Crude nears record quarterly price

Sam Fletcher
OGJ Senior Writer

Oil prices had a strong start this year with the first quarter on course for the fifth-highest quarterly average price ever for key benchmark crudes and “on track to average even higher for the balance of the year,” said Costanza Jacazio, vice-president of Barclays Capital Commodities Research in New York.

“The path of upstream earnings has been a near-perfect ‘V’ shape, with the blip down in late 2008 and early 2009 having been reversed relatively quickly,” Jacazio said. “By contrast, downstream earnings have been following, at best, an ‘L’ shape. Refinery margins have remained depressed, albeit averaging a little higher than the very weak fourth quarter of 2009. Indeed, the first quarter looks set to be one of the weakest five quarters over the past 5 years for refinery profitability,” she said.

Jacazio observed: “The upstream has always been the more glamorous part of the industry as it generated economic rents, which were further protected by the Organization of Petroleum Exporting Countries’ policy, and which also generated most of the past and the present leaders of the major international oil companies. Oil refining has never accrued the same mystique and has often acquired the image of being a source of value destruction. High exit costs, occasionally perverse responses to price incentives and protective regimes in several key competing countries have all, inter alia, made the adjustment path in the downstream a long and often tortuous one.”

Jacazio said, “Strong demand for crude in China and India is one of the key positive factors for the upstream over the next 5 years. However, aggressive refinery expansions plans in the same countries are key negative factors for downstream margins. Spare crude output capacity started the downswing at a very limited level, and has remained under OPEC’s effective control throughout the cycle. By contrast, spare distillation capacity started the cycle at higher levels, and has been further bolstered by lower demand and significant capacity increments. Even with the recent capacity deferments, it seems most likely that by the middle of the decade, significant and stubborn upstream capacity tightness is likely to coexist with relatively slack conditions in refining.”

She noted, “Indeed, it may take many years for downstream excess to be burned up fully. The diagnosis is still of a crude-led market extending into the medium term, with rising crude price floors and potentially a need for some further burning up of demand to ration scarcer capacity.”

Downstream recovery lacking
The downstream sector has not yet transitioned to a recovery phase. “In Europe and the US, refining margins, as well as utilization rates, reached a low point in the fourth quarter, with earnings from the sector continuing to deteriorate,” said Jacazio.

“While margins have improved slightly in 2010 to-date relative to the extremely depressed levels of late 2009, they still remain well below first quarter 2009 levels, as well as low by historical standards. Moreover, there is no sign yet of a rebound in utilization levels across the Organization for Economic Cooperation and Development. Indeed, the downstream sector is now facing the combined effect of the slump in demand and the roll-out of the investment cycle following prior years of refining tightness and high margins. This simultaneous reshaping of the demand and supply sides has meant the complete structural reconfiguration of the underlying balances of the refining system, in our view. The key problem hampering the recovery in the refining sector is the size of new downstream capacity being added in fast-growing demand centers and across low-cost oil producing regions. Besides enjoying a competitive advantage, these projects are often strategically motivated and thus subject to a lower risk of cancellation,” she said.

Gas recovery uncertain
At their recent institutional investors conference, analysts in the Houston office of Raymond James & Associates Inc. said there were as many views on the timeline for recovery of natural gas prices “as there are people in the room, though the bias clearly points to a more painful and protracted downturn than most companies and investors would have anticipated a year ago.”

On the oil side, they said, there was broad-based agreement the global market is fundamentally healthy.” Raymond James noted reports showing OPEC nations increased drilling at the fastest rate in over 2½ years in January-February, which may place pressure on prices. “The spike in the rig count comes alongside news that member nations, excluding Iraq, exceeded production quotas by approximately 1.9 million b/d during the month of February,” they said.

(Online Mar. 15, 2010; author’s e-mail:

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