
Crude oil exports are on the rise…
The US shale revolution, mixed with the lifting of the US crude oil export ban in 2016, has drastically changed the balance of the global energy market. Already the largest oil producer in the world, the United States is expected to become a net exporter of crude oil by 2020, providing a relief valve for producers and leading to increasing domestic prices to match export parity.
Geopolitical risks to supply…
At the same time, geopolitical concerns in countries with heavier crude (e.g. Venezuela) could impact supply for US refiners, forcing them to find alternative sources for heavy crudes or leading to suboptimal use of current configuration of their refining kit. These alternatives are likely to be more expensive and/or less suited to current refining kits, potentially leading to lower value products or underutilization of cracking and coking assets.
Domestic demand flat or declining…
Going forward, refined products are expected to have stagnating demand over the next few decades in the OECD nations as transportation fuel dynamics change. Recently, changes in driving habits such as ridesharing and autonomous vehicles are touted as gamechangers to put fewer cars on the road and drivetrain competition has increased with electric and natural gas vehicles making inroads. However, adoption rates would have to move exponentially to materially displace cars and trucks in the current fleet. More important to refiners in the near term, fuel efficiency continues to improve, and more and more companies are allowing telecommuting and other flexible work schedules to reduce commutes.
Difficult to compete in export market with local refiners…
With increased domestic crude exports, US refiners will look to the export market as demand in non-OECD countries for crude oil and refined products should continue to rise the next several years. However, US refiners will have to compete with local refiners in those international markets who have their own geopolitical (e.g. taxes, trade, subsidies) and regional advantages (e.g. access to customers, partnerships). Refiners looking to secure export demand should look to partner with local incumbents.
As a result of upcoming headwinds and volatility, integrated refineries are going to have to become more operationally effective and agile to maintain desired margins. That said, it is our experience that while most IR firms understand the main drivers of profitability (market, asset mix, operational effectiveness, scale, availability, etc.), few take the time to look at these holistically and decompose their contribution margin by each driver.
Without decomposing contribution margin, performance gaps can often be masked. This issue can be magnified in times of high crack spreads. For example, a strong regional advantage (e.g. refineries located in PADD 5) could lead to outsized margin, while masking deeper operational and commercial inefficiencies.
As seen in the decomposed contribution margin analysis below, refinery A’s (positioned in PADD 5) contribution margin is driven almost completely by it’s market advantages. Refinery B (positioned in PADD 3) is an industry leader in operational effectiveness (e.g. low OPEX/bbl) and was able to overcome regional disadvantages to drive a higher contribution margin than A. Refineries C & D, however, are unable to overcome the same disadvantages.
Operationally effective refiners have lean operations and strive for the lowest costs. Lean operations will be critical for US refiners in the future as margins are threatened by coming industry headwinds. Some best practices by operationally effective refiners include the following:
Refiners also need commercial agility in order to capitalize on opportunities to diversify risk and increase returns. For example, there will continue to be opportunities for consolidation (e.g. ANDV/MRO) and vertical integration. Additionally, as demand slows domestically, there will be new opportunities in the export market. Refiners will have to be agile in their asset mix/kit configuration to meet demand in a variety of markets. Some best practices by agile firms include:
Those refiners who combine both strategies will be able to rapidly adapt to market changes in productive, cost-effective ways and generate superior returns.
Depending on the maturity of the firm, improving operational effectiveness and agility could require incremental or transformational change. PwC Strategy&’s platforms offer companies the ability to focus on the right aspects of their business to navigate the changing marketplace and effectively execute strategy.