Distillate hangover | FT Alphaville

Distillate hangover

The latest weekly inventory data from the EIA has shown another unexpected build in crude and distillate inventories. Gasoline stocks, meanwhile, registered a much bigger than expected draw as the numbers via Reuters show:

Highlights from EIA report - Reuters

The key takeaway, of course, should be that there is a growing disconnect appearing between crude/distillate inventory and gasoline inventory. The evidence is now pointing to the fact that the US gasoline market is  fairly well balanced in terms of supply and demand, if not under-supplied.

A contrasting picture, however, is  apparent for the crude and distillate market, where supplies are now significantly outstripping demand. When you consider how much better distillates performed versus gasoline most of last year it does become hard to reconcile. However,  the market picture has changed dramatically since then.

At the time the industry was expecting diesel (and hence distillate) demand to grow versus gasoline as consumers switched over to diesel-fuelled vehicles.

Accordingly, many US refineries decided to invest heavily in upgrades maximising diesel production over gasoline. What they were not expecting, however, was the sudden turnaround in profitability between the two products groups.

BP’s results on Tuesday, for one, confirmed that refining trend, as well as the fact that costs were borne because of the  upgrade decision. As they explained in their statement (our emphasis):

Compared to the same quarter last year, the segment’s performance was significantly better, with the benefits of improved operational and cost momentum more than offsetting the effects of a weaker environment. Despite the improved global refining indicator margins, actual refining margins were worse than the same quarter last year. Upgrading margins were particularly poor in the first quarter due to narrowing of the gasoline-distillate and light-heavy crude spreads, which adversely impacted our highly upgraded facilities. Petrochemicals margins and volumes were also significantly worse than a year ago. These environmental effects were more than offset by a substantially improved operational performance in refining, a very strong supply and trading contribution and significant cost improvements from our simplification and efficiency efforts and the absence of major restoration and repair costs. 

Of course, in hindsight, the narrowing of the gasoline-distillate spread can be rationalised by the somewhat dramatic demise of industrial production that occured in late 2008 – industry being the biggest consumer of distillate products overall.

This means unless industry picks up, refiners will have no choice but to adjust once again.  In the meantime, though, margins will suffer. While the large refiners will bear it, the toll could be much greater for smaller operators — of which there are many in the US. Some could even be forced into bankruptcy and closure.

Nevertheless, a rebalancing is needed. Goldman Sachs, for one, believes a recovery in the energy complex is impossible until it happens. As they explaiend in a research note on Tuesday (our empahsis):

The key to the forward oil price path will be how diesel rebalances
While the recent rise in refinery runs will likely help to clean up crude oil surpluses, distillate surpluses will need to be dealt with through lower prices to stimulate demand and stronger relative gasoline prices to incentivize more naphtha and gasoline output at the expense of distillate output. It is important to emphasize that without this rebalancing of the distillate market, it will be very difficult to argue for higher crude oil prices in the second half of this year. As a result, we are maintaining our nearterm short bias with a $45/bbl target and our end-of-year target of $65/bbl.

And indeed the chart shows that overall US Gulf Coast refining margins are on the decline again:

USGC refining margins - Goldman Sachs

Also worth noting is the sweet-sour spread. As you can see from the chart below the spread narrowed significantly when Opec started cutting output. This is because output adjustments are heavily skewed towards a heavy sour grade  — Saudi Arabia, mostly a sour producer, being the largest swing member.

As the Opec cuts were so large they eliminated a large proportion of sour crude from the market. This narrowed the spread so much it even created a temporary premium for sour vs sweet for the first time since 1999. This in turn, has impacted the types of crudes refineries have been processing, refiners once again seeking sweet over sour due to the cost benefits.

Sweet-sour spread - Goldman Sachs

Related links:
Tanked
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Crude inventories still a problem
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The crude inventory problem, pictorial edition
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Contango smashing
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