Margins for oil majors continue to ebb



Both BP and Royal Dutch Shell posted better than expected results last week, boosted by their refining operations. However, this positive trading backdrop is unlikely to last.

The oil refining industry has been weak for many years due to the stuttering global economy and because of its significant overcapacity across the world.

"Industry refining margins increased sharply from year-ago levels across all of the regions in which we operate," Simon Henry, Shell (LSE: RDSB.L - news) 's finance director, said last week. "It's been quite a while since we've been able to make such positive comments on the downstream macro."

French group Total (Brussels: FP.BR - news) and ExxonMobil also saw their latest quarterly profit boosted by refining.

However, the third quarter of the year was exceptional. A huge oil tank blaze struck the Amuay refinery in Venezuela, which usually processes about 645,000 barrels of oil per day. Compounding this, there was also a series of maintenance shutdowns in the US and some European capacity has been mothballed due to the weak economic backdrop.

"We think this rally's been driven at least as much by capacity outages, such as… the fire in Venezuela and hurricanes on the Gulf Coast, rather than by stronger demand conditions," Mr Henry said.

Traded contracts known as "crack spreads" measure the profitability of downstream refining operations. These are the difference in price between the cost of a barrel of oil and the cost of the refined products. It is a measure of the profit that refiners can expect to make.

The term comes from the process of "cracking", in which the complex hydrocarbons in crude oil are broken down and distilled into refined products such as petrol. Crack spread futures are traded on exchanges as a way for refiners to hedge their exposure and investors to play the market.

Different refiners using different types of crude "crack" oil to produce different products. However, the most common form of crack spread is the Nymex-quoted 3:2:1 spread. It is essentially the price of one barrel of heating oil plus two barrels of petrol minus 3 barrels of oil. If the figure is negative, refiners lose money. If it is positive, then process is profitable.

Crack spreads started to rise in May this year, but have slumped since the start of October. This means refining is broadly half as profitable today as it was one month ago. Indeed, after Shell warned that refining margins would fall, every single crack spread futures contract monitored by Bloomberg fell.

Margins have been much lower in Europe (Chicago Options: ^REURUSD - news) . This situation led to the collapse of Switzerland's Petroplus earlier this year and the closure of the group's Coryton refinery in Essex.

The UK has serious issues with its refining capacity. A report prepared for the Department of Energy (NYSEArca: JJE - news) and Climate Change (DECC) in June by energy consultancy Purvin & Gertz highlighted how the UK's refining capacity has failed to keep up with changes in the UK economy.

An increasing number of "greener" diesel cars and the rise of low-cost aviation have substantially increased demand for both kerosene and diesel (known as middle distillates), with petrol consumption falling.

"UK refineries have not been able to keep pace with this changing demand pattern," the report noted. "Most are configured to match a profile of higher gasoline and fuel oil demand, together with lower jet and diesel demand. To reconfigure their processes to produce more middle distillates and less fuel oil and gasoline requires substantial investment in new conversion units."

Increasingly, refining is turning into an unattractive proposition, particularly as many new refineries are planned in Asia. BP has sold its massive Texas City refinery as part of its divestment programme. For some years, oil majors have been closing or selling off their downstream operations. This trend will not stop any time soon.

= QE3 rally out of steam =

Commodity (Euronext: COMIN.NX - news) prices have dropped back since the Federal Reserve announced QE3 the US central bank's third round of quantitative easing, or money-printing in September. "This may be a classic example of 'buy the rumour, sell the fact', but doubts about the effectiveness of repeated asset purchases are also growing," said Capital Economics.

In the absence of support from stimulus hopes, worries about global economic activity have been weighing on commodities. "The prices of all the leading industrial metals [copper is shown above] fell throughout October, aside from a small and short-lived rally in the middle of the month on reassuring Chinese data," the consultancy notes.

= Tankers queue to unload fuel as tempers fray in New York (Frankfurt: A0DKRK - news) =

As America begins the post-Sandy clean-up, analysts are weighing up the impact of the extreme weather on energy consumption.

Although the damage to oil refineries has not been severe, energy supply chains have been seriously disrupted by the weather.

Oil tankers have been waiting for days outside New York harbour to unload their cargoes, prompting the US government on Friday to waive its ban on foreign tankers directly supplying the north-east.

Motorists in affected areas have been queuing for miles to fill up their cars with one clash over a driver pushing in resulting in a man being charged for waving a gun.

As well as raising tempers, the tight supply has raised gasoline, or petrol, prices on the east coast and no immediate easing of the situation is in sight. "Regional product markets may remain tight for a while, given that regional gasoline and distillate stocks were both below their five-year averages when Sandy hit," warned Larry Hatheway at UBS (NYSEArca: DJCI - news) .

However, in the longer term, market worries are focused on the likely negative impact of Sandy on energy demand and prices.

As analysts at Deutsche Bank (Xetra: 514000 - news) saw it, "given that Sandy slammed the densely populated Eastern (AMEX: EML - news) coastal region and that power outages remain widespread, this is likely to have a dampening effect on economic activity and consequently oil demand."

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