Why Won't Those Oil Imports Drop?

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Includes: DWTI, SCO, UCO, USO, UWTI
by: Jesse Moore

Summary

U.S shale primarily produces light tight oil (LTO), which has a large production surplus.

This poses a risk particular to U.S. shale producers that will drag the international market down, but damage the U.S. market much more.

Investors looking to play an oil rebound should understand the end users of oil products and why WTI will likely trade at a discount to Brent going forward.

Two months ago, I wrote an article titled "U.S. Shale Has A Hidden Oversupply Problem." In it I described the reasons why consumption of U.S. LTO (light tight oil) was stifled among refiners of crude oil. Analyzing demand side data showed that any amount of U.S. LTO above a base level would be put into storage, as it had no other means of consumption. This base level increases yearly. However, most U.S. refineries have failed to execute projects that allow for substantially more use of "home grown" LTO. The world has too much light oil and, unfortunately, light oil does not provide the refining margins that refiners need for their return on investment.

As we move forward to the present, we have seen two months of consistent or rising U.S. imports. We saw oil outages in Canada that were quickly replaced by Gulf oil, and we will continue to see U.S. imports rise or remain static as U.S. production drops. As I noted in the above-mentioned article:

Since 2014, the refineries surveyed (and take note this is only 61% of refiners) have increased the capacity to process super light crude by roughly 0.7 mmbpd, while actual processing grew by roughly the same. Over the same time, crude oil production rose from 7 mmbpd to a peak of 9.6 mmbpd and currently sits at two mmbpd. If we assume that the remaining refiners not surveyed have seen similar increases, there has been a minimum increase of 1 mmbpd surplus of domestic LTO that can not be refined since 2014. That doesn't even take into account the extreme surplus of LTO that existed in 2014 and prior.

Excess LTO

The world's crude surplus is primarily in light oil. As this oil came on to the market in excess, driven by shale production, refiners did what they could cheaply to increase their demand. However, it was and is not enough. Shale oversupply is well over 2 million barrels per day, and moving forward, I forecast that we will not see a drop in oil imports as U.S. production drops. Oil inventories will continue to rise on the whole as we exit the summer months, and that will lead to refinery maintenance. As such, we will once again test the limits of the world's oil storage.

What this means is not that the world has too much crude oil. It has too much light oil. Heavy oil is extremely profitable for refiners, as shown by a breakdown at elevated prices.

Click to enlarge

Source: American Fuel & Petrochemical Manufacturer's Review 2015

Eventually, the market will begin to tighten. We have seen a rise in gasoline demand across the U.S. and Europe at lower prices that has partially masked the LTO oversupply for now (LTO produced more gasoline/diesel than heavy oil). In the coming months, we are likely to see these markets diverge. I have long held the view that WTI is fundamentally hampered much more than Brent, Gulf, or Canadian oil due to the sheer volume of light tight oil being delivered. This danger is unique to shale producers, and is a risk that we could see played out in a race to the bottom for WTI.

Conclusion

If shale producers find themselves competing for buyers or storage, and if production does not decline faster than expected, it is likely that we will see WTI diverge from international benchmarks. Excess LTO is not leaving the U.S., as exports remain low and imports remain steady. Investors looking for a rebound will be much safer in companies with exposure to heavy oil, lower costs, and businesses closer to Asian markets where demand is growing and refinancing capacity is increasing. There is a reason that Exxon Mobil (NYSE:XOM) spent vast sums over the previous years exploring offshore Asia despite a substantially higher cost per barrel produced.

WTI and Brent will always be linked. However, I see an increasing likelihood that WTI will trade at a heavy discount to Brent in the coming months. By winter, I expect to see a $5 discount as storage levels dwindle and summer demand subsides. Investors looking to play a rebound should be aware of the different end uses that these crude varieties ascribe themselves, and adjust their holdings accordingly.

Tightening credit markets could by the final nail in the coffin for many companies struggling to survive. Additionally, the risk of bankruptcies has receded from investors minds, allowing battered companies to rise substantially over the previous weeks. If sentiment turns, it will happen quickly and forcefully. Exposed investors could suffer if they don't fully understand the downside exposure of the current market.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: This article is based on opinions and those opinions are subject to error. It is not investment advice and should not be used as such.