Refineries Shut Down, Cutting Inventories and Jobs

Posted by Steven Zweig on October 13, 2009 at 10:44 am

Sunoco's Eagle Point, NJ refinery. (image: sunocochemicals.com)

Weak demand for crude and its distillates, including heating oil, are keeping prices low. With the economy mired in recession, dampening every aspect of fuel demand, even the projected cold winter may not be enough to soak up excess heating oil and raise prices.

Reporting on the oil markets usually focuses on supply and demand as abstract market forces, their impact felt primarily in price changes. To a great extent, that’s understandable: for most people, the bottom is, after all, the bottom line—they want to know the impact on their wallets.

Refinery shutdowns aim to keep supply down and lift prices—that affects your wallet. But we can also take a step back and look at the bigger picture, and see how other people are affected. When revenues decrease and companies cut production and shutter locations, it’s not abstract statistics that lose their jobs—it’s human beings.

As Bloomberg.com reported Monday, battered by persistently low heating oil prices and intractably high supplies, refiners are cutting production. Valero is closing down its Aruba plant, while much closer to home, Sunoco is idling its Eagle Point, New Jersey refinery.

This isn’t done lightly, of course. Taking a plant offline safely and properly costs money, and starting it up again when—if—demand increases costs more. Right now, distillate stocks—the category of refined fuels that includes both home heating oil and diesel—stand at 171.8 million barrels, the highest level in more than a quarter century. In 2009, inventory has risen by 33.9 million barrels, to a level sufficient to meet all U.S. need for the better part of two months without any new production. A consequence of this oversupply is that the profit margin on heating oil has plummeted. Since heating oil is refined from crude oil, the margin is usually given in terms of the difference, or spread, between the price of the raw material—crude—and the price of the finished product—heating oil. And since the process of refining is also called “cracking” the oil, this measure is called the “crack spread.”

Based on futures contracts, the crack spread for January is predicted at between $5 and $5.50 per barrel. A year prior, it was $19.60 per barrel, which means it’s fallen by nearly three-quarters. At the same time, meteorologists predict the coldest US winter in a decade—in other words, even including the impact of a colder-than-normal winter, heating oil prices and refinery margins remain low. How low? So low that the US Energy Department forecasts that heating costs will fall 8 percent this winter.

Of course, a severe winter will raise prices: if it’s even colder than currently predicted, that will increase heating oil use and prices. If that’s combined with overall economic improvement, increasing utilization of all kinds of fuel, refinery margins could be pushed up to $10 a barrel or more, according to the head of commodities research at Bank of America-Merrill Lynch.

However, at present things do not look good on the economic front. Despite some positive signs—industrial production up 0.8 percent; a slight recent expansion of the service sector—unemployment continues to rise, to a 26-year high, and nonfarm payrolls drop faster than expected. It’s far from given that there will be an economic upsurge on the near-term time horizon. At the same time, the state of contango in oil markets—futures contracts trading higher than prices for immediate delivery—creates an incentive to buy and store oil for future sale. And that keeps driving inventories higher, which will keep holding prices down.

As commodities expert Stephen Schork wrote Monday, “this heating season’s early start notwithstanding, the market is not pricing in a premium on winter material, i.e. the market is not pricing in concern regarding the availability of supply for winter.” That’s because with the ever-building inventory, there is no concern about heating oil supplies. It’s cold out, but as the title of Schork’s blog says, not cold enough to affect supply.

Refinery utilization rates—how much of their capacity refineries are using—are only at 85 percent. If it falls below 80 percent, the crack spread could drop to $1 or less: essentially, no profit. The only way to avoid that, in the face of continued weak demand, is by idling capacity. Past a certain point, that requires idling refineries.

That means that the low heating oil prices we expect to enjoy this winter may be paid for by other people’s livelihoods. Here in the Northeast, Sunoco will be furloughing 400 employees from its Eagle Point plant. If the refinery resumes operation, they’ll be able to return to work. If not…well, that’s the human face behind the price movements and abstract market forces.