Will Oil Prices Continue to Rally?

The price of oil is climbing back to the $100 mark. The recent developments in the oil market might push oil prices to hover over $100 in the near future. Let’s examine the recent developments in the oil market and see how these changes might affect leading refinery companies.

Demand is rising; supply is contracting

According the U.S Energy Information Administration , refinery inputs sharply rose in recent weeks. As of last week, refinery inputs reached 15.93 million barrels per day, which are nearly 3.5% above last year’s levels. The elevated refinery inputs may have contributed to the rise in the price of oil. The other side of the equation is the changes in U.S supply. In recent weeks, oil imports have dropped to 7.52 million barrels per day — nearly 9.4% lower than last year. Conversely, oil production has slowly increased in the past several months. Alas, the rise in production didn’t offset the drop in imports. In total, the supply (comprising of imports and production) declined in the past couple of weeks, while the demand for oil has increased. The developments in the gap between supply and demand and the changes in weekly oil prices are presented in the chart below.

oil market tight loose oil price  December  16-20

Source: Energy Information Administration

As you can see in the chart above, in the past several weeks, the supply has fallen below refinery inputs; this development suggests the oil market has tightened. If this trend persists, this could further push up the price of oil in the coming weeks.

Looking forward to 2014, according to the EIA oil report , the current expectations are that U.S oil consumption will remain stable compared to 2013. On the other hand, oil production is projected to rise by roughly 14%. This trend is likely to pressure down the price of oil later next year.

But in the short term, oil price might continue to rise. If you consider an oil related investment such as oil ETF, you should take into account its disadvantages.  

Oil ETFs

One of the potential disadvantages of owning an oil ETF such as United States Oil (NYSEMKT: USO), is the adverse impact the Contango could have on its pricing. A contango occurs when long term future contracts are priced higher than short term contacts. The USO ETF mostly owns near month’s future contracts. Before the contract expires, however, the ETF sells near month future contract for next month contract. If the next month contract price is higher than near month’s price, the market is considered in Contango[l4] ; in such a case, the investment value of next month contract would tend to rise slower than the spot price of oil, or drop faster. Therefore, when the market is in Contango, the ETF loses money with respect to the changes in the spot price of oil. If the Contango continues to occur, holders of the USO ETF won’t benefit from the rally of oil as much as investors, who hold oil contracts, would.

Finally, investing in USO includes a 0.45% management fee. This is another factor that will further cut down the return on such an investment.

The chart below presents the movement of USO and the price of oil normalized to the end of November 2012.

USO oil price

Source of Data: Energy Information Administration and Google Finance

As seen above, the price of oil rose by 11.7% during the year, while USO rose by 9%. This isn’t a huge gap, but still means a lower return for ETF holders.

Besides investing in oil via contacts and ETFs, oil refinery companies are also an alternative worth such as Valero Energy (NYSE:VLO) and Marathon Petroleum (NYSE:MPC).

Let’s review how these companies are expected to perform in the fourth-quarter. 

Are refinery companies making a comeback?

Leading refinery companies such as Valero Energy (NYSE:VLO) and Marathon Petroleum (NYSE:MPC) are likely to see a rise in their refinery margins, which was low in the past several quarters and contributed to the decline of these companies’ profitability. In the third-quarter, Valero Energy’s profitability fell from 3.8% in 2012 to 1.5% in 2013. Conversely, the company’s revenues rose by 4.1%, year over year. The rise in revenues was mostly due to higher throughput volumes on account of less unplanned maintenance activity and less weather-related downtime.

Marathon Petroleum , even more than Valero, sharply increased its revenues by 23.7%.  Despite the sharp rise in revenues the company’s profit margin also contracted from nearly 9% to 1.2% in the third-quarter. The jump in revenues was due to a spike in total refinery throughputs of approximately 39%. This rise in throughputs was mostly attributed to the GalvestonBay refinery, which Marathon Petroleum acquired on Feb. 1, 2013.

In the fourth-quarter, average refinery inputs  in the U.S grew by 2.5% — this number could suggest that leading refinery companies have also increased their throughput volumes by a similar rate. Moreover, the price of West Texas Intermediate (WTI) crude oil increased in the fourth-quarter by roughly 10%, year over year. The discount on WTI over Brent has also improved to an average of $11.9 per barrel — the highest level since the first quarter. This discount is still nearly half the discount in the fourth-quarter of 2013, but it does suggest the profitability of both companies may improve compared to the third-quarter. Therefore, these companies are likely to further augment their revenues and improve their profitability in the fourth-quarter.

Take away

The oil market might continue to heat up in the near future, which could benefit refinery companies. The rise in oil prices and improved discount on WTI oil over Brent oil could result in higher profit margins for oil companies. Looking toward 2014, however, the current expectations are that the oil market will loosen, which is likely to bring oil prices down to the low $90.


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Disclaimer: The author holds no positions in stocks mentioned and does not plan to initiate positions within 120 hours of the posting of this article. This article is to be used for educational, research and informational purposes only and does not constitute investment advice. There are no guarantees, expressed or implied, of future positive returns in regards to the subject matter contained herein. Understand the risks inherent in investing before making the decision to invest or consult an investment professional for more information. Reasonable due diligence has been performed in regards to the information in this article. However, the author expressly disclaims any liability for accidental omissions of information or errors in fact.