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Why the Crude Rally Has Fizzled, Concluded: Market Analysis Series - Part 3

This is the third and final segment of a three-part look at why oil prices have failed to rally despite OPEC’s best efforts at managing supply cuts. Not only have prices failed to rally, both NYMEX WTI and ICE Brent have fallen around 9% over the past three weeks. In case you missed them, be sure to read part 1 and part 2.

Refiners do what is in their best interest, too.

Bank of America Merrill Lynch analysts recently said that refiners the world over need to weigh capitalizing on current strong margins — and risk dumping products into an already glutted market — or forgo profits now in the hopes of rescuing global product prices.

“Refiners need to be careful not to repeat last year’s mistake and raise production in response to high margins only to add to already high inventories,” the analysts said. “In a way, they face a big dilemma: be penny wise now and possibly look pound foolish later, essentially run harder now and suffer in six months, or run softer now and forgo profits.”

The recent strength in refining margins across much of the world suggests refiners, like many of the world’s oil producers, will continue to do what is in their best interest: use cheap crude to make refined products for profit.

Graph+1+-+Refining+Margins+Have+Risen+Since+November

So what is the current state of the global refined product market?

While product cracks have kept refining margins profitable, it is more likely than not that they have already peaked at levels largely below those seen last year.

European gasoline had strengthened on the seasonal pull from the U.S., but even this seems to have already dried up. In Asia, gasoline cracks could have peaked for the season at just over $10/b. In 2016, gasoline cracks peaked at just under $12/b in late-March.

Distillate cracks the world over are better, but last year was a particularly bad year for distillate sellers.

Total Amsterdam-Rotterdam-Antwerp product stocks have risen steadily this year, according to PJK data. Stocks for all other products except fuel oil — which largely gets arbitraged away to Singapore — have risen as well.

Graph+2+-+ARA+Refined+Product+Stocks+Have+Risen+in+2017

Recent refinery work in China was expected to cut into the country’s ability to export products, tightening regional product balances. But remember, China is a massive exporter. The country exported 1.32 million mt (351,927 b/d) of gasoil in February, up 67% year on year and up 37% from January. So clearly, if this were to happen, we’re talking about a drop in the bucket.

Japan’s inventories across the barrel are also healthy, as are South Korea’s. A Korea National Oil Corporation official chalked South Korea’s recent gasoil and gasoline builds up to sluggish domestic demand and fewer exports. The official went on to say that the outlook for the rest of the year was little better.

Graph+3+-+Fujairah+Product+Stocks+Remain+Elevated

U.S. product stocks have been falling, but again, this is partly seasonal, rather than structural. It is also notable that U.S. product stocks have been falling from massively glutted levels, and are, by and large, still well-above their respective five-year averages. U.S. gasoline stocks have come off record highs set this February, but they still remain nearly 7% above the five-year average, according to Energy Information Administration data.

Atlantic Coast low and ultra low sulfur diesel stocks have fallen from record highs this winter, and yet they are still 62% above the five-year average. On the export-capable Gulf Coast, stocks are also falling, but remain more than 13% above the five-year average.

Exports to Europe and Latin America had been strong, but a recent dive in clean freight rates suggest there are too many ships and not enough cargoes. Either way, exports look to be slowing.

So, why are refiners continuing to churn out products? Because they’re getting a great deal on all this relatively cheap crude! With refining margins where they are right now, it’s little wonder product stocks can’t clear. It would help if forecast demand lived up to expectations, but so far, this has not happened.

For crude prices specifically, hurdles remain. U.S., North Sea, West Africa and Latin crudes will continue to displace OPEC barrels for as long as freight stays cheap and the OPEC cuts themselves keep Dubai comparatively strong.

In its latest crude oil market outlook, Platts Analytics’ Bentek Energy analysts acknowledged as much.

“It appears that the market largely believes the cut being extended will take place; however, U.S. inventories aren’t helping support the notion that the shifts that have taken place in supply and demand to date are achieving their desired result,” they said.

Just Wednesday, Platts reported that China received a record 4.83 million b/d of crude from OPEC in March. While Saudi barrels were down, they were more than made up by barrels from Angola, Kuwait and Venezuela.

No matter how you slice it, today’s crude market is set up to quickly displace lost supply. And this dynamic will most likely hold up until the Brent/Dubai EFS and the WTI/Dubai spread unwind. Cheaper Dubai will be the key to that. And that will come about when OPEC countries again compete for market share.

A recent upturn in Persian Gulf-Asia VLCC rates suggest this may be in the cards sooner than some had expected.

Still, crude prices may very well rise. Geopolitics is ever present — as seen by the recent U.S. bombing of Syria — even if geopolitics does not command the premium that it once did.

In fact, my colleague Herman Wang recently noted that a wider conflagration across the Middle East could put the OPEC-led output cut deal at risk. This, of course, would be bearish for crude prices, assuming actual output levels remain unaffected by conflict.

But then again, anything is possible.

It is no understatement that it will take a lot of U.S. demand to balance the market.

And not just refinery demand, but also product demand too. And not just in the U.S. The world product market will have to be able to absorb even more U.S. refined products.

In order to do this, economies must grow. While this is forecast by many to happen, rebalancing will not happen until actual refined product and crude inventories tighten, which will go hand in hand with stronger spot differentials and crack spreads for European and Asian products. When that starts to swing, a rebalancing is in effect.

In the face of a world saturated with crude oil, the only thing that can truly balance this market is fresh demand from new technology, or a massive reduction in global refinery capacity.