Oil companies posted the lowest downstream margins in the first quarter of this year since the mid-1980s. Operating income from refining and marketing during this period was 50% down on 2001’s first quarter. Refining margins have always been volatile, subject as they are to movements in spot prices at both ends of the process. This year has been unusual in that retail margins were also poor. Refining is often regarded as a loss-making business, with long periods of apparently low margins keeping revenues low. Nevertheless, it is a business that oil companies have to be in if they are to survive in the industry over the long run.
In 2000 and 2001, average gross refining margins in Northwest Europe and on the US Gulf Coast were consistently high, making these two years extremely profitable for refiners. However, in the fourth quarter of last year product prices started a rapid slide and by the end of the year margins had collapsed to the low levels of 1999, reaching in Europe the lowest level for fifteen years. Weak global demand, which has been below year-ago levels for four consecutive quarters now, has coincided with a period of OPEC production constraints that has kept crude prices relatively strong. Refining margins have thus been squeezed at both ends.
Even if spot refining margins are reported as negative, it does not necessarily follow that all refiners are making a loss, provided they cut runs to the appropriate level. However, when prices are volatile, spot margins can change quickly, making refiners’ decisions about throughputs out-of-date before they have been implemented. When European margins fell sharply in the fourth quarter of last year, refiners did not cut runs significantly until February.
Although individual refineries are categorised as complex, semi-complex or simple, according to which combination of upgrading units they contain, in practice almost all refineries yield a particular mix of products depending upon the level of crude throughput. When simple margins are poor or even negative, throughputs will - in theory, at least - be cut back to the point at which the marginal yield is complex or semi-complex. Marginal product output yielded by the European refining system is usually semi-complex. The gross product worth of a semi-complex yield is currently only just above the price of Dated Brent and crude runs are close to the boundary between complex and semi-complex yields. The configuration of US refining capacity is much more sophisticated than in Europe - around two-thirds of its capacity is needed to fill deep-conversion coking capacity. However, the two regions have markedly different demand barrels, requiring distinct combinations of refinery units. While the US needs to imports large volumes of gasoline at the margin, Europe has a deficit of middle distillates.
Refiners aim to perform better than the average by having lower costs than their competitors and attaining higher prices for their products. Strategies to cut costs include mergers to gain economies of scale, operating refineries as ‘hubs’ and entering into term contracts with crude producers. Higher output values can be obtained by making specialist products such as lubricants, developing niche markets (such as the ultra-low-sulphur diesel market in Europe), increasing the degree of complexity at refineries and concentrating sales in regions such as the US West Coast, where prices are set at the margin by the cost of imports.