A Big Time Squeeze for Refineries is About to Begin

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After banking some very hefty profits for Energy Advantage and Energy Inner Circle subscribers on refining stocks earlier this year, the entire sector now is about to land "between a rock and a hard place."

Once a high-flying place for investors to earn substantial profits, refiners have been under pressure for the last two months. But that's actually just the beginning of what's to come.

What I call a "quadruple whammy" is now about to take hold.

For refiners, that means a major correction is about to begin, which is why investors should be wary of the sector-at least in the short term.

In fact, four separate factors are now colliding at the same time and none of them are very encouraging for refinery shares.

Here's why, refineries are about to experience a big time squeeze...

Refinery Stocks Face Margin Pressures

Recall that refiners make their profit from a margin reflecting the difference between what it costs to produce oil products and the wholesale (or "rack") price reflecting the first sale of products out of the refinery.

That refinery margin, in turn, results from several factors: the cost of crude oil (as the primary raw material, still the largest single component determining wholesale prices); crude and product inventories; supply and storage volume; transit; demand; and refinery capacity.

Normally, the margin benefits from a higher Brent to West Texas Intermediate (WTI) spread, allowing processors to pass on a higher pricing component downstream to distributors and ultimate retail end users.

That means a higher premium paid for Brent over WTI usually results a higher refinery margin and improved refinery profits.

Brent is the benchmark crude rate set in London, while WTI is the benchmark used on the NYMEX. Both are sweeter (less sulfur content) than some 70% of all oil consignments traded worldwide each day, resulting in most trade occurring at a discount to Brent or WTI.

In addition, despite being a slightly better grade, WTI has been priced at a discount to Brent in each consecutive trading session since mid August of 2010. The regularity of the "Brent premium" meant that U.S. refiners could count on this element in margins moving forward.

But that's not the case any longer...

Welcome to the "Quadruple-Whammy"

Now a variety of factors are about to take hold. Here's what I mean:

Whammy Number 1: As I discussed, the Brent-WTI spread is rapidly disappearing. Brent had been priced higher than WTI by over 26% of the spread to the price of WTI (the better way of looking at the full impact of the spread in the U.S. market) in December, by more than 20% in early March, and still in double digits in late April.

As of yesterday's close it is at barely 2%.

Whammy Number 2:Global demand for oil products is threatening to accelerate again, testing the ability of processors to keep up. OPEC's most recent report is the fourth in less than a year (the second by OPEC) calling into question the ability of refiners to meet expected worldwide demand spikes the way they have in the past.

Now don't panic here. We are not running out of gasoline, diesel or heating fuel (although we may see some regional spot constrictions in some parts internationally). Rather, refiners are not going to be able to parlay lower-cost production cycles into the market when demand allows higher wholesale and retail prices.

Oil product supplies will still be available in most areas but the refiners will be passing through production at a lower margin. That reduces profits.

Whammy Number 3:As the supply of raw crude oil begins to have difficulty keeping up with the rising demand for refined product, refiners will have product runs reflecting less than full capacity (even factoring in downtime for refurbishment, repair, and seasonal adjustments). That will reduce an important efficiency element that both contributes to the profitability resulting from the refinery margin as well as explains how a greater aggregate volume of oil products has resulted in the U.S. despite a reduction in the number of refineries.

Another hit in profitability.

Finally, the biggest impact may well come from the factor most difficult to estimate...

Whammy Number 4: It is rising geopolitical tensions. The most direct impact here would be an interruption of supplies for any protracted period of time. The current instability in Egypt is not an encouraging precursor. As yet, however, it has not actually interrupted any supply lines. Protests in eastern Libya, on the other hand, have cut exports...and those go directly to Europe.

Here's the problem. This is not as much the effect on oil consignment prices ("wet barrels" of oil actually in trade) as it is on crude oil futures contracts ("paper barrels). In a normal oil market (and I'm not certain whether I still remember what one of these looks like!), futures contracts are set on the expected price of the next available barrel.

However, in markets beset by uncertainty of supply, traders base the futures contract on the most expensive price of the next available barrel. We are already beginning to see acceleration in futures contract pricing as a result of Egypt, and the events there have yet to interrupt the actual transit of a single drop of oil.

This translates into an inflated price of crude for future delivery, further reducing the refinery margin once it is processed.

Refinery stocks will certainly return as a solid investment play. But until the current downward pressures abate and the refinery margin improves, this is not where you want to have your emphasis.

About the Author

Dr. Kent Moors is an internationally recognized expert in oil and natural gas policy, risk assessment, and emerging market economic development. He serves as an advisor to many U.S. governors and foreign governments. Kent details his latest global travels in his free Oil & Energy Investor e-letter. He makes specific investment recommendations in his newsletter, the Energy Advantage. For more active investors, he issues shorter-term trades in his Energy Inner Circle

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