What's Happening?

The previously proposed tariffs on Canada and Mexico will go in effect beginning March 4. The U.S. proposed a 10% tariff on energy imports from Canada and a 25% tariff on all other Canadian goods as well as all imports from Mexico. If enacted, the announced tariffs could increase the cost for U.S. refining companies that process Canadian and Mexican crude slates. We believe this will also result in increased costs for U.S. refined products and squeeze refining margins.

The U.S. imports approximately 4 million barrels per day (bpd) of crude from Canada, and more recently has imported less than 500,000 bpd from Mexico. (see chart) The main crudes imported from Canada is Western Canada Select (WCS) and Maya from Mexico, which are both considered heavy sour barrels. Only certain refineries are configured to process heavy oil because it requires additional, more expensive, processing to produce high-value refined products. As such, these crude slates typically price at a discount to lighter crude slates because only certain complex refiners can process heavy crudes as their feedstock.

U.S. crude oil imports

Why It Matters?

A 10% tariff on the current price of oil (approximately $60 per barrel [bbl]) comes out to approximately $6/bbl or, $0.15 per gallon. Many market participants believe the cost would be shared by Canadian oil and gas producers, refining companies, and consumers. If we assume 50% of the cost is passed on to the refiner, that amounts to a cost increase of approximately $3/bbl. This would drive up the feedstock costs for refiners and essentially result in higher prices at the pump for consumers. Reduced profitability could lead to reduced utilization at some Midcontinent refineries, further driving up prices at the pump for consumers.

WCS and Maya are similar in quality (see image) and cannot be easily replaced by U.S. crude oil. California crude oil production is not sufficient to replace these barrels. It's unlikely the U.S. would replace these crudes with Venezuelan Merey crude given the amount of production coming from Venezuela. Furthermore, it would be difficult to use Arab heavy crude for the landlocked refiners without waterborne access.

New tariffs will weaken profit margins. Refiners located on the coasts have the flexibility to replace these barrels with other crudes. Marathon Petroleum Corp., Phillips 66, Flint Hills Resources L.P., CITGO Petroleum Corp., HF Sinclair Corp., and PBF Holding Co. LLC are some of the biggest purchasers of crude from Canada. Refineries located in the U.S. Midcontinent are more exposed to the Canadian crudes because they source their feedstock from crude oil pipelines owned by Canadian midstream energy companies such as South Bow Corp. and Enbridge Inc. MidContinent refiners that are specifically located in PADD 2 will be the most affected because they mainly run on Canadian crude. Being landlocked, it would be very difficult to replace these barrels with a similar heavy crude from another region. The Capline Pipeline would have to reverse (again) to bring other crudes from the Gulf Coast, which we don't think will happen any time soon because this pipeline is now directing crude to the Gulf Coast for export markets. Valero Energy Corp., Deer Park Refining L.P., PBF Holding, Phillips 66, and Marathon Petroleum are some of the biggest purchasers of crude from Mexico. Mexican crudes are typically imported by waterborne means so we believe they're more likely to be replaced with barrels from other countries.

What Comes Next?

A refinery has a minimum level of fixed costs, so one that is configured to run these crudes would have a very high cost per barrel if running at reduced rates and this wouldn't be economic over the long term, potentially resulting in closures unless the cost of Canadian crude declines.

The following refiners have assets in the Midcontinent region:

• CITGO: The Lemont, Ill. refinery runs approximately 50%-55% of Canadian crude. This refinery has a strong competitive position and makes up 22% of CITGO's total refining capacity.
• HF Sinclair: The assets in the Midcontinent region make up 40% of the company's total refining capacity but Canadian crude is less than 25%. The El Dorado, Kan. refinery is a large purchaser of Canadian crude.
• Marathon Petroleum: Roughly 25% of the company's refining capacity is in the Midcontinent. Its Canadian crude exposure is approximately 20% of its supply. The company's Robinson, Ill. and Detroit, Mich. refineries would be disadvantaged. Its Washington state Anacortes refinery could replace the Canadian barrels if necessary.
• Par Petroleum LLC: The company has up to 20% of supply exposure to Canadian crude. Of all the refining assets, the Billings, Mont. refinery would be most disadvantaged.
• PBF Holdings: Assets in the Midcontinent region make up approximately 18% of the company's refining capacity. The Toledo refinery would likely realize higher costs. PBF's Northeast assets ran less than 20% from Mexico, which it will likely replace with other crudes.
• Phillips 66: Less than one-third of its supply is Canadian crude. Nine of its refiners partially source Canadian crude.
• Valero Energy Partners L.P.: The company has some Midcontinent exposure but could replace these barrels based on their location.

Although industry margins were weaker than expected last year, we believe most refiners are well positioned from a liquidity and leverage perspective to handle an uptick in operating costs should operating costs increase. (see table) For investment-grade merchant refiners, we think the overall impact to credit quality will be neutral given the diversity of their assets, some of which benefit from stable midstream operations and low leverage. We believe certain speculative-grade rated refiners with a concentration in the Petroleum Administration for Defense District II (PADD II), which covers the U.S. Midwest, could see credit ratios and liquidity deteriorate if they end up bearing a higher percentage of the tariff and the tariffs remain in place over the long term. This is because we tend to view asset diversity as a credit strength as it diversifies cash flows. Should a refiner that lacks asset diversity make the difficult decision to shutter its operations, it will likely lead to a weakening of its business risk profile.

If prices at the pump go up, refiners that can easily swap Canadian- and Mexican-sourced barrels may capture higher margin if they were not paying the tariff. Certain refined product pipelines that originate in the Gulf Coast region would likely benefit from strong utilization while Midcontinent refiners would likely consider asset rationalization due to higher costs. We are unlikely to see new crude oil pipelines being built to supply midcontinent refiners with alternative crude oil leaving management teams with the decision of considering whether to continue to invest in the existing asset base or not.

Should the tariffs proceed as proposed, a tariff on Canadian crude oil will have more of an impact on the U.S. refining sector if costs are borne by the refiners. It's possible the announced tariffs could evolve within the coming weeks or months. However, even if these new tariffs are eventually lowered or removed, we believe the lingering uncertainty around U.S. trade policy would limit any new pipeline expansions or new construction of crude oil pipelines crossing the border.