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Michael McDonald

Michael McDonald

Michael is an assistant professor of finance and a frequent consultant to companies regarding capital structure decisions and investments. He holds a PhD in finance…

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The End Of The European Refining Boom Or Just A Pause?

The End Of The European Refining Boom Or Just A Pause?

It’s been a painful year for energy investors with most oil-related stocks down significantly. One of the few exceptions to this rule of thumb is the refining sector as many refining companies have seen substantial benefits from the fall in the price of oil.

As crude prices have collapsed, gasoline and other derivative product prices have been coming down much more slowly. As a result, spread margins have widened considerably and refiners have seen profits boom. Companies like Valero and other big name refiners have seen their stock prices leap higher as the glut of crude has led many oil producers to rush to sell their production. Related: Is Oil Trending? How Twitter Influences Oil Price Volatility

What the markets gives, the markets take away though, and as oil prices have rebounded a bit over the last few weeks, many analysts now see refining margins shrinking back closer to pre-collapse levels. For European refiners in particular this may be a major problem going forward. U.S. refiners are still benefiting from the export ban on most U.S. produced crude which in turn distorts the price for U.S. crude, holding it down and inflating refiner margins. European refiners have no similar advantage.

European investment managers appear to be getting nervous and some are taking profits and reducing their bets on the refinery sector. European refiners Saras S.p.A, Neste Oyj, Hellenic Petroleum, and other independent refiners have posted returns averaging 28 percent year-to-date, surpassing all other groups on the Stoxx Europe 600 Index. But margins appear set to eventually shrink by around 65 percent from $8.85 per barrel to around $3.10 a barrel according to Wood Mackenzie Ltd. The firm is looking for refiners to return to historical norms, and while the timing on that return may be up in the air, the stocks are unlikely to keep moving higher in the medium term, Wood Mackenzie analysts say. The firm expects refinery margins to shrink by 50 percent in 2016 vs. 2015. Related: Oil Prices Still Not Low Enough To Fix The Markets

There is considerable debate on the issue though. Refiners are optimistic about margins staying elevated over time. Saras, for instance, reported margins of $10.50 a barrel in the second quarter versus year earlier results. The company has told investors that it expects margins to remain strong thanks to the widespread availability of cheap crude. Goldman Sachs is backing this argument as well. The investment bank said in September that it expected oil prices to remain low through at least 2020 and potentially for up to 15 years. That scenario is extreme and certainly anathema to most oil price investors, but should Goldman’s forecast prove prescient, refiners may have years of heady margins ahead. Related: How The Oil Price Crash Will Make Markets More Efficient

Yet even if oil prices remain subdued, that is no guarantee of strong margins for refiners. The margins for refiners rely on the crack spread between oil and end use products like gasoline. Gasoline prices also appear set to fall somewhat with Wood Mackenzie forecasting year end stocks of diesel and gasoil of 260 million barrels at the end of 2015 versus 240 million barrels at the end of 2014. That increase in fuel, combined with tailing off of demand could create margin pressure on both ends of the spectrum and potentially undercut refinery margins, even if oil prices do not rebound to the degree some analysts are expecting.

In light of this dual risk on both ends of the margin spectrum, it is little wonder that many investors are starting to become apprehensive about the profit outlook in quarters ahead. While the party may not be over for refiners yet, the risks in the space have certainly increased and prudent investors should take heed and reduce their exposure a bit.

By Michael McDonald of Oilprice.com

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