The confluence of events that caused the North American refining sector to experience the strongest refining margins and operating performance in decades may be ending. However, S&P Global Ratings expects independent refiners' creditworthiness to remain resilient to some weakness in demand and other possible headwinds as we approach the end of 2023 and look to 2024.

With third-quarter earnings results quickly approaching, we await the narrative that will develop around recent weakness in gasoline cracks and some softening in refining margins more broadly. We are eager to know if management teams intend to stick to the financial policies of the past 18 months by holding high cash balances and maintaining ample liquidity, as well as their current thoughts on rewarding shareholders.

Are Lofty Refining Margins Coming Down To Earth?

The recent correction in gasoline cracks raises questions about whether the precipitous decline--the Nymex crack peaked in late summer at about $40 per barrel (bbl) and is now below $10/bbl--is mainly due to the usual drop in seasonal demand as refiners switch from summer to winter grade gasoline, or something structural.

Before we address possible causes for the recent weakness in gasoline cracks, we note the WTI 3-2-1 indicative crack has fallen below the five year average of about $19/bbl to roughly $17/bbl, but is still above the pre-COVID average of $13.60/bbl.

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The steep drop in gasoline cracks could be an overcorrection partly due to seasonality, but may also reflect weakened demand as a result of inflationary pressures generally, slower economic growth, the extreme weather that occurred on the East Coast that limited driving in September, and fewer miles driven as the summer driving season winds down. The fall season also brings scheduled maintenance and turnarounds for the industry, and if lower gasoline cracks persist we could see refiners start reducing utilization earlier than usual as gasoline cracks prove uneconomical. We expect average refinery utilization to decline to the high-80% area nationally, from the very robust mid-90% area the industry maintained through the summer.

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Gasoline inventory levels have risen since the beginning of September as a result of some of the demand weakness, but we expect the independent refiners we rate to limit gasoline production or switch to more distillate runs, although this can also put downward pressure on distillate margins. Another headwind North American refiners are dealing with is a narrower heavy-light differential. Gulf Coast refiners will see margins impacted by the smaller Brent-Maya spread, which has narrowed from a high of $19.23 per barrel in the first quarter of 2023 to $8.72 in the third quarter. The Brent-WCS spread has shown a similar contraction from about $17/bbl in the beginning of 2023 to about $9.75/bbl.

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While there is a pullback in gasoline demand, the same cannot be said for demand for diesel and jet fuel. Distillate demand remains steady, and inventory levels for both diesel and jet fuel are at the bottom end of the five-year range. U.S. demand for jet fuel, based on average passanger count from the U.S. Transportation Security Adminstration, indicates strong passenger levels in September and October, with overall passenger count tracking 2019 levels. All of these data, while not definitive indicators, supports the continuation healthy refining margins going into the traditionally slower fourth quarter period.

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Lower RIN Values Are Pressuring Margins

The price of renewable identification numbers (RINs) has also declined recently, which will have mixed effects on the refiners we rate. We believe the price of the D6 RIN--the ethanol RIN value used for gasoline blending--is already factored into the gasoline price and refining margin, therefore a lower RIN value will also reduce margins. The value of this RIN has dropped about 50 cents to roughly 90 cents per gallon from the beginning of September to mid-October, or about 5 cents per gallon in the price of gasoline (gasoline contains a 10% ethanol blend). While this has also put downward pressure on gasoline margins, it provides some relief for refiners that have significant RIN obligations, which reduces that balance sheet liability. While we do not impute debt for these obligations as many refiners historically have received small refinery exemptions from the EPA, we could change our view if these obligations become due.

The D4 RIN value, used for bio-massed based diesel, has also decreased by almost 45% over the same time period to about $1, mainly due to the ramp-up of renewable diesel production and favorable blending economics. While the lower RIN value will pressure margins, we believe the benefits of refiners converting a portion of their capacity to renewable fuels outweigh the risks. Renewable fuels will reduce greenhouse gas (GHG) emissions and also provide refiners incentives of $1 per gallon under the Inflation Reduction Act (IRA), as well as low-carbon fuel standard (LCFS) credits that should enhance returns. Many of the refiners we rate are producing renewable fuels and we expect that production will reach about 4.1 billion gallons by the end of 2024.

Table 1

Historically Strong Credit Quality To Remain Strong

Despite the recent pullback and mixed signals exhibited by refining margins, demand for refined products is comparable to pre-pandemic levels and is still above historical mid-cycle levels. We expect margins to continue to be credit-supportive given low inventory levels and tight product supply. Continuing on the back of a strong fiscal 2022, the North American refiners we rate achieved higher-than-average margins in the first half of 2023, albeit lower than the unprecedented levels achieved in the first half of 2022. We expect U.S. refiners will benefit from their relative advantage over most global sources of supply, including lower energy costs, favorable feedstock flexibility, and refinery complexity.

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Credit quality remains among the strongest we've seen as refiners remain disciplined, carrying large cash balances in addition to strong liquidity profiles and conservative capital structures. The potential inflationary risk and energy transition risks could pressure these issuers going forward, but we expect companies will maintain their credit quality despite the near-term headwinds from inflation and economic uncertainty, and the longer-term risk from the evolution to alternatives to hydrocarbon-based fuels.

Table 2

Capital allocation is not threat to credit quality

Refiners are flush with cash, providing them with considerable flexibility around financial policy, and their allocating capital to shareholders is not harming credit quality in our view. The rated portfolio repaid the debt borrowed during the pandemic downturn in 2021, and credit metrics are the strongest they have been in years, with substantial cushion in coverage and financial leverage ratios. We generally view share buybacks done at management's discretion as more supportive of credit quality than those done under a predetermined plan, because management can turn it off if cash flow or liquidity declines. The table below shows that refiners still believe share buybacks are an important way to return value to shareholders and a good use of excess cash.

Table 3

Valero, Phillips, HF Sinclair, and PBF all bought back shares while also maintaining positive free discretionary cash flow. Marathon has been very clear with investors that its preferred method of returning value to equity holders is through its share repurchase program and has been very aggressive in its approach, with more than $12.5 billion of shares repurchased during the 12 month period ending June 30. Marathon recently announced a 10% dividend increase for the third quarter 2023 and an additional $5 billion share repurchase program, which is in addition to its previous program, which still has about $4.3 billion remaining as of September 30. We balance Marathon's announcement with our expectations of it continuing to hold a significant cash balance and our expectations of consolidated debt to EBITDA coming in at the lower end of our 1.25x-1.75x range for year-end 2023.

We still believe the North American refining industry is well positioned as 2023 winds down. Industry performance and credit quality resiliency in the next 12-18 months depends on the usual external factors beyond companies' control, including economic activity, demand patterns, crude differentials, inflation, and commodity prices. However, we think creditworthiness will depend heavily on financial discipline if the industry enters a low point in the cycle, and whether management remains true to the financial policies that put them in their current position of strength. Third-quarter earnings could begin to shed light on this.