By James Cordier
Oil prices are on the way back up. The big question in the media these days is where is it going now. Like everyone else, I have my opinion (which I gladly shared on Fox Business this week, while my fellow analyst was aghast that I dare counter Goldman’s forecast).
Goldman and the other bears may eventually be right. Prices may indeed level off or even fall later this year. But they may be trying to turn the music off on a party that is just hitting its stride. Let’s examine what is driving crude prices now.
Current fundamentals favor bulls
A big focus of many oil bulls has been the falling rig counts in the U.S. To be sure, U.S. rig counts have fallen drastically. There are only 84 rigs now operating on North Dakota's Bakken Shale vs. 209 in early 2012. Nationally, the count is down to 679 from 1,527 just last year. Yet crude production levels have not yet fallen significantly. We cannot then, directly attribute the rise in crude prices simply to falling rig counts. Something else is going on.
Economic incentive for refineries
Last week, the weekly Energy Information Agency stocks report showed the first draw on crude oil inventories in several months after swelling to all-time highs in April. This week saw the second consecutive draw on stocks. This weeks consensus was for a 400,000-barrel draw on stocks. Instead, we saw a 2.2-million-barrel draw. Last week, consensus was for a 1.5-million-barrel build in stock levels. Instead, the EIA report showed a 3.9-million-barrel draw on stocks.
It appears that expectations are finally becoming reality.
This is not due to lower production but to refineries ramping up production, thereby using up crude supplies at a faster rate.
Refinery profit margins are soaring — giving them incentive to ramp up production now to make more profits while it lasts. And ramp up they are. As of May 1, U.S. refinery operating rates stood at 93%. This vs. 90.1% at the beginning of April and 87.8% at the beginning of March.
Refineries operating at higher capacity means producing more end products, such as gasoline. This means using raw crude oil at a faster rate, thereby drawing down supply.
But higher profit margins don't tell the whole story. There is another reason refineries are using up crude at a faster clip.
Crude-oil demand has a very cyclical nature to it. The summer driving season kicks in about June. Good weather brings vacationers and more overall traffic to the roads, driving up demand for gasoline. Distributors prepare for this phenomenon in advance by building up gasoline stockpiles in the spring. This increase in wholesale demand means refineries increase output during these time periods.
Thus the combination of high refinery profit margin and increased wholesale gasoline demand are driving up refinery operating rates. This is expected to begin to draw down crude stockpiles.