As all energy investors know, it has been a terrible year for oil and natural gas companies. Many stocks are down half or more from their 52-week highs. Yet amidst the carnage, one energy group has held up very well – refiners.
Companies like Valero (VLO) and Phillips 66 (PSX) have traded flat or even moved higher over the last year. This reality has largely been driven by the glut of crude bringing down input prices for these firms while continued stable demand for gasoline and diesel has led to better crack spreads. The crack spread refers to the profit per barrel of oil that refiners earn from turning oil into finished products like gasoline, diesel, and jet fuel.
While 2015 was a strong year for downstream operators, refiners could soon follow oil companies’ downward trajectory. Crack spreads are increasingly coming under pressure as the laws of supply and demand come into balance. Highly profitable crack spreads are drawing more refining capacity online and leading to more supply for many derivative oil products. Established refiners are struggling to combat already high inventories of gasoline and other products by cutting production at key plants, but that effort is unlikely to help sustain cracking margins over the short term. Energy analysts are forecasting that cracking spreads will fall substantially and margins in certain areas of the country such as the Midwest are already under severe pressure or are even negative thanks to limited storage capacity for final delivery products.
The situation is little better overseas. Asian fuel producers are facing increasing competition from China, which is exporting a surging level of refined crude products. Chinese net product exports are forecast to rise by 31 percent this year over and above robust export increases last year. Diesel exports rose 75 percent from China last year much to the chagrin of Indian and South Korean refiners.
Just like in the U.S., margins for cracking have fallen hard as new supply has rushed to take advantage of lucrative opportunities in the field. Singapore Dubai cracking margins are running around $1.90 per barrel so far for 2016 versus $3.96 a barrel in the fourth quarter of 2015.
China is hurting refiners and the global petroleum market in two ways then. First, the sudden shift in Chinese economic models has curtailed domestic oil demand, leading to falling oil prices and falling domestic demand for industrial oil derivatives. Second, to help Chinese refineries cope with the new harsh market conditions, China has started allowing many independent Chinese refineries to ship their output abroad. Diesel margins are particularly at risk as the product has seen a significant slowing of domestic Chinese demand and thus a very rapid build in export volumes.
With diesel exports authorized up to 1.8 million barrels per day for China, versus 900,000 barrels per day last year, there is little doubt that Asian diesel prices will fall dramatically. This may cause a chain reaction that slowly spreads west perhaps ultimately hampering margins in Europe as well.
Investors cannot do anything to stop this negative chain of events and there is little sign of the situation improving in the near term. While crude has managed to rebound off of its recent lows, that reality is cold comfort for most investors and only serves to hide the fact that oil prices are likely at least $20 per barrel below where most producers need them to be. If cracking margins ultimately plumb the same relative depths of profitability (or lack thereof), then 2016 could prove to be a harsh year indeed for refiners.
By Michael McDonald of Oilprice.com
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