The Oil Market Is Uncomfortably Sustainable
The latest oil rally is among the most uncomfortable I've ever seen from the consensus. On one end, macro recessionary calls continue from the crowd. China's PMI data continues to disappoint to the downside leading some to believe that China's implied oil demand figures are over-inflated. On the other end, supply-driven constraints are making the bulls uncomfortable as the "kool-aid" remedy will eventually be pulled resulting in lower oil prices. I'm not seeing a lot of overexcitement from the latest oil rally, and despite the uncomfortable feeling, I believe this rally is sustainable.
Over the years I've followed the oil market, there are certain true truths to follow:
Never fight the Saudis.
Always watch exports.
Crude follows refining margins.
These three things have basically never changed. And while we advocated readers to follow the first two principles closely, we are going to talk about the 3rd variable today.
Since the COVID-led oil price crash of 2020, we've long said that the only way for the oil rally to be sustainable is for it to be led by refining margins. One of the mistakes we made last June was that we expected refining margins to fall, but for crude to remain strong. Here's what we said specifically:
According to EA, refinery throughput from May to August will increase by ~5 million b/d. Assuming refineries can deliver, then we should see refining margins start to fall.
Source: Barchart.com
Today's price action is also interesting as it appears to confirm the start of higher refinery throughput on the horizon. One thing to keep in mind, however, is that falling refining margins could also be perceived as bearish implied demand, so we need to watch Brent timespreads to confirm that it's just higher throughput and not bad demand.
And if you look at the Brent 1-2 timespread, crude is getting tighter which indicates to me it's just higher refinery demand (higher throughput).
Now this analysis is really important for figuring out where oil is headed. As we wrote last week, consumers are already paying the end price (e.g. crude + refining margins). As a result, if refining margins fall by ~$15/bbl because crude rallied by $15/bbl, the end result is the same.
Using today's 3-2-1 crack spread, we get an implied margin of $53/bbl. Adding that to WTI, the end result is $173/bbl. Refining margins fell by $4/bbl today while crude is flat, so the end result is consumers are paying $4/bbl less. (For those of you thinking in terms of gallons, divide the barrel figure by 42 to arrive at per gallon.)
Looking ahead, my thinking is that refining margins will fall. Demand destruction is real and we are seeing some of that take hold now. With the ~5 million b/d of the expected increase in refinery throughput, I think refining margins fall back to $35/bbl or -$18/bbl from today. The end-user price assuming crude stays flat at $120 is then $155/bbl. This should give crude some room to rally. We could see as high as $135/bbl or $170 end-user price if demand holds up, but that's likely the top of the range.
In summary, the mistake we made was to assume that if Brent timespreads are strong (i.e. physical market), a fall in refining margin is expected as higher throughput would reduce margins.
Now if we look back at the 2022 data, that was not the reason refining margins started to fall.
You can see that refinery utilization was still well below the 2015-2019 average, and the fall in refining margins last year was the result of disappointing demand over higher throughput.
So what's the point I'm trying to make?
The point is that the current refining margin rally we are seeing (right now) is likely to be more sustainable than last year.