Refining Margins Are Collapsing, Crude Prices Will Follow

| About: The United (USO)

Summary

A crude glut is being converted into a product glut, don't be distracted by the smoke and mirrors.

With elevated refining capacity worldwide, falling margins will result in a sharp pullback.

The pullback will originate from Chinese teapot refineries, which are high-cost refineries dependent on high margins.

The heavily long oil market will continue to retreat into winter, possibly testing lows reached in January.

The primary argument for integrated oil (NYSEARCA:USO) companies is for refining and chemicals profits to negate upstream losses when oil prices crash. For me, integrated oil companies provide a deeper look at what is happening on the consumption side of the economy.

Supply and demand are much more elastic in the market for secondary crude products than for crude itself. As refineries act as a value-added manufacturer by splitting atoms and producing end use products, they are much quicker to react to imbalances. That imbalance is often reflected in the refining margin. Rising summer demand saw the refining margins around the world grow. As supply rushed to catch up, utilizations rates rose in tandem.

US Utilization of Refinery Capacity Chart

US Utilization of Refinery Capacity data by YCharts

As supply rushed to the market to match incremental demand, the margin being made by refiners quickly plummeted against a backdrop of record gasoline inventories. The expected summer demand boost did not reach as high as many had hoped. To be sure, until recently, refineries had a tailwind of rising oil prices on their back. As oil prices stagnated, and entered a decline, the obvious effect was that margins would be squeezed.

Click to enlarge

Source: BP Quarterly Report

For many integrated oil companies, this margin crash will be a blip on the radar. In the long term, it is inconsequential, apart from causing a quarterly drag on earnings for companies like ExxonMobil (NYSE:XOM), Chevron (NYSE:CVX), Shell (RDS.A, RDS.B), Phillips 66 (NYSE:PSX), and BP (NYSE:BP). What matters is what we talked about in the second paragraph - the fact that refineries respond much quicker to supply and demand imbalances.

Refining Economics

In much of the world, refineries struggle to make a significant ROI. This is particularly the case in sparsely populated countries such as Canada and Australia where it 's hard to maintain capacity at a level which makes the facility profitable. The same difficulties apply, albeit to a lesser extent in more densely populated places such as the U.S., Asia and in the Eurozone, but the same economic problem applies. Refining profits are difficult to come by, require close market attention, and quick responses to prices for both supplies, and the end products.

High refining margins into June were in part due to rising prices; falling prices will have the opposite effect on those margins. If we see declining margins in places where high-cost manufacturers are producing excess inventories, it is not hard to envision a relatively significant downtick in oil demand.

However - how much is considered significant?

Much of the rhetoric regarding excess production at the peak of the oil bust had an excess of 2-3 million barrels per day. The glut now sits lower, but the actual figure is impossible to nail down. A refined product glut has consumed much of the crude glut - a conversion of products that has only masked the underlying issue. Perhaps we can find a market participant at the high end of costs, and in an already oversupplied market. Bring on the Chinese teapot refineries.

Teapot Manufacturers

China's total net exports of oil products - a measure that strips out imports - will rise 31 percent this year to 25 million metric tons - Bloomberg

Back in May, I wrote an article that discussed whether the Asian refining glut could result in a crude crash. China had vastly exceeded its internal demand for refined products and started exporting the excess. Rather than slow the ascent of refining, China went on to approve increasing numbers of small teapot refiners to import crude, and export the finished products.

The problem with these small refiners is that they are small, utilize less efficient technology, and are dependent upon large crude margins to be profitable. For a scary number to throw around - they make up as much as 25% of China's 14+ million BPD total refining capacity.

Since I wrote that article, product exports have continued to rise as oil prices did, followed by a crash in margins. The Wall Street Journal reported that China is now exporting over 1 million BPD of refined products.

Click to enlarge

J.P Morgan's head of energy investing discussed the outcome in a recent post:

Over the last three months refiners produced two times more gasoline that distillate, which is a ratio not seen since 2012. Modest to stagnant global diesel demand has also led to ample distillate inventories.

The post goes on to describe the stockpiling of refined products offshore Singapore, the overproduction in the USA, and the diminishing backlog of crude tankers idling in Chinese waters. Refinery margins for Asian refiners have fallen as much as one-third, with little sign of stopping. As the summer driving season comes to an end, refined products in storage continue to reach new highs, as global demand underperforms, a crude crash could be imminent.

Investor Takeaway

There is ample evidence to convince even a skeptical jury that there is an oversupply of refined products. Declining liquids demand in the developed world will start to bite as summer ends, and margins will decline even further. We are increasingly likely to see a sharp drop in Chinese crude imports, which won't necessarily reflect economic troubles - just the state of the crude market. The result will be lower prices for longer as the market continues to adjust. A change of market conditions could swiftly hit the massively long oil markets. I continue to sit and wait for the correction.

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.