There are not enough refineries running to supply the world’s demand for gasoline and diesel, so inventories are falling and margins are ~500% above any point in recent history. There isn’t enough supply of oil to feed the refineries that are running, so inventories are falling, and prices are up ~70% from a year ago. There isn’t enough gas or coal in Europe or Asia to stockpile ahead of winter, so prices are up 300-400% from this time last year. Subsidies can lift the price at which demand is destroyed, but without meaningful supply additions, demand will eventually fall to balance markets.
Conoco (COP) CEO Ryan Lance said we were approaching demand destruction pricing for oil markets in March. Goldman wrote that the refining crisis would encourage demand destruction in June. And in JPMorgan’s view, demand destruction has already arrived. Although much is written about rising gasoline prices in places like California, demand destruction is likely to occur in poorer countries, where data is more difficult to monitor. But as wealthy consumers bid prices to a level that developing nations cannot afford, shortages are already occurring in Africa and parts of Asia.
In utility markets, wealthy nations in Europe are likely to bid natural gas away from poorer nations. Pakistan is already struggling to pay higher prices for liquified gas, and price signals suggest many Asian nations have already begun to burn more coal. Without increased supplies, prices for coal and gas are likely to bump up against levels where developing markets’ ability to pay for the fuels becomes curtailed.
However, in oil the dynamic could play out differently. Using rough numbers, the world consumes ~100mb/d of oil products. In reality, not all of that oil is refined, as much of the 100mb/d is actually natural gas liquids, sold into the chemicals supply chain or directly to consumers. But for purposes of illustration, let’s say the world currently has ~100mb/d of refining capacity. Given that Russia and China are holding supply off the market, it could be that effective refining capacity is 98mb/d. In addition to the above assumptions on demand for oil from refiners (98mb/d), and demand for oil products from consumers (100mb/d), let’s assume that oil production is running at 96mb/d.
Assuming the above, the oil market would be in a deficit of 2mb/d; 98mb/d processed by refiners, but only 96mb/d produced. Given draws in global inventories, despite the 1mb/d release of strategic reserves, that number should be approximately correct. However, oil products are also drawing in this example, by ~2mb/d as consumer demand 100mb/d of products while only 98mb/d are being refined.
But these assumptions are approximate. Subject to change from policy measures and producer activity. As demand is destroyed, the market will find out very quickly which of the two markets is most undersupplied. In the above example, if demand for gasoline and diesel fell by 3mb/d, refining would become over-supplied. Refining margins would revert to historic norms, ~80% below current levels, and refining stocks would fall. Yet, in this example, oil would still be undersupplied and oil prices would likely remain elevated. However, if an SPR release, OPEC supply response or further reduction in product exports from China and Russia resulted in refining being the bottleneck, then oil prices could fall rapidly, while refining margins remained elevated.
Given the size of the market, and enormous impact on price from small imbalances (1-2%), and given the first-of-its-kind refining bottleneck, investors are sure to remain keenly focused on supply/demand trends throughout the supply chain. For those less confident in the eventual outcome, integrated producers offer the safest bet, as companies like Chevron (CVX), Exxon (XOM) and Shell (SHEL) will see economics shift between the upstream and downstream segments, but remain captured within the integrated model. For those wagering that refining will be more undersupplied than upstream production, pure-play refiners like Valero (VLO), Philips (PSX) and PBF (PBF) stand to benefit the most. And if refining capacity proves ample as demand falls, upstream producers like Pioneer (PXD), Canadian Natural (CNQ) and Devon (DVN) will benefit disproportionately.
In the very near term, Q2 results are sure to impress across the various energy sub-sectors. However, rapidly shifting energy markets (USO) (UNG) (CRAK), paired with a deteriorating macro environment, are unlikely to lift all boats equally in the second half of 2022.