Oil, like all commodities, is no stranger to price fluctuations. Volatility in oil prices is rarely a problem for producers or consumers thanks to a variety of financial instruments used to hedge against the risk of wild swings. Unfortunately, we are in one of the rare times when oil prices have been significantly lower for longer than expected after a period when many companies ran up debts to take advantage of high prices. The swing from $114 a barrel to $25 a barrel over the last two years is set to force hundreds of energy companies into bankruptcy.
After months of sub-$50 oil prices, there have been plenty of articles about the mismatch between the end of China’s insatiable demand for oil and the oversupply caused by competition between US, OPEC, and Russia producers. More recently, the aftereffects of the prolonged glut are being felt in the downstream sector.
The refiners of crude oil did not immediately feel the pain of falling oil prices, the falling cost of an input helped keep costs down and allowed stockpiling of a resource their businesses would always need. Now a flood of refined products is cutting deeply into profit margins. And nowhere is the problem more visible than in Asia as Chinese diesel exports rose ~75% last year and Asian oil refining margins are half of they were February of last year.
As China continues to dump cheap refined products, international prices of oil products are set to crash just as dramatically as crude oil prices. Domestic incentives to export from China and a shortage of storage globally make it likely that discounted oil products will push down prices. US refineries are already feeling the pressure as companies like Valero Energy Corp. and PBF Energy Inc. reduce refining operations in Tennessee, Ohio and Texas. Reduced consumption of crude by refiners will only exacerbate the oil price collapse.
“It’s like this death spiral,” said Andy Lipow, president of Lipow Oil Associates LLC. “You have run cuts, crude inventories increase, the crude price gets hammered, and then the margin eventually gets restored, enabling refiners to pick up runs and convert the crude surplus into a product surplus, then you repeat the process.”
Storage tanks filling up is another problem in a long line of problems facing oil producers. Inventories of crude are reaching the point of bursting creating two major issues: (1) companies still pumping will soon be forced to either pay higher prices for storage or sell oil for even less and (2) when output finally starts declining, prices will stay depressed while consumers work through truly monumental stockpiles.
With the glut set to continue for most of 2016, expect to see greater and greater strains on producers as storage options run out and the ultimate pain of shutting down pumps becomes the only viable choice.