Will Oil Prices Change Course and Fall?

Will oil prices fall from their current high levels? Let's examine what could bring oil prices down and the ramifications for Chesapeake Energy and Marathon Petroleum.

Jun 24, 2014 at 11:15AM

The price of West Texas Intermediate oil is getting close to the $110 mark. The recent developments in Iraq are pushing oil prices higher. At the same time, the premium of Brent oil over WTI has diminished to around $5. These developments are likely to impact oil producers such as Chesapeake Energy (NYSE:CHK) in a different way than oil refiners such as Marathon Petroleum (NYSE:MPC). Let's see what could bring down oil prices and what the potential ramifications are for oil producers and refiners.

Lower spread
By the end of the first quarter, the spread between Brent and WTI was around $6.50 per barrel. Currently, the spread is close to $5.50 per barrel. Will the spread keep falling? 

In the recent OPEC Summit, the members decided to keep OPEC's production unchanged at 30 million bbl per day. According to the recent OPEC report, its production during May was 29.6 million bbl per day.

The current concerns revolve around the recent violence in Iraq. In May, the country's production remained stable, according to the recent OPEC report. Iraq's production accounts for nearly 10% of OPEC's total production. A drop in its production could pressure up oil prices over the short run. Back in 2011, Libya's civil war resulted in a sharp fall in its production, which hasn't recovered since. Libya's oil output is currently 200,000 bbl/day, but back in 2010 it was around 1.6 million bbl/day. Back then, Saudi Arabia picked up its production to reach OPEC's quota of 30 million bbl/day. Since Iraq's production is much higher at 3.2 million bbl/day, a disruption could have a substantial impact on the oil market. 

For the U.S, however, Iraq accounts for only 3% of its total oil imported in 2013. A disruption in Iraq's oil output isn't likely to have a direct impact on WTI oil prices. 

Conversely, oil production of non-OPEC countries has picked up in recent months, according to the latest monthly update by the International Energy Agency. 

Therefore, for now, the stable production of OPEC and rise in non-OPEC countries' production are likely to keep Brent oil close to WTI oil, unless of course, the tensions in Iraq further escalate to a revolution. If the turmoil in Iraq translates to a sharp fall in its oil output, this could bring Brent oil prices higher and widen the gap between Brent and WTI. 

In the meantime, the ongoing drop in the spread between Brent and WTI is likely to reduce margins for oil refineries such as Marathon Petroleum in the second quarter of 2014. In the first quarter, the company's gross profitability dropped to 4.8% -- a year earlier this spread was 7.6% .

In the past couple of months, the spread between Brent and WTI was $6.60, which is 28% lower than in the second quarter of 2013. This low margin is likely to reduce Marathon Petroleum's profitability this quarter. If the spread falls further, the company may need to revise its current outlook for a $7-$12 range. 

High imports and production
According to the latest U.S Energy Information Administration report, oil supply has grown by 0.4% since the beginning of the year. This was mainly due to the 4% gain in oil imports and 1.4% increase in oil production. As a result, the total supply (comprising of imports and production) has reached 15.74 million barrels per day. 

During the second quarter (to date), the average price of WTI and Brent oil rose by 8.3% and 5.1%, respectively, compared to the same quarter last year. These elevated prices will improve the top and bottom line for oil producers such as Chesapeake Energy.

For Chesapeake Energy, oil accounted for 44% of its sales in the first quarter. Based on this rate, and assuming all else equal, the company's revenue from production is expected to pick up by 3.5% in the second quarter compared to the first quarter. 

In the coming quarters, Chesapeake Energy plans to increase its oil output from assets such as its Eagle Ford shale holdings. This would further improve its profit margins with such high oil prices.  

In conclusion
The recent conflict in Iraq may drive Brent oil price higher, but the fundamentals show that WTI could come down below $100 in the coming months due to strong production and stable demand for oil. In the meantime, oil producers such as Chesapeake Energy will benefit from these high oil prices. On the other hand, oil refiners such as Marathon Petroleum will record smaller profit margins due to the declining spread between Brent and WTI. If the tensions in Iraq result in a sharp drop in its oil output, however, this could bring the spread between Brent oil and WTI higher and thus improve the company's profitability in the following quarters.   

Lior Cohen has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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