US Oil Fundamentals Trending in the Right Direction

08/06/20 | Stacey Morris and Andy Hipskind

Summary

  • Lower demand created a domino effect across the energy value chain with the impact reaching from refiners to producers to midstream.
  • Moving into the summer, demand has improved noticeably, and some of the headwinds from earlier this year and industry responses to those headwinds are unwinding.
  • Improvements in demand and production trends are welcome developments for midstream as these result in higher volumes.

The COVID-19 pandemic has profoundly affected day-to-day lives, as people spend more time at home and travel less. With many states implementing social distancing measures, restricting large gatherings, closing schools, and generally encouraging people to stay at home, oil demand plummeted in the US (and globally) earlier this year. While restrictions have eased partially in many places, the impacts on gasoline demand linger as a result of ongoing coronavirus distancing measures. Today’s note discusses the ripple effects of weakened demand in the US, the overall improvement seen in recent months, and the implications for midstream.

US crude inventories are starting to fall after jumping earlier this year as demand plummeted.
Stay-at-home measures significantly reduced demand for gasoline as well as for other refined products. In turn, the lower demand for gasoline and other products resulted in reduced demand for crude from refiners, which process crude into usable products like gasoline, diesel, and jet fuel. While demand for diesel and jet fuel also fell (read more), gasoline is particularly important as it represents about half of US petroleum demand, and it typically accounts for the largest portion of US refinery yields. In other words, processing one barrel of crude yields more gasoline than any other product. For these reasons, we primarily focus on gasoline.

Decreased demand created a domino effect across the energy value chain. Refiners had to lower utilization to avoid an oversupply of refined products as inventories began to climb. Lower refinery utilization led to lower oil demand, which caused crude inventories to increase, as shown in the chart below. Meanwhile, an oversupply of crude and limited storage capacity drove oil prices lower, incentivizing producers to shut in some production. This is the script that played out earlier this year. Refinery utilization bottomed in mid-April at 67.6% as demand troughed. Imported barrels from Saudi Arabia also added to crude inventories. Cargoes purchased during the short-lived price war that began in March started to arrive in the US in May. Oil imports increased by over 2 million barrels per day (MMBpd) for the week ended May 22 – the biggest weekly jump since the mid-1990s. Halfway through July, crude imports returned to more normal levels, and crude inventories fell by 18 MMBbls in the two-week period from July 17 to 31.

Improving demand supports a reversal of industry measures taken in 2Q.
Moving into the summer, demand has improved noticeably, and some of the headwinds from earlier this year and industry responses to those headwinds are unwinding. Based on a trailing four-week average, US gasoline demand is down 10.8% relative to 2019. On their earnings call last week, management of refiner Valero (VLO) noted that gasoline demand in June for their system was back up to 88% of normal after falling by about 50%, and they were seeing improved demand in export markets as well. Refining utilization remains well below normal for this time of year but has ticked up to 79.6% as of the end of July. West Texas Intermediate oil prices have been relatively stable around $40 per barrel since June, and the contango in the futures curve has moderated – another hallmark of an improved market. The stability in oil is allowing producers to restore volumes that were curtailed in April and May. For example, ConocoPhillips (COP) noted on last week’s earnings call that they expect curtailed production from the Lower 48 to be fully restored by September. In short, demand, refinery utilization, and oil production are heading in the right direction, but the ongoing recovery is still somewhat fragile, requiring a careful balancing act by the industry.

What are the implications for midstream?
Improvements in demand and production trends are welcome developments for midstream as these result in higher volumes. Many companies have noted the benefits of minimum volume commitments (MVCs) and deficiency payments in their 2Q20 results, which have helped protect cash flows from lower throughput. While MVCs are an important backstop, improving fundamentals are constructive and reinforce the notion that 2Q was likely the trough for this year.

Many investors expected outsized benefits to midstream in 2Q from their storage capacity given the steep contango observed earlier this year as inventories jumped (read more). While storage is vital in supporting industry operations and allowing flexibility for refiners and producers, it is often overlooked until it becomes scarce. For midstream, storage tends to be contracted for long-term periods, leaving less storage available to capitalize on contango opportunities (i.e. opportunities to store hydrocarbons today to sell at a higher price in the future). However, some midstream names saw benefits in 2Q or anticipate benefits in the balance of this year. For example, Plains All American (PAA) increased its 2020 EBITDA guidance by 3% in part due to the benefits of contango opportunities in its Supply and Logistics business. Enterprise Products Partners (EPD) discussed a $500-600 million benefit this year from spreads, including contango benefits, and expects to end up at the higher end of that range. ONEOK (OKE) noted on its 2Q earnings call that it would realize contango benefits from 2Q in the second half of this year. Storage and contango opportunities have been a small silver lining in a tough environment.

Bottom line
The fundamentals for the US oil market have improved noticeably in recent months with the pace of the demand recovery thus far likely proving better than feared. Improved demand paves the way for increasing refining utilization and restored production incentivized by more stable oil prices – welcome developments for midstream.