With Brent Crude oil driving higher on Wednesday — up nearly $1 and trading at $67.59 in early afternoon New York trading – Morgan Stanley analysts Martijn Rats and Amy Sergeant point out that European refining margins have weakened recently. This is creating a negative correlation, where refining stocks head lower as the underlying product, Brent crude, moves higher.
Brent crude: Watch for trading range with $70 high
With the primary pipeline distributing Brent crude just recently opened and the futures contract in backwardation – the front month is trading higher than the back month -- Francisco Blanch, head of commodities research at Bank of America Merrill Lynch, sees a trading range for Brent in 2018 – touching the $70 level but averaging $56, nearly $10 off the current price.
The backwardation could be due to near-term supply concerns, with pipeline flow stoppages and what Morgan Stanly analysts Rats and Sergeant “limited product stocks,” oil prices could be buoyed in the coming year – assuming too much additional production capacity does not come online.
On a near-term basis, Rats and Sergeant look at an unusually large amount of refinery maintenance planned in the first half of 2018 as a weight on the scales of supply and demand. “European refiners already plan to take as much capacity offline for maintenance during the Mar-May period as last year,” they wrote in a January 2 report. “Those plans usually expand further as time goes by, but they already suggest that as much as 1.5 mb/d could be offline in May - approximately 11% of total European capacity.”
The move higher in price may create a self-fulfilling prophecy. With oil crossing the important $66 benchmark, previously shuddered shale oil platforms are likely to come back online, creating more supply and thus lower prices – eventually. “The U.S. shale-OPEC tug of war will simultaneously cap upside price potential and downside risks,” Stephen Brennock, an analyst at PVM Oil Associates Ltd. in London, told Bloomberg.
Brent crude: Higher prices often lead to increased global supply, much of it out of the US
When looking at European refiners, whose profit margins and stock prices have both moved lower as stock prices have moved higher, Morgan Stanley’s Rats and Sergeant see the backwardation sending a message.
The ICE Brent forward curve recently moved further into backwardation. The front of the curve has rallied, up 26% since September 1, while the year out end of the curve is up but 17%. “This has put pressure on spot margins while the weaker back end of the curve has allowed forward margins to hold up,” Rats and Sergeant wrote.
The shape of the derivatives curve is one issue driving European refining margins lower, as are weaker product spreads and a period in November and early December of maximum refining runs. “With very little planned maintenance and few unplanned outages, late November/early December saw max refinery throughput at a time when winter demand is yet to fully kick in, putting downward pressure on spot margins,” Rats and Sergeant observed.
But current conditions could change, as stop margins have seldom stayed below forward margins for extended periods of time. Either forward margins can fall to correct the imbalance, or, as Morgan Stanley predicts, spot margins can strengthen.
“History tells us that high utilization and high refining margins tend to be linked, with higher margins in Brent crude needed to incentivize maximum throughput,” Rats and Sergeant pointed out. In September the pair pointed to strong utilization and margins, but noted a caveat.
“However, with very high maintenance in Q1 and Q2, combined with strong demand and low product stocks, we think utilization will need to return to close to September levels in some months,” they wrote with a degree of concern for the unpredictable. “With low stocks, there is also upside price risk for any unplanned events.”