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August 9, 2009

Energy Trends: Crude Oil, Products & the Refining Sector

By Dian L. Chu, 08/09/09

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, US 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/gasoil 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 gasoil 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
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Item Reviewed: Energy Trends: Crude Oil, Products & the Refining Sector Rating: 5 Reviewed By: EconMatters