Oil & Gas Refining & Marketing

Refiners will reduce run rates over the next month or so to clear unintended inventory accumulation, but it's not like they've never had to deal with this situation.

Special Report

We view the "sweet spot" for market-balancing oil prices to be within a range of $50-$65/ barrel: Oil prices will be below/in the lower half of this range during 2016H2 and will average in the upper half of this range in 2017, perhaps exceeding the range in 2018. Without OPEC serving as an attentive "human regulator" of production, bouts of oversupply and undersupply will have to be managed through the drill bit (not the output valve), leading to increased price volatility beyond our "sweet spot" range. In this environment, quick-reacting U.S. shale producers and service companies are best positioned to benefit early in the up-cycle.

Monday's upgrade of the energy sector to neutral and the exploration & production index to overweight does not mean that refiners are out of the woods. In fact, the opposite is true, because the crude oil supply glut will morph into a refined product glut. Refiners are still running full out, likely in response to strong gasoline demand, but that is creating a glut of distillate inventories and boosting overall fuel supplies. Overall refined product consumption is barely growing, underscoring that inventories will continue to build. Weakening overall demand for finished oil product is also evident in the plunge in railcar shipments, which heralds a potentially painful decline in relative stock performance (top panel). Part of the plunge in rail shipments of oil reflects reduced shale oil production, which will boost refiner input costs via higher crude oil prices. Keep in mind that refining margins are already under cyclical stress, because of the tight spread between Brent and WTI crude oil prices (third panel). Our refiner earnings model, based on refining margins and utilization rates, is plunging. Consequently, the odds of a sustained profit squeeze are high. We reiterate our high conviction underweight. The ticker symbols for the stocks in this index are: BLBG: S5OILR - PSX, VLO, MPC, TSO.

Bearish sentiment is a red herring, as most other measures of investor positioning point to a strong undercurrent of bullishness. That is contrarily worrying.

Refining stocks have been slammed this year, and we expect more pain ahead. Companies had continued to operate at full throttle, as measured by the relentless advance in refinery production (second panel), likely reflecting expectations for ongoing demand strength and decent export markets. However, both gasoline and refined product inventory have been steadily building since last year, warning of excess inventory accumulation. Worse, refined product consumption is contracting, underscoring that it will take output cuts to work through the supply glut. Refiners have an incentive to pull back, given that refining margins are essentially nil, but the implication is a potentially sizeable profit hit. The index is not priced for an earnings downturn. We maintain our high-conviction underweight. The ticker symbols for the stocks in this index are: MPC, PSX, TSO, VLO.