Petroleum Refining and Oil Prices: Is it Time to Dig into Oil and Energy Stocks?

Sam Subramanian PhD, MBA

Weakness in the U. S. dollar and hopes of an improving global economy have thus far pumped up the price of oil. Oil has nearly doubled in price over the past three months.

While oil is taking its cue from the U. S. dollar on a day-to-day basis, the uptrend appears to be running into resistance in recent trading sessions.

News of unrest in nations like Iraq and Nigeria has failed to spike oil prices. The reality of slack product demand is seeping into the oil pits.

Product demand

Gasoline demand in the U. S., is nearly 6% lower than it was a year ago. According to the U. S. Department of Energy, gasoline inventories recently tallied 205 million barrels, following their biggest weekly increase.

The distillate picture is even more disconcerting. The deep recession has slowed industrial activity including freight transportation and taken a toll on diesel demand. Total U. S. demand for distillates is averaging nearly 3.4 million barrels per day, about 20% lower than year-ago levels.

Oil Price Forecast

In the near-term, gasoline demand in the U. S. should start to taper after the Fourth of July weekend. Beyond this seasonality, trends in disposable income will become a key factor driving gasoline demand. In distillates, diesel demand is likely to move in tandem with Gross Domestic Product while heating oil demand will be driven by weather patterns particularly in the Northeast.

Looking outside the U. S., China and to a lesser extent Brazil and India are expected to contribute to global growth. Europe is mired in a deep recession and is widely expected to lag the U. S. in recovery. As such, the possibility of a synchronized global recovery that rapidly boosts oil demand appears remote. Led by a 4.9% decline in U. S. consumption, the International Energy Agency expects global oil demand to fall 2.9%.

Meanwhile, supplies of oil seem adequate. While OPEC countries appear to be generally disciplined in limiting shipments to around 28.0 million barrels per day, non-OPEC production is increasing. Russia's output appears to be higher than earlier estimates.

Against this backdrop of slack product demand and plentiful oil supplies, it is prudent to take a relatively conservative view on the outlook for the price of oil. This backdrop also has somber implications for refining and alternative energy shares.

Take Profits in Alternative Energy

The fortunes of alternative energy stocks like First Solar (FSLR) and ETFs like PowerShares WilderHill Clean Energy (PBW) are tied as much to the price of oil as investors' risk appetite. Alternative energy stocks are unlikely to fare well if oil loses price momentum and upside is capped in the near-term. Given the healthy run-up in alternative energy shares in recent months, it is worthwhile to consider paring bets here.

Hold-off on Refiners

Slack distillate demand is causing refiners to curtail production when they should be building inventory ahead of the winter season. U. S. distillate inventories have climbed to 42 days of supply from nearly 28 days of supply a year-ago. The average price of diesel in the U. S. has fallen below that of gasoline for the first time since 2007.

Barring a major surge in demand, high distillate inventories are likely to act as a buffer and keep prices in check. It is prudent to take a wait-and-see posture on shares of refiners like Frontier Oil (FTO), Holly Corp. (HOC), Tesoro Corp. (TSO), and Valero Energy (VLO). If global growth surprises to the upside and product demand becomes more robust, such stocks can offer healthy potential for appreciation over the long-haul.

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