Higher Inventory Drags Down Oil

The U.S. Energy Department's weekly inventory release showed a surprise buildup in crude stockpiles. The agency’s bearish report further added that gasoline supplies rose much more than analysts projected, while refinery rates remained at historically low levels. The only saving grace came in the form of distillates, whose stocks were down more than expected.  

The federal government’s Energy Information Administration (EIA) reported a 2.1 million barrel rise in crude inventories for the week ending November 27, as against analyst expectations of a drawdown. The substantial increase in stockpiles can be attributed to curtailed refinery operations and improved domestic production, partially offset by reduction in crude oil imports.

Current crude oil stocks, at 339.9 million barrels, are 6.1% above the year-earlier level and remain above the upper limit of the average for this time of the year (depicted in the first EIA chart below). The supply cover increased marginally, from 24.3 days in the previous week to 24.5 days of supply, and is well above the year-earlier level of 21.9 days.
 

 
Supplies of gasoline rose by a whopping 4.0 million barrels from the previous week (analysts hoped for a much lower build), as motor fuel demand continues to be stifled on the back of high unemployment. At 214.1 million barrels, current inventories are above year-earlier levels, and are above the upper half of the historical range, as shown in the following chart from the EIA.
 

 
Distillate fuel inventories (including diesel and heating oil) dropped by 1.2 million barrels last week (compared to an expected fall of 450,000 barrels) to 165.7 million barrels, reflecting stable demand ahead of the winter. However, it remains above the upper boundary of the average range for this time of year. This is shown in the following chart, also from the EIA.
 

 
Refinery utilization was down 0.6% from the prior week to 79.7%, contrary to analyst expectations of an uptick. The recent refinery shutdowns in the midst of weak profit margins are keeping refinery runs below 80%, historically low levels for this time of year. 

The overall demand picture remains weak, as reflected by the dip in the total refined products supplied over the last four-week period, a proxy for overall petroleum demand. It fell by 3.2% from the year-earlier period, with gasoline up 0.7%, distillates (includes diesel) down 7.7% and jet fuel up 0.1%.

With crude inventories and gasoline supplies both rising last week, we take this as an indication that demand in the world's largest economy remains weak. As a result, following the EIA release, oil prices fell below the $78 per barrel level. Additionally, we believe that the higher-than-expected drop in distillate inventories was triggered by weak refinery activity rather than a much-awaited pick-up in oil demand.

As such, we prefer to maintain our cautious stance on oil refiners like Sunoco Inc. (SUN - Analyst Report), Tesoro Corp. (TSO - Analyst Report) and Western Refining Inc. (WNR - Analyst Report), given that the overall environment for refining margins is likely to remain poor going into 2010.

The sharply lower refinery utilization (at just 79.7% of capacity) provides enough evidence that refineries are cutting back on production because the economy is still struggling on the demand side. Being the largest independent refiner, Valero Energy Corp. (VLO - Analyst Report) remains particularly exposed to this unfavorable macro backdrop. We see little reason for investors to own Valero and have an Underperform recommendation on the company. In fact, crude consumption has fallen so much that recently Valero had to idle its Delaware City refinery.

Companies like ConocoPhillips (COP - Analyst Report) and ExxonMobil Corp. (XOM - Analyst Report) – oil majors that have significant refining operations – are also expected to remain under pressure until pricing and demand improve.

We would also like to maintain our cautious outlook (Neutral recommendation) on integrated oil players and oilfield service firms until the demand outlook improves. Companies such as Chevron Corp. (CVX - Analyst Report), Marathon Oil Corp. (MRO - Analyst Report), Hess Corp. (HES - Analyst Report), Schlumberger Ltd. (SLB - Analyst Report), Baker Hughes Inc. (BHI - Analyst Report) and Weatherford International (WFT - Analyst Report) fall in this category.

Read the full analyst report on SUN

Read the full analyst report on TSO

Read the full analyst report on WNR

Read the full analyst report on VLO

Read the full analyst report on COP

Read the full analyst report on XOM

Read the full analyst report on CVX

Read the full analyst report on MRO

Read the full analyst report on HES

Read the full analyst report on SLB

Read the full analyst report on BHI

Read the full analyst report on WFT