The downturn in global crude oil prices since June 2014 has coincided with both higher and lower profitability in the U.S. downstream sector, depending on which region of the country one considers.

While not every U.S. refiner may consider this a “golden age,” most would likely agree the environment is better now than it was only a few years ago. Crude production is still going full tilt, export markets are robust and there’s money to be made.

Of course, the landscape could look quite different down the road.

“There are many dynamics supporting how the U.S. refining industry has arrived at the current opportunity, but there is no complex algorithm. The market often rewards simplicity, which we believe improves the likelihood for refining shares to continue their differentiated performance moving forward,” observed Driehaus Capital Management’s (DCM) Josh Rubin in a September 2013 paper.

As portfolio manager of international discovery and global growth funds at Chicago-based Driehaus, Rubin helps identify appropriate investment ideas relevant to the strategies. In a recent interview with Hart Energy, he said lower crude feedstock costs should continue to contribute to North American refinery profitability.

“The paper reviews an industry that we believe is an outsized and underappreciated beneficiary of the energy revolution: North American refiners,” he said. “We do still see the great majority of factors that benefitted the refiners continuing to benefit the refiners going forward, but in many cases, we are seeing offsets to declining prices that we might not have built into our case before.”

For one, refiners not only have logistical advantages in transporting oil, they have advantages storing oil and have been able to make the most of locational arbitrage opportunities during recent price volatility, Rubin said.

“We are also seeing some capital costs fall, because equipment or materials imported from countries with weakening currencies now costs less. This allows U.S. refiners to generate more free cash flow,” he added.

Josh Rubin

Refiners’ cost of capital is falling with global interest rates, allowing them to continue repurchasing shares and to fund accretive capex or bolt-on acquisitions, Rubin further noted.

“We’re also beginning to see U.S. consumers driving more with the lower oil prices, and increasing demand for transportation fuel at home has been pretty rare,” he said. “We’ll need to watch to see if it is offset by weakening demand from Latin America where some diesel and other exports have been shipped.”

According to another consultancy, McKinsey & Co., downstream-market developments in response to last year’s oil-price collapse are generally following historical patterns of behavior and typically progress through three stages. In the first stage, market volatility is the dominant force.

“Product prices often fall less quickly than crude as demand for products to build storage grows. This first phase normally comes to an end after a few months as soon as product price declines catch up with crude price declines,” McKinsey analysts Tim Fitzgibbon, Agnieszka Kloskowska and Alan Martin advised in a mid-February research note.

In the second stage, supply and demand fundamentals stabilize resulting in a compression of refining margins.

“With lower crude prices, there is a general compression of most refining products spreads and differentials. Most spreads reflect the “cost” of transforming one crude or product into another, with most of the cost theoretically being equivalent to a loss of volume,” the analysts note. “At lower absolute prices, the cost of this volume loss declines, narrowing the spread.”

The third and final stage depends on the sustainability of the “new” crude price environment, according to the report. “With sustained low prices, there will typically be a rise in demand for light products. This comes both directly from the reduced incentives to improve efficiency or boost non-oil based substitutes and from the indirect effect of lower prices on economic growth.”

For U.S. refiners, however, the effect of lower crude prices as a driver of future profitability will be minor relative to the global supply/demand balance for refining and the longer-term mandated drive for efficiency gains in automotive fleets.

“Unfortunately, this is quite clearly negative,” the McKinsey note concluded. “While some increase in light product demand is possible in the longer term, it most likely will not be enough to outweigh the impact of the expected global refining capacity overhang and the resulting poor refinery utilization in some key regions.

Currency Movements

At a high level, DCM’s Rubin sees OPEC’s decision in November not to curtail production as the greatest driver to the recent oil-price crash.

“We are seeing numerous oil-growth projects being curtailed by energy companies around the world,” he explained. “Many, like offshore, are long lead-time projects that, once delayed, will take years to bring online whenever companies are again ready to reconsider investing. Consequently, we believe that within 18 to 24 months, global supply and demand dynamics will have rebalanced to support prices substantially above [current] oil prices.”

But whether “substantially higher” means $80 per barrel (/bbl) or something lower, it will be driven primarily by currency dynamics, Rubin said.

Commodities typically follow an inverse relationship with the value of the dollar. When the dollar strengthens against other major currencies, commodity prices typically drop. When the value of the dollar weakens against other major currencies, the price of commodities generally move higher.

The connection may be conspicuous and inevitable, but it’s not always fully appreciated. In fact, most empirical research often ignores the oil price/U.S. dollar exchange relationship, a February 2013 Ghent University paper advised.

Compared to the first quarter of 2012, prices for West Texas Intermediate (WTI) crude are about 50% lower in U.S. dollars, around 40% lower in euros and roughly 23% lower in Japanese yen.

“If you start the comparison in October 2014, there are similar currency differentials, because the U.S. Federal Reserve, European Central Bank and Bank of Japan all began indicating their various intentions for quantitative easing,” DCM’s Rubin said. “With foreign central banks seeking to stimulate local economies while the U.S. Fed considers raising interest rates, the stronger U.S. dollar has made oil cheaper for Americans, but the benefits have been felt less in weaker-currency countries.

According to Rubin, it would be difficult for oil to rise back to $80/bbl at current exchange rates, because oil prices would have to be as high or higher in many foreign currencies as they were a year or two ago when oil was at $100/bbl.

“Consequently, we think the future rise in the USD-denominated oil price will be partially dependent on global purchasing-power parity and currency strength,” he told Hart Energy. “Too much of a price increase in dollar terms would weaken foreign economic recoveries, and consequently demand, which would again destabilize the supply/demand dynamics.

“So we do still expect the price of oil to rebound in the future, but most likely closer to $70/bbl rather than $80/bbl,” Rubin added.

Editor’s Note: This is the first installment in a two-part series on U.S. refining opportunities in the current low-price oil environment. After more than 30 years of challenges, investors in the refining sector are expected to reap the rewards of the North American energy industry’s hard work and innovation over the last decade.

Contact the author, Kristie Sotolongo, at ksotolongo@hartenergy.com.