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Wednesday, May 4, 2016

Where are 2016 Fuel Margins Headed?

Source: Observations from the Executive Suite
By Jeff Kramer, Managing Director, NRC Realty & Capital Advisors

The retail fuel markets have recently completed two years of record strong fuel margins for a number of reasons (see chart below courtesy of OPIS). What caused this trend and might it continue?

Several cost push factors have been and are causing upward pressure on margins. One important factor has been rapidly rising land and construction costs, especially for prime locations, which then also get reflected in selling multiples of existing stores and chains. Labor costs are now increasing more than productivity gains. Obamacare, insurance, site development and ever increasing regulatory costs keep adding expense. And, then there are capital outlays for PCI compliance.

But wait, 2014 and 2015 have seen crude oil prices decrease from over $100 per barrel to as low as $26 per barrel, similar to 2008, that also brought record retail margins. I wrote in my NRC article on March 10 (see Observations from the Executive Suite, nrc.com website), that headline predictions of $20 oil were likely to bring some stabilization or correction. Since then, the U.S. Dollar has dropped more than expected, bringing back oil prices quite a bit to the $45 WTI range. Oil prices have been significantly helped by declining U.S. production rates and by the drop of the U.S. Dollar, certainly due to Federal Reserve inaction, but likely also reflecting a still very sluggish economic environment in the U.S. It is also likely that Obama anti-business regulations, U.S. Congressional inaction and the very negative and uncertain Presidential race are causing both business and consumer caution. When will the real Donald Trump please stand up, as they used to say on that TV show “What’s My Line”? He has said he would fire Janet Yellen – is that supposed to make me feel good?

In any kind of economic slowdown, margins in general often fall as competition gets more entrenched. Weak competitors cut prices to stay liquid, while strong competitors try for market share gains. Some areas of the country are seeing large new store expenditures based on a higher margin foodservice model, which often require significant traffic on the forecourt. Some operators have historically had negative breakeven fuel margins giving them considerable flexibility to drive traffic with price. Also, Walmart’s reentry into retail fueling and the supermarket companies' ultimate reactions could become quite a localized issue.

Another important factor affecting retail fuel margins will be how low oil prices may cause the integrated companies to attempt to recover greater refining profits through price to offset their huge reductions in crude oil production profits. Even though refining is a worldwide, cyclical business, and refiners have huge crude oil inventories to convert into products, mergers have created fewer competitors. Retail has also consolidated somewhat, but retail competition is much less concentrated, except perhaps in areas where sites and construction opportunities are limited.

As refiners successfully draw gasoline inventories during their ongoing maintenance season, any summer unplanned refinery shutdowns could have large regional impacts, with California usually the most sensitive, due to unique gasoline specifications.

In my March 10 article, I estimated regular gasoline rack-to-retail margins to average 18 cents per gallon nationally in 2016. I have also felt that gasoline demand would be higher by 2%, which seemed like a good number at the time, but I may have been optimistic. Perhaps new car fuel efficiencies, working from home on the internet, a smart and cautious consumer, Uber, and online food and convenience item deliveries are taking their toll. Electric cars are on the horizon. The next new issue affecting competition could be offsite fueling – where are the fire marshals when you need them?

                       
Annual Rack-to-Retail Margin for U.S.US Refining Crack Spreads