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Despite tough end to 2018, analysts see refining equities on solid footing

U.S. tax reform, a more favorable regulatory environment, access to cheap crude oil, and consolidation drove year-to-date U.S. refining sector total return toward 30% through the first three quarters of 2018, but a dismal fourth quarter—during which falling oil prices, macroeconomic concerns, and a gasoline glut spooked investors—saw U.S. refiners underperforming the broader market by the end of the year.

Crude oil discounts kept refinery utilization at record levels to boost gasoline production and push gasoline prices down even as the U.S. became a net exporter of oil and petroleum for the first time on record.

"Rising crude oil prices and high levels of gasoline demand contributed to rising gasoline prices from January [2018] through May [2018]," the U.S. Energy Information Administration said in a Jan. 4 Today in Energy blog post. "Gasoline prices subsequently remained relatively stable from June [2018] through October [2018] before falling oil prices, high gasoline inventories, and flattening U.S. gasoline demand helped bring the U.S. average price down by nearly $0.50 per gallon between October [2018] and December [2018]."

The EIA said the 12-week gasoline price decline at the end of 2018 was the longest since the 17-week decline that ended in January 2015.

On the last day of trading in 2018, the S&P 500's year-over-year total return was a loss of 4.4%, while that of the S&P 500 Oil & Gas Refining & Marketing index was a loss of 11.1%.

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During 2018, inland U.S. refiners with an ability to access constrained production coming out of the Permian Basin as well as discounted Canadian crude oil outperformed the broader market, while those with a larger, more diversified footprint that includes assets on the Gulf Coast underperformed their peers, as it is more difficult for some refiners on the Gulf Coast to access discounted crude oil production.

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Beginning in the third quarter of 2020, a plan to reverse the 1.2 million-barrel-per-day Capline system, which carries crude oil from St. James, La., to Patoka, Ill., could increase Gulf Coast refiners' access to Canadian crude.

"Adding new US inland and Canadian crude into the Eastern Gulf market will be especially helpful for [Marathon Petroleum Corp.'s 556,000 bbl/d] Garyville, LA refinery, which accounts for 18% of the company's total refining capacity and historically has had a tougher time procuring access to such discounted barrels than similar refineries on the Texas Gulf Coast," Tudor, Pickering, Holt & Co. analysts wrote in a Jan. 3 note. "This has also been an issue for Phillips 66 (24% of company refining capacity in Louisiana), [PBF Energy Inc.] (21%), and [Valero Energy Corp.] (13%)."

More broadly, as pipeline capacity comes online, refining executives expect the crude oil discounts will narrow. However, some analysts expect the market to remain volatile with some regional crude price differentials persisting longer than others.

"Many midstream projects coming into service in late 2019 and 2020 will provide relief to [Permian] basin takeaway capacity constraints and the strain on commodity prices," analysts from Moody's Investors Service wrote in a Jan. 3 report. "But while [Alberta government-mandated production] curtailment quickly helped boost prices, it does not change the region's long-term risk of low margins; without additions in long-term pipeline takeaway capacity, Alberta crude prices will remain volatile and cheaper than WTI."

Looking ahead, even amid the prospect of narrowing crude oil discounts, investors expect tougher marine fuel sulfur standards known as IMO 2020 will benefit refiners.

"There was a willingness to add exposure to refiners in 2019, particularly from those underweight already," Goldman Sachs analysts wrote in a Dec. 26, 2018, report, citing investors. "Most investors still believe that IMO 2020 will be a tailwind for refining margins, barring a major economic slowdown. … Additionally, while [Western Canadian Select] differentials and Brent-[West Texas Intermediate crude oil] spreads have compressed, they are still at levels that should support positive free cash flow and capital returns."