Energy Trends: Crude Oil, Products and the Refining Sector

Crude and product futures are seeing an influx of investors who are betting that global economic activity will turn around later in 2009, with oil fueling the rebound. Buying in the oil market has focused on the improving outlook for diesel demand, which is more closely tied to industrial activity and consumer spending than other fuels. Many traders see an uptick in diesel consumption coinciding with peak winter demand for heating oil in the U.S. Northeast.

However, we need to examine the following market fundamental forces before leaving the rosy glasses on:

High Inventory Levels

The U.S. oil product market has shifted from a gasoline/distillate imbalance to a supply glut of both gasoline and middle distillates. U.S. supplies of distillate, including heating oil and diesel, are at a 24-year high. (Fig. 1) There are also an estimated 85 million barrels of oil product sitting in floating storage alone, with much of it along the Gulf Coast.


New Refining Capacity to Come Online

Meanwhile, spare refining capacity continues to increase. Refiners have invested in capacity additions after a continuous spell of demand outpacing supply, and those capacity additions are about to come on line. The considerable amount of refining capacity under development could further reduce refinery margins from current levels. Spare capacity, which was as high as 25% in the early 1980s, has declined to about 6-7% in recent years. The announced projects, if realized, would create a capacity cushion of around 20%. Merrill Lynch estimates global demand for petroleum products to fall 5.2 mn b/d below capacity this year.

Between 1995 and 2007, $385 billion was invested in global refining. In the U.S. and Europe, investment went largely for improving product quality, while in Asia and the Middle East it went for expanding crude capacity. So, the actual global capacity remains tight, but in the mid term it will become easier due to the slack in demand.

Most of the capacity requirements needed by 2012 are already scheduled to be met by announced projects, except for China. However, project delays and cancellations due to the global financial meltdown could mean the global refining capacity cushion will remain low beyond 2013, should this scenario play out.

Gasoline vs. Diesel

There is usually a direct relationship between personal income & employment and that of gasoline demand; and GDP output related to demand for distillates, petrochemicals, and other refined products. Both the gasoline and distillate markets are struggling with an incredibly weak global demand picture brought on by the recession. However, gasoline is expected to have an advantage over diesel through 2010 due to relatively favorable inventory levels and low pump prices helping demand. (Fig. 2)

At present, U.S. refineries are working hard to reduce distillate production. Relative to a peak of 30% at the start of January, U.S. distillate yields are now down to 26.7% in May, according to the latest U.S. EIA data. This reduction is helping to clear the gasoline and heating oil market imbalances, and gasoline production is now increasing relative to heating oil. As additional refining capacity is coming online in China, India and Vietnam, middle distillates may suffer more than other petroleum products before they recover in late 2010.

However, longer term demand for diesel, which has fewer substitutes than gasoline, should grow faster because of global economic growth. Europe will continue to be a net importer of diesel/gas/oil and a net exporter of gasoline. As the imbalance of net European trade flow increases, there will be growing dependence on the US gasoline market for exports and Russia/CIS for gas/oil imports. We should expect increasing diesel exports from the U.S. into the higher-margin European and Asian markets.

Further Reduction of Utilization Rate Necessary

Royal Dutch Shell (RDS.A) CEO Jeroen van der Veer recently commented on the current poor refining margins, the world has more oil refining capacity than needed. So far, refining output cuts have not gone deep enough to balance the products markets and to support margins. Further cuts are expected through 2010, at the minimum. For example, stung by losses and slumping fuel demand, Valero Energy Corp`s (VLO) 16 refineries may run at just 78% of capacity during the 3rd quarter of 2009, down from its current 80-85% levels. Merrill Lynch estimates refinery utilization rates to fall to 81% down from around 85% last year. The latest data from the US IEA showed the domestic utilization rate at 83.8% in May, down from the peak of approximately 93% in 2004.

How About the Crude Oil Market?

As for future crude oil demand, the International Energy Agency and other leading forecasters still expect global oil demand to fall in 2009, though consumption is expected to improve toward the end of the year. (Fig. 3)

Based on market fundamentals, a decline in crude oil prices in the medium term is expected as extra crude oil production capacity and refinery conversion capacity becomes available. The recent increase in crude oil prices is considered to be largely due to a tighter crude supply/demand balance, although shortages of conversion sour & heavy crude capacity in the refining industry have contributed to an increase in the relative value of light crude.

Future Trend

Refining has been a low margin business for several decades and this is likely to persist. Although the industry has started to experience higher returns since 2004, the recent economic downturn across the globe has again transformed it to its traditional model of a high-investment, low-return business. As demand for products like gasoline is unlikely to fully recover in the coming years, and global refining capacity additions are expected to out pace incremental demand growth, with a flurry of proposed environment-related legislation all threatening to pressure global refining margins. Going forward, the sector’s margins will likely be sustained mainly by middle distillates, which will have steady demand.

Up till now, the refining sector is dominated by international oil companies (IOCs) despite recent nationalizations in some regions; however, National Oil Companies (NOCs) are expected to drive the refinery capacity expansion in the next few years as low returns discourage private investments resulting in China, the Middle East and India emerging as the global major refining hubs.

Where to Invest?

Instead of investing directly in the refiners, a better way to position portfolio holdings is to invest in companies like BASF (BASFY.PK), W.R. Grace & Co. (GRA) and DuPont (DD). In addition to a strong global presence and a diversified industry portfolio, these companies are also major players in the market for refinery catalysts, which play a key role to in helping refiners meet fuel standards, improvise operational efficiency, increase conversion & selectivity, and keep pace with the ever-present green movement. With the industry paradigm shifting to NOCs/international markets and increasing legislative requirements on the refineries, these companies are best positioned to take advantage and adapt to this low refining margin environment.

Disclosure: No Positions

Comments

[A Barrel Full:]

A good comprehensive summary of the sector. I have just one gripe.

You say:
.....although shortages of conversion sour & heavy crude capacity in the refining industry have contributed to an increase in the relative value of light crude......

However, in the current market, light/heavy differentials have all but disappeared. Ural crude has traded above Brent.

No doubt we will get back to normality as the economy recovers, but we are not there yet.

Aug 11 05:25 AM

[Bob van der...:]

Your article does leave out the political anti-capatalist atmosphere running rampant in this country as a factor on the future trends in the petroleum industry. They have been painted with a broad brush by the current administration as being greedy and not out for the public good. Alternative energy is being taunted as the panacea to have the US become energy independent by 2020. It will become so with federal support and the carbon cap and trade tax being placed on the refiners. That does not give an incentive to build or improve refineries with the downside being that their products may not have a market. Presiden Obama expects to have that in place by 2012—and he's got high expectations. Obama's administration projects that $645 billion in cap and trade revenue from the likes of oil and electric companies would flow in over the next ten years. That cost cannot be absorbed by the oil refiners and will be passed along to the consumer in higher fuel prices depressing demand even more.

Aug 11 06:57 AM

[jerrydd:]

Betting on oil refiners is a losing game. They are currently shutting down refineries, many permanently because of one fact, they just don't need that many as demand, crude production will never reach early 08 levels again.

As soon as the world economy comes back oil will head for $150-200/bbl driving the economy back into recession. If you don't think this will happen explain why.

Our only chance to get out of this cycle is a oil tax so it pays it's full costs instead of being subsidized in our income taxes. Then we get a tax cut from the revenue and help switching to more eff cars, retrofitting our homes for energy eff, etc or the price will go up and OPEC, Russia makes the money. Your choice.

Aug 11 09:31 AM

[Ferdinand E...:]

Hmm. I really knew quite a bit about refineries a couple of years ago, and gave some nice lectures on the subject, but I was never able to convince myself to do something really serious with the subject.

One thing however I remember. Excluding one or two outstanding exceptions, I couldn't understand how any 'independent refiner' in the U.S. would want to have anything to do with the business. I was also unable to figure out why refining (and petrochemicals) are not moving 'en masse' to the Middle East, as I once assured some students.

Aug 11 09:33 AM

[A Barrel Full:]

allow me to be so bold as to answer your question.

The refining business is a tough one at the moment, but just 18 months ago was very profitable. The independents like Valero, bought up their assets at amazingly low prices. It looks like the cycle is starting again.

The small guys really don't have much choice. If they close their refineries down, they have to pay clean up costs. So they keep going until they actually go bust.

Refining is a business where transport costs can eat up much of your profit, which is why it doesn't all move to the Middle East. Petrochemicals is becoming more concentrated though, as companies like Sabic have a massive cost advantage.

Long term, only large scale, efficient and complex refineries will be able to stay in business.

On Aug 11 09:33 AM Ferdinand E. Banks wrote:

> Hmm. I really knew quite a bit about refineries a couple of years
> ago, and gave some nice lectures on the subject, but I was never
> able to convince myself to do something really serious with the subject.
>
>
> One thing however I remember. Excluding one or two outstanding exceptions,
> I couldn't understand how any 'independent refiner' in the U.S. would
> want to have anything to do with the business. I was also unable
> to figure out why refining (and petrochemicals) are not moving 'en
> masse' to the Middle East, as I once assured some students.

Aug 11 10:14 AM

[Mad Hedge F...:]

zxcvn. I ran some numbers today and came to the staggering conclusion that at $3.60/BTU, natural gas is now cheaper than coal in some markets. One ton of high grade Pennsylvania anthracite costs $65/ton. Some 18 million BTU’s of natural gas, the energy equivalent, costs $66, and doesn’t give you black lung, asthma, lung cancer, polluted air, and mountains of ash. The BTU equivalent of crude comes in at $210, and high test gasoline at an extortionate $420. The crude/NG ratio is at 19:1, an all time high, and an entire generation of ratio traders has been wiped out. It’s just another one of those six standard deviation events which seem to be happening constantly. And like a rubbernecker driving past a gory accident where the human organs are draped over the detailing, I am always interested in wipe outs. Yes, I saw the movie Crash. Don’t ask. Why aren’t the power companies jumping in and burning gas instead of coal? There is the minor issue in that the industry needs $500 billion and ten years to build the plants to take advantage of the enormous new supply. So only frenetic production cuts will support the price until then, which are accelerating as you read this. Or a major hurricane. Better keep UNG on your screen and buy the next wash out.

Aug 11 01:03 PM

[Dian L. Chu:]

This article is also on Reuters www.reuters.com/articl... and Daily Markets www.dailymarkets.com/s.../

Aug 11 03:26 PM

[Dian L. Chu:]

Yes, the the loss of the deep differential that used to exist for heavy, sour crude has hammered refiners. It is a growing trend among US complex refiners to shut down coker units, as light-heavy crude differential is one of the more significant in determining coker rates.

Credit Suisse recently noted crude differentials looked bad for complex refiners in 2009 and may not recover much in 2010, citing a combination of OPEC production changes and new global refining capacity startups.

I did not get into the light/heavy differential much here as it is a factor in the relative crack spread, which was discussed in the "Gasoline vs. Diesel "section, and also due to the length and technical nature of the article.

Thank you for a very insighful comment.

On Aug 11 05:25 AM A Barrel Full wrote:

> A good comprehensive summary of the sector. I have just one gripe.
>
>
> You say:
> .....although shortages of conversion sour & heavy crude capacity
> in the refining industry have contributed to an increase in the relative
> value of light crude......
>
> However, in the current market, light/heavy differentials have all
> but disappeared. Ural crude has traded above Brent.
>
> No doubt we will get back to normality as the economy recovers, but
> we are not there yet.

Aug 11 06:29 PM

[Dian L. Chu:]

Yes, natgas is now looking more attractive than coal as a power source. As indicated in my 6/24/09 article regarding the domestic natgas, power companies are beginning to ratchet back investments in coal-generated plants to take advantage of low natgas prices and hedge against costly climate-change legislation.

However, the natgas production cut, and the incremental demand from the power gen sector are unlikely to balance the domestic natgas market anytime soon with the exiting inventory overhang and the expected new LNG cargos coming into the US.

LNG is expected to "globalize" the the natural gas market making it more competitive with crude oil. A lot of the LNG contracts now are priced to index crude. So give it some time for a global natural gas market to develop and mature, the prospects for the 8 to 1 theoretical crude oil to natgas price ratio appear bright probably by 2015. Meanwhile, we quite possibly will get stuck with a $4/mcf ceiling through 2014.

Your comment is greatly appreciated.

On Aug 11 01:03 PM Mad Hedge Fund Trader wrote:

> zxcvn. I ran some numbers today and came to the staggering conclusion
> that at $3.60/BTU, natural gas is now cheaper than coal in some markets.
> One ton of high grade Pennsylvania anthracite costs $65/ton. Some
> 18 million BTU’s of natural gas, the energy equivalent, costs $66,
> and doesn’t give you black lung, asthma, lung cancer, polluted air,
> and mountains of ash. The BTU equivalent of crude comes in at $210,
> and high test gasoline at an extortionate $420. The crude/NG ratio
> is at 19:1, an all time high, and an entire generation of ratio traders
> has been wiped out. It’s just another one of those six standard deviation
> events which seem to be happening constantly. And like a rubbernecker
> driving past a gory accident where the human organs are draped over
> the detailing, I am always interested in wipe outs. Yes, I saw the
> movie Crash. Don’t ask. Why aren’t the power companies jumping in
> and burning gas instead of coal? There is the minor issue in that
> the industry needs $500 billion and ten years to build the plants
> to take advantage of the enormous new supply. So only frenetic production
> cuts will support the price until then, which are accelerating as
> you read this. Or a major hurricane. Better keep UNG on your screen
> and buy the next wash out.

Aug 12 12:47 AM

[PairsTrader:]

The effects of the cap and trade plan on the refining sector is probably best as a topic for another article, since it is a rather complex issue.

However, Ms. Chu did discuss the impact of cap and trade on the GDP, industrial sector and consumers in her article dated 6/28/09, if you are intersted.

I've been following Ms. Chu's blogs. I agree with her views on the cap and trade, and the health care reform.

On Aug 11 06:57 AM Bob van der Valk wrote:

> Your article does leave out the political anti-capatalist atmosphere
> running rampant in this country as a factor on the future trends
> in the petroleum industry. They have been painted with a broad brush
> by the current administration as being greedy and not out for the
> public good. Alternative energy is being taunted as the panacea to
> have the US become energy independent by 2020. It will become so
> with federal support and the carbon cap and trade tax being placed
> on the refiners. That does not give an incentive to build or improve
> refineries with the downside being that their products may not have
> a market. Presiden Obama expects to have that in place by 2012—and
> he's got high expectations. Obama's administration projects that
> $645 billion in cap and trade revenue from the likes of oil and electric
> companies would flow in over the next ten years. That cost cannot
> be absorbed by the oil refiners and will be passed along to the consumer
> in higher fuel prices depressing demand even more.

Aug 12 01:02 AM

[Alan von Al...:]

Bob, I think I disagree. Integrated majors and mini-majors like Marathon will cut capex, exploration, trim operating staff. There's no retail demand (cash-in-pocket) for higher prices at the pump. Summer driving season didn't happen. Winter fuel oil use will be lower this year, as consumers opt for cheap thermal underwear and sweaters sewn in China.


On Aug 11 06:57 AM Bob van der Valk wrote:

> Your article does leave out the political anti-capatalist atmosphere
> running rampant in this country as a factor on the future trends
> in the petroleum industry. They have been painted with a broad brush
> by the current administration as being greedy and not out for the
> public good. Alternative energy is being taunted as the panacea to
> have the US become energy independent by 2020. It will become so
> with federal support and the carbon cap and trade tax being placed
> on the refiners. That does not give an incentive to build or improve
> refineries with the downside being that their products may not have
> a market. Presiden Obama expects to have that in place by 2012—and
> he's got high expectations. Obama's administration projects that
> $645 billion in cap and trade revenue from the likes of oil and electric
> companies would flow in over the next ten years. That cost cannot
> be absorbed by the oil refiners and will be passed along to the consumer
> in higher fuel prices depressing demand even more.

Aug 12 12:18 PM

[joneslw1:]

I would say that light/heavy differentials are today being driven as much by crude supply and as refining capacity (which is now balanced). Mexico, Venezuela and Russia are all experiencing heavy crude production declines and the world's most significant swing producer, Saudi Arabia, effectively sets the price differential by controlling the output of Saudi Heavy.

A Washington nourished by the Dem's diet of pathological hatred of oil and gas industry and thermodynamic hooey is doing everything possible to damage the US energy economy and refining in particular.

While it's true that transporation cost eats up much of refining margins, remember that transport costs are a wash when you compare shipping crude oil from the Middle East/Indian Ocean with shipping products the same distance. The new, world scale, highly flexible, low cost refineries being built in India and the Middle East, coupled with the Dem's persistent and pernicious degrading of the US industry, will lead to the erosion of refining capacity in the US.

Additionally, the high differentials seen last year were driven in part by the govt. induced global timing of low S diesel implementation, which is now behind us.


On Aug 11 05:25 AM A Barrel Full wrote:

> A good comprehensive summary of the sector. I have just one gripe.
>
>
> You say:
> .....although shortages of conversion sour & heavy crude capacity
> in the refining industry have contributed to an increase in the relative
> value of light crude......
>
> However, in the current market, light/heavy differentials have all
> but disappeared. Ural crude has traded above Brent.
>
> No doubt we will get back to normality as the economy recovers, but
> we are not there yet.

Aug 14 01:05 PM

[Chickenpookie:]

Sounds like it's not time to buy into refiners yet, maybe not even for years....

Aug 15 03:11 PM

[PairsTrader:]

Yea, bro. See my stock talk yesterday: Short $VLO, Long $DD / $GRA /$BASFY.PK. Good tradings to you!

On Aug 15 03:11 PM Chickenpookie wrote:

> Sounds like it's not time to buy into refiners yet, maybe not even
> for years....

Aug 17 07:52 PM