In the oil pond, the ugly ducklings are transformed into beautiful swans. Forget the romance of drilling wells in remote deserts, jungles and the frozen North. What really matters are the grim fuel factories with their pots, pans and flares that belch black smoke. Royal Dutch Shell PLC's downstream businesses more than doubled their profits in the second quarter as did BP PLC while France's Total SA managed to triple its earnings from distilling crude oil into gasoline, diesel and jet fuel.
It's almost a godsend for big oil, battered by the collapse in the crude price. Without the profits from manufacturing, the oil majors would certainly be cutting their dividends. And there will be a few smug faces among the remaining grey-haired chemical engineers, still walking the corridors at Shell and BP despite decades of downstream disposals and cost-cutting. It is no accident that Total, which was less aggressive in shedding its refineries, is suffering less in the crude oil downturn. While BP's underlying net profits were cut by two-thirds and Shell's earnings were down by more than a third, Total escaped with a mere 2 per cent dip in its profit.
In the circumstances, it is tempting to wonder whether Shell bought the wrong business when it agreed in April to take over BG Group. It was an upstream grab, a decision to invest about $70-billion expanding Shell's oil and natural gas production capability and the deal was sold to investors on the assumption that crude oil had reached its nadir and would soon be in recovery.
But timing is everything. The crude price seemed to be going Shell's way in May and June, with West Texas Intermediate rising above $60 per barrel, but over the past few weeks it is again plumbing the sub-$50 depths and Ben Van Beurden, Shell's chief executive officer, is talking about a downturn that could last years.
Cheap crude oil feedstocks in the United States have been a boon for refiners, which have been able to cherry-pick the cheapest cargoes to fill their distillation units. The evidence is in the average refining margins, the net gain in value of a barrel of crude put through a refinery. According to BP, the global refining margin has risen over the past year to $22.10 per barrel from $15.70. The surge in profitability is most acute in the United States, where refiners have been spoiled for choice, thanks to America's ban on crude oil exports. The third-quarter U.S. Northwest refining margin has soared to $36 per barrel for the current period from $19.80 last year.
Refiners tend to do well at the end of the summer driving season. As U.S. consumers head for the beach or the national parks, demand for gasoline surges and the wholesale price for gas climbs. If crude supplies are ample, a canny refiner can boost his margin, which is known as the crack spread. In the current glut of crude created by the output of shale oil from North Dakota and Texas, feedstocks are exceptionally cheap, but demand has been strong. After years of buying just enough gas to commute from work to home, Americans are once again filling the tank, regardless of their driving plans. This is showing up in gasoline crack spreads, which America's Energy Information Administration highlighted in a report in May when the gasoline crack spread reached 38 cents per gallon, the highest level since 2007.
The EIA said the main factors causing the crack spread surge were "the lowest crude oil prices in several years, robust U.S. gasoline consumption and exports, and higher-than-expected demand for liquid fuels in Europe and some countries outside the Organization for Economic Co-operation and Development." Independent U.S. refiners, such as Valero, are reaping the benefits as investors bid up their stock, the only rays of sunshine in a gloomy oil sector.
Still, the big question is whether the refining boom is a flash in the pan to be followed by another long period of weak margins. The gasoline crack is highly volatile and is a popular trade in the derivatives market. While the front month RBOB gasoline crack is $29 per barrel, the price falls quickly to just $11 in December. The point is that widening gasoline cracks are market signals of burgeoning demand for fuel, in turn a signal that refiners want more crude.
Could this mean that the double dip in the crude oil price will be followed by a rapid recovery in the autumn? That depends on a multitude of other factors, including the continuing weak European markets, the slowdown in China and, even more important, the speed at which Iranian oil returns to the global market. My guess is that we will not see a return to very high crude prices for several years. It will be a world in which refinery profits will continue to sustain the oil majors, not least because governments will continue to demand ever tighter emission controls on vehicle and fuel manufacturers. That will enable the refiners to charge more for their products even as the crude price remains weak.
It could be a longer summer drive for refiners than many expected.
Carl Mortished is a Canadian financial journalist and freelance consultant based in the United Kingdom.
Carl Mortished