Baker & O’Brien, Inc.’s 2023 Q1 PRISM™ update shows that during the first quarter of 2023, refinery margins continued to decline from 2022 Q2 record highs seen after the Russian invasion into Ukraine. Average U.S. refining cash margins for the quarter remained very robust at $19.51/B, close to $10/B above the margins seen during 2022 Q1 before the invasion.

Overall, U.S. cash margins declined slightly from 2022 Q4 alongside crude and product prices as the Federal Reserve’s efforts to slow inflation began to take effect. PADD 5 is the outlier with margin gains primarily due to natural gas prices "cooling off" from the anomalous spike in December 2022. Overall U.S. refinery utilization decreased by 3.9% over the prior quarter. Total U.S. light product demand was down by 0.2% over the quarter, with rising gasoline demand offset by reduced jet and diesel demand.

The year-on-year comparison shows a somewhat different picture for U.S. refinery utilization and demand. Refinery utilization decreased by 2.0% from the first quarter of last year. While jet demand remains higher than last year, gasoline is nearly flat. Diesel demand is down almost 11%, resulting in a 2.9% drop in demand.

Other Key Refining Margin Metrics from 2022 Q4 to 2023 Q1 are mixed, as illustrated in the following table. Product crack spreads fell sharply in PADD 1 and, to a lesser extent, PADD 2, while PADD 3 and PADD 5 spreads rose slightly. The light-heavy crude oil price spread (WTI – WCS) weakened, impacting the margins of coking refineries that process heavy sour crude oil.

Special Topic: Are Carbon Costs Weighing on European Refiners?

In a recent Special Topic, we highlighted the competitive challenges hard-pressed European oil refineries face from high natural gas prices. One of the additional regulatory burdens for European oil refineries compared to other regions is that they operate under a cap-and-trade-type scheme for carbon emissions, either the European Union Emissions Trading System (EU ETS) or the United Kingdom (UK) ETS. Traditionally, margin analysis for EU refineries has assumed this cost burden to be minimal. As the costs of carbon allowances recently traded at the €100 mark, in this quarter’s Special Topic, we quantify the economic burden placed on EU oil refiners associated with EU ETS.

When assessing the economic impact of the EU ETS, it is important to remember that EU refineries are currently allocated allowances, so the true cost impact relates only to emissions that exceed the allocation. As shown in Figure 1, the level of allowances has been reduced over time (yellow bars) such that today’s allocated allowances cover around 70% of European refineries’ emissions (blue bars). The EU processed around 9.85 million barrels per day (MMB/D) of crude in 2022, so the cost to refining margins on average has been about €0.95/barrel with EUAs at €100. This is equivalent to about 10% of EU refiners’ total OPEX cost and 15%-20% of variable OPEX (depending on natural gas prices) — sizable amounts. However, this aggregate view camouflages the creation of winners and losers from the disparate carbon position and exposure to carbon costs for each refining facility.

While the refining sector as a whole only needs to pay for about 20% of its emissions, this varies greatly from one refinery to the next, as shown in Figure 2, which ranks refineries by the magnitude of their verified emissions (black bars; highest emitters to the left). A handful of refineries’ allocations (yellow bars) are higher than what they emit, while a few others emit much more than allocated. The refinery with the greatest allowance deficit in the chart (black and yellow bars to the far left) processes 300 thousand barrels per day (MB/D) and could see its margins impacted by a sizable €3.25/barrel (at €100/metric ton [MT]) or about 50% of the refinery total OPEX.

Given that many EU refineries are amongst the most energy-efficient globally, not surprisingly, the EU is concerned about so-called carbon leakage — where EU petroleum production is replaced with more carbon-intensive imports from regions with less stringent climate policies. The purpose of the Carbon Border Adjustment Mechanism (CBAM), introduced in April 2022, is to level the playing field by charging an appropriate emission-related tariff on refined products entering the EU.

As free allowances are phased out likely by 2030, refineries in the EU — and any that wish to import products to the EU — will have to factor in substantial carbon-related costs. The CBAM will also result in some importers paying additional compliance costs. U.S. refiners already report their emissions to the U.S. Environmental Protection Agency (EPA), so they likely will not have additional compliance costs to sell into Europe. But refineries from developing nations (where diesel imports have grown dramatically to replace Russian imports) that might not report their emissions would have to produce auditable emissions numbers to continue selling into the EU.

Europe’s “first mover” status related to carbon trading comes at a price for petroleum exports, such as its surplus gasoline. So, while the CBAM offers protection in their home EU markets, the competitive position of European refiners will likely be undermined in Atlantic Basin export markets, such as New York Harbor or South America. The carbon costs are an additional competitive disadvantage against major refining centers such as the U.S. Gulf Coast, India’s Jamnagar, Korea, and the Middle East.

How the EU ETS will shape the futures of EU oil refineries is difficult to predict. However, one certainty is that the oil refining margin analysis needs to factor in the associated compliance costs. Our annual European refinery assessment, due later this year, will do just that, providing a deeper insight into the likely winners and losers.