Several months ago we reported that the next big threat to oil prices had nothing to do with oil fundamentals, either lack of demand or excess supply, or technicals, i.e., algo buying or selling, and everything to do with the upcoming glut of the most important crude byproduct: gasoline.
Sure enough, now that summer is here, this prediction is playing out just as expected and as Reuters reports, summer driving season is in full swing and American motorists are filling their tanks at a healthy clip, but that is not swelling the profit margins as much as usual at U.S. independent oil refiners such as PBF Energy and Valero Energy Corp.
How come? As it turns out, the optimism that refiners had in the spring that the gasoline excess would clear out has not materialized. During the first quarter earning season, refining executives shrugged off the industry’s lousy earning as an aberration that would be remedied this summer. “We still are bullish gasoline and bullish octane," PBF CEO Tom Nimbley told investors in an earnings call back then. “The driving season really hasn't hit that hard yet.”
It has now, and while Nimbley was right about the surging summer demand, refiner margins are still being squeezed as gasoline and diesel inventories stubbornly sit well above five-year averages. Historically, summer gasoline demand usually fattens margins for refiners with seasonally high levels for the crack spread, the premium of a barrel of gasoline over a barrel of crude oil. But not this year said analysts who expect the situation to remain bleak in the weeks ahead unless there are large drawdowns in inventories.
Earlier today the DOE reported a modest 122K drawdown in gasoline stocks, which however is nowhere near enough to pressure gasoline inventories lower which remain much higher than they were last year at this time, and analysts have slashed earnings estimates for big U.S. refiners who report second-quarter results in coming weeks.
Nowhere is the situation more dire than the US East Coast, where refineries have been forced to cut production, just as we forecast several months ago they would have to as the relentless supply in crude did not balance out the demand for refined product. As Reuters points out, refiners on the East Coast, also known as "PADD 1" by the U.S. Energy Department, are typically the first to feel a profit pinch, because their margins tend to be thinner than those of other regions.
“PADD 1 is a holy mess,” said Andrew Lebow, senior partner at Commodity Research Group in Darien, Connecticut. “It is very unusual. If a market becomes extremely oversupplied, like PADD 1, they are going to have to cut runs.” That is another way of saying refiners will have to stay shut, which in turn will force crude to build up in various on and offshore storage locations.
As a result, the U.S. gasoline crack spread a proxy for refiner margins, has dropped 34 percent in two weeks. On Wednesday, it hit a five-year low for this time of year below $13 a barrel. That is less than half the crack spread of $28 a barrel at this time last year.
"An RBOB crack trading 13 bucks in the middle of driving season is unheard of," one trader told Reuters.
Here's the reason why: East Coast gasoline stocks hit a record 72.4 million barrels, about 17% higher than the same time last year. Overall, U.S. gasoline stocks were at 239 million barrels in the week to June 24, nearly 10 percent higher than last year and 15 million barrels more than the five-year average. The glut is so extreme that several tankers full of products were forced to sit idle in New York Harbor recently, waiting to unload. Note: not tankers full of crude, but gasoline. The full crude tankers will come next when they have no refiners to sell to.
What is strange is that inventories have grown despite government data that U.S. motor travel continues to surge, unless of course the government data is inaccurate. Analysts noted that U.S. refiners switched to maximum gasoline mode earlier than usual during a fleeting moment of high margins in the early part of 2016. Imports also have been higher than normal in recent weeks, adding to the glut.
John Auers, executive vice president at Turner, Mason & Co, a Dallas-based consultancy, warned that if inventories remain historically high at the end of the summer - as they seem to be - refiners could be forced to cut production significantly to account for weaker seasonal demand.
Making matters worse is that none other than that perpetual capital misallocator, China, suddenly finds itself in the midst of a gasoline export boom: since the local refineries have been mimicking those in the US and operating until recently at a feverish pace, and since local demand for gasoline has not materialized, China is now forced to find offshore buyers for all its record excess gasoline.
As Bloomberg added recently, China's May gasoline exports increased to 780,000 tons, the highest since December. “China’s high fuel exports are a result of robust oil processing and sluggish domestic demand,” Zhang Bin, an analyst with Shandong-based SCI International, said by phone. “The outbound shipments coming out of independent refineries also helped push up the volume."
While the biggest importer of Chinese export gasoline has so far been Singapore, it is only a matter of time before it own storage becomes glutted, and China is forced to redirect, potentially sending cargoes in a US direction.
Which would make the US glut even worse. But even if China's gasoline does not make US landfall, absent a miracle, and looking at that crack spread chart one isn't coming, earnings for refiners will be abysmal for yet another quarter. The 10 largest independent U.S. refiners booked a combined net income of $944 million in the first quarter, down 74 percent from a year earlier, a Reuters analysis showed. That put profits on track to be much less than the annual level of more than $10.6 billion in the past five years. The reason: there is just too much gasoline floating around as a result of the unprecedneted dynamics in the energy markets, where there is simply too much of everything on the production chain: from crude, to distillate, to gasoline.
Auers estimated that second-quarter margins would come in as the lowest for this normally profitable quarter in at least five years. Over the last 30 days, estimates for second-quarter earnings have fallen 17 to 20 percent for four of the major U.S. refiners, Phillips 66, Valero Energy , Marathon Petroleum and Tesoro, according to Thomson Reuters StarMine.
But what is worse is that with the inventory bottlenecking having reached all the way to the gasoline level, in lieu of refiner buying, crude producers will be forced to start selling oil and dumping prices just to get marginal demand as both onshore and offshore storage is near capacity. Most likely this will happen in the next few weeks, when coupled with the near full Chinese SPR, the slump in Chinese oil demand, the elimination in Nigerian supply overhangs, the resumption of Libyan exports, it will send the price of oil tumbling, and incidentally replaying the summer of 2015 when crude crashed...
... right around now.