Will Oil Prices Continue to Rally?

The price of oil is climbing back to the $100 mark. and recent developments in the oil market might push oil prices to hover over this level in the near future. Let's examine the recent developments in the oil market and see how these changes might affect leading refiners. 

Demand is rising; supply is contracting
According the U.S Energy Information Administration, refinery inputs rose sharply in recent weeks. As of last week, refinery inputs reached 15.9 million barrels per day, which is nearly 3.5% above last year's levels. The elevated refinery inputs may have contributed to the rise in the price of oil. The other side of the equation is the change in U.S. supply.

In recent weeks, oil imports have dropped to 7.5 million barrels per day -- nearly 9.4% lower than last year. Conversely, oil production has slowly increased in the past several months. Alas, the rise in production didn't offset the drop in imports. In total, the supply (comprised of imports and production) declined in the past couple of weeks, while the demand for oil has increased. The developments in the gap between supply and demand and the changes in weekly oil prices are presented in the chart below. 

Source: Energy Information Administration

As you can see in the chart above, in the past several weeks the supply has fallen below refinery inputs; this development suggests the oil market has tightened. If this trend persists, this could further push up the price of oil in the coming weeks. 

Looking to 2014, according to the EIA oil report, the current expectations are that U.S. oil consumption will remain stable compared to 2013. On the other hand, oil production is projected to rise by roughly 14%. This trend is likely to pressure the price of oil later next year.

But in the short term, oil prices might continue to rise. If you consider an oil-related investment such as an exchange-traded fund, you should take into account its disadvantages.  

Oil ETFs
One of the potential disadvantages of owning an oil ETF, such as United States Oil Fund (NYSEMKT: USO  ) , is the adverse impact contango could have on its pricing. Contango occurs when long-term future contracts are priced higher than short-term contacts. This ETF mostly owns near-month's future contracts. Before the contract expires, however, the ETF sells near-month future contract for next month's contract. If the next month's contract price is higher than near-month's price, the market is considered in contango; in such a case, the investment value of next month's contract would tend to rise slower than the spot price of oil, or drop faster.

Therefore, when the market is in contango, the ETF loses money with respect to the changes in the spot price of oil. If the contango continues, holders of this ETF won't benefit from the rally in oil as much as investors holding oil contracts would. 

Finally, investing in the United States Oil Fund includes a 0.4% management fee. This is another factor that will further cut the return on such an investment. 

The chart below presents the movement of this ETF and the price of oil normalized to the end of November 2012. 

Source: Energy Information Administration and Google Finance

As seen above, the price of oil rose by 11.7% during the year while the ETF rose by 9%. This isn't a huge gap but still means a lower return for ETF holders. 

Besides investing in oil via contacts and ETFs, refiners such as Valero Energy (NYSE: VLO  ) and Marathon Petroleum (NYSE: MPC  )  are an alternative worth considering.

Let's review how these companies are expected to perform in the fourth quarter.  

Are refiners making a comeback?
Leading refinery companies such as Valero Energy and Marathon Petroleum are likely to see a rise in their refining margins, which have been low in the past several quarters and contributed to a decline in profitability. In the third quarter, Valero Energy's profitability fell from 3.8% in the 2012 period to 1.5% in 2013. Conversely, the company's revenue rose by 4.1%, year over year. The rise in revenue was mostly due to higher throughput volumes on account of less unplanned maintenance activity and less weather-related downtime. 

Marathon Petroleum, even more than Valero, grew its revenue by 23.7%. Despite the sharp rise in revenue, the company's profit margin also contracted from nearly 9% to 1.2% in the third quarter. The jump in revenue was due to a spike in total refinery throughputs of approximately 39%. This rise in throughputs was mostly attributed to the Galveston Bay refinery, which Marathon Petroleum acquired on Feb. 1. 

In the fourth quarter, average refinery inputs in the U.S. grew by 2.5% -- this number could suggest that leading refinery companies have also increased their throughput volumes by a similar rate. Moreover, the price of West Texas Intermediate crude oil increased in the fourth quarter by roughly 10%, year over year. The discount of WTI versus Brent has also improved to an average of $11.9 per barrel -- the highest level since the first quarter. This discount is still nearly half the discount in the fourth quarter of 2013, but it does suggest the profitability of both companies may improve compared to the third quarter. Therefore, these companies are likely to further augment their revenues and improve their profitability in the fourth quarter. 

Takeaway
The oil market might continue to heat up in the near future, which could benefit refiners. The rise in oil prices and improved discount of WTI oil versus Brent oil could result in higher profit margins for oil companies.

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