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Oil prices up, margins down
Why did refining margins go down in the last quarter of 2017? The main reason was the rapid increase in oil prices. However, as the rise was triggered by temporary factors, crude prices may soon be expected to decline, pushing refining margins up.
At the end of 2017, oil prices reached a three-year peak and the average quarterly price was approximately USD 61 per barrel, having risen by more than USD 9 (17.7%) on the third quarter. While the upward trend, started in the third quarter of 2017, is rooted in the oil market fundamentals, the acceleration of price growth in the fourth quarter, still observed in the first half of January 2018, came as a result of unexpected factors that limited the growth of current supply and raised the risk premium in oil prices. The price growth is mostly driven by a solid increase in global demand for oil and liquid fuels, caused by the strengthening of economic growth in virtually all regions of the world. According to IHSM estimates, global demand rose by 1.8 million barrels a day (mbd) in 2017 and a similar increase is expected in 2019. Added to that should be the oil output cuts introduced by OPEC countries and Russia in early 2017 and planned to be extended until the end of 2018. In 2017, the average annual volume of oil production in the OPEC countries dropped by 0.1 mbd, and the low crude prices in the first three quarters of 2017 hindered production growth in non-OPEC countries as well. The fundamental driving forces include also a sustained decrease in oil and fuel stocks in OECD countries, seen since mid-2017 and caused by the factors mentioned above. The process was aided by the “shale band” effect and a slowdown in US production between February and June. In the following months, US output increased hand in hand with the prices, which however did not exceed the upper end of the shale band at USD 60 per barrel of Brent crude. This happened only on October 27th, just before the OPEC summit at which the production cut was extended until the end of 2018 and Libya and Nigeria joined the deal.
In the previous post I pointed out that the accelerated growth in oil prices observed in the fourth quarter was caused by the accumulation of unexpected developments, while the combination of fundamental factors over the next year or even two years exerts no upward pressure on oil prices, justifying their current levels. Global oil stocks remain high. Although declining in OECD countries, they still are above the five-year average. The spare production capacity of ‘cheap' oil (oil reserves kept below ground, ready to be extracted at short notice) is also growing. Production levels in the US (tight oil) continue to respond strongly and quickly to rising prices. IHSM estimates show that in September 2017 US output reached 9.5 mbd, just below the 9.6 mbd peak of April 2015. 2018 is expected to see monthly production increases of 300,000 bd on average, and if the WTI oil price grows to 60 USD per barrel, the output could rise to 900,000 bd.
Why are oil prices growing then, somewhat against the fundamental factors, and why do the latest projections of investment banks say that the growth will continue over the next few quarters? The reason is backwardation, an untypical structure of the oil futures (paper) market. The unusual and short-lived nature of backwardation results from temporary undersupply, which drives up the spot prices so high that they reverse the slope of the futures contract curve. Oil spot prices rose due to a drop in stocks, indicating the prevalence of current demand over supply, caused by the clash of fast growing demand with OPEC cuts and non-recurring factors. On the other hand, the prices offered in futures contracts are below the spot prices as the market expects sufficient supply in the long run. If the market considered the supply shortages permanent, the prices in futures contracts would also increase to levels justifying release of additional supplies. The market would remain in natural contango (when oil price in forward and futures contracts is higher than spot price).
Although not permanent, backwardation is a powerful incentive for financial investors to take long speculative positions in the paper markets: to buy oil futures with delivery deferred for two months or more (at a future price lower than the current one) and keep the contracts to offer them for sale only one month before their maturity dates, at a price higher than the purchase price but lower than the spot price (taking the short position). Currently, long positions substantially outnumber short positions, because rolling of futures contracts in backwardation yields higher than when the market is in contango. The record high increase in oil futures purchases generates additional demand for oil and, as the sum of transactions in paper markets is 50 times higher than the sum of physical transactions, the paper market transactions make the oil price trends deviate, for some time, from the trends resulting from the physical market fundamentals.
The attractiveness of backwardation for financial investors may continue to support the upward trend in oil prices for some time. However, if no new oil supply cuts are imposed in the coming quarters, crude prices should fall in the next quarter or two. The return of oil prices to the fundamentals should be accompanied by an improvement in refining margins, which are now under the pressure from excessively high oil prices.