The Oil Market’s Big Squeeze

The Oil Market’s Big Squeeze

Oil got smacked in US trade overnight. It was down over 3%.

This comes exactly a day after I said oil looked strong.

The media pointed the finger at trade war tariffs hitting demand, as well as a smaller draw on crude inventories than expected.

However, I’m not panicking. Here’s why.

Crack spreads in the US are wide and creating record margins for refiners.

This, as I explain below, is very bullish for oil over the long term.

Watch the ‘crack’ for oil’s long-term outlook

The crack spread is the margin a refiner earns by taking a barrel of crude oil and turning it into gasoline, jet fuel and diesel.

The dream scenario for a refiner is to be able to source cheap crude but receive high prices for its refined products. Right now, that’s exactly what’s happening in North America.

The Wall Street Journal reports that two refiners — Phillips 66 and Marathon Petroleum Corp — just recorded their highest second quarter profits ever. Naturally, with a dynamic like this, they’re running at full capacity.

The reason for the current bonanza is that US West Texas Intermediate (WTI) oil is trading at a discount to the international benchmark Brent.

The price for WTI this morning was US$66.78; Brent was US$72.22 a barrel.

That allows US refiners to source American crude at the WTI price — which amounts to even less in different parts of the country — but export refined products at the global benchmark price.

While refiners do this with such strong margins on offer, they’ll continue to buy crude oil.

This, over the long term, will bolster the market.

Why the crude shakedown?

The oil price is down because commodity markets are volatile by nature. It goes with the territory.

It might also be in relation to what’s happening in Europe at the moment.

There’s a massive spat going on right now between the management at Ryanair, Europe’s largest low-cost airline, and its staff.

480 German pilots just announced they’re going to join a scheduled 24-hour strike on Friday, and their Dutch colleagues will do the same.

That adds to previous announcements from Irish, Swedish and Belgian pilots.

What’s more, it’s the peak travelling season in Europe right now. The whole region goes on holiday in August.

Some 400 Ryanair flights are going to get cancelled. And planes that don’t fly don’t burn jet fuel.

So you could call it a multitude of factors working against crude oil at the moment. Yet none of them are permanent roadblocks.

In my view, the fundamental trends underpinning the oil bull case remain intact.

In fact, any dip in the oil price is a buying opportunity if you ask me.

Here’s why.

A light at the end of the tunnel

The US Energy Information Administration (EIA) just released its Short-Term Energy Outlook report.

It reveals that the crack spread to produce ultra-low sulphur diesel (ULSD) has widened of late.

This means it’s more profitable for refiners to produce ULSD than it was earlier.

Despite this, the level of inventories for ULSD is abnormally low for this time of year.

The EIA expects these inventories to stay low until December, at least.

This means consumption is outpacing the ability of refiners to get ULSD out to market and build out a strong buffer should further supply problems hit.

This situation is highly likely to get worse before it gets better.

That’s because global shippers are about to become big buyers of diesel fuel. New environmental regulations have been brought in to prevent shippers from using traditional (and highly polluting) bunker oil.

In fact, the race is on for the world’s refining system to adjust to this massive change.

Yet not all refineries are the same. Some were built decades ago on the assumption that gasoline would be the dominant product in demand.

Others don’t have the infrastructure to convert the old, nasty bunker fuel — which is going to collapse in price — into more valuable, lighter products.

As the old bunker fuel falls in price, low-sulphur diesel is likely to rise as huge demand enters the market.

This is the kind of thing that has the potential to increase costs throughout supply chains all over the world.

The world’s biggest shipping company is Moller-Maersk. Just this week, it released a profit warning because of low freight rates and higher fuel costs.

But note that this profit hit doesn’t take into account the obligation to pay more for fuel to meet the new regulatory requirements.

That’s not the kind of stock I’d be looking to buy considering the pressures building.

In fact, you should keep this in mind for any business or stock you consider that has a significant input cost around energy.

I can’t tell you what’s going to happen to the crude price in the short term. But I think it’s going up sooner rather than later — and a lot faster than anyone thinks right now.

On the upside, that will be music to the ears of tiny oil explorers.


Callum Newman Signature

Callum Newman,
Editor, The Daily Reckoning Australia