Oil Majors Could See Trouble Ahead

Rupert is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Over the past year oil majors such as Chevron (NYSE: CVX)ExxonMobil (NYSE: XOM)Phillips 66 (NYSE: PSX) previously part of ConocoPhillips - and Royal Dutch Shell (NYSE: RDS-B) have all reported great earnings. The reason for these better than expected earnings was higher refining margins.

Refining margins are effectively the profit margin that each company makes for a barrel of oil after it has been refined into a petroleum product and sold. Over 2012, refining margins were high as refinery shutdowns and adverse weather conditions drove up the selling prices of refined products due to supply constraints - this lead to higher refining margins for all refiners across the world. Obviously this benefited the big oil majors, as they have the majority of their operations focused on refining as it is often the most stable part of their business.

<table> <tbody> <tr> <td> <p>Company</p> </td> <td> <p>% of business involved in refining</p> </td> </tr> <tr> <td> <p>ExxonMobil</p> </td> <td> <p>81%</p> </td> </tr> <tr> <td> <p>Chevron</p> </td> <td> <p>72%</p> </td> </tr> <tr> <td> <p>Royal Dutch Shell</p> </td> <td> <p>91%</p> </td> </tr> <tr> <td> <p>Phillips 66</p> </td> <td> <p>80%</p> </td> </tr> </tbody> </table>

The problem is, after the bumper season of 2012 there are now significant headwinds facing refining margins. These headwinds come in the form of increasing supply and decreasing world demand, both of which are forecast to increasingly squeeze refining margins in 2013.

There are three main refining margin indicators:

  • The US indicator
  • European Refining Margin
  • The Asian cracking margins. 

Last year saw the US refining margin jump from $6 per barrel (bbl) up to $16 bbl through some points of the year, especially around the time of Hurricane Sandy. The European refining margin also jumped from as low as $2bbl up $12 as a major refiner in the UK became insolvent and filed for bankruptcy. These margins are some of the highest that have been seen in many years. Indeed, the last 2 months of 2011 saw refining margins fall so much that refiners in the US were actually losing -$2bbl!

These historically high margins seen in 2012 have already disappeared as the average refining margin in all three zones at the end of 2012 was near $5, and there is even more pain forecast to come.

As I have already said, the majority of last year’s gains were brought about through supply constraints. However, this year there will be a lot more supply coming on-line. It is expected that global refining capacity will increase by a total of 1.7 million barrels per day in 2013. Furthermore, it is predicted there will be another capacity increase of nearly 2 million barrels per day in 2014.

All this additional capacity is not good for refining margins. Despite the planned increase in refining capacity in 2013 there is forecast to only be an increase in demand of 1 million barrels per day. That leaves a surplus and oversupply of 700,000 barrels of refined oil per day.

This overcapacity is going to hit refining margins. Over the course of 2013 margins are expected to average $4bbl in Asia and Europe and at some points falling as low as $2bbl. The US, on the other hand, will see margins of around $6bbl - much less than the record margins seen this year.

These falling margins will hit the oil majors hard. With such a high amount of their revenue stemming from refining they depend on decent margins to provide recurring income. Furthermore, as it is well known that oil production volumes from the oil majors are decreasing.  Hydrocarbon production is often the most lucrative and erratic side of the oil majors business, even though it only accounts for such a small amount of revenues. Big oil is increasingly relying on refining to produce stable cash flow.

To highlight the dependency on refining margins and the impact of profit they have, here are the results from Chevron, Exxon, Shell and Phillips 66 over the second and third quarters of last year. The refining margins I am using are an average of the US and European margins.

<table> <tbody> <tr> <td>Company</td> <td>Refining Margin Q2</td> <td>Revenues Q2</td> <td>Refining Margin Q3</td> <td>Revenues Q3</td> <td>% Change </td> </tr> <tr> <td>Exxon</td> <td>$8bbl</td> <td>$124B</td> <td>$6.3bbl</td> <td>$112B</td> <td>-1.6%</td> </tr> <tr> <td>Chevron</td> <td>$8bbl</td> <td>$63B</td> <td><span>$6.3bbl</span></td> <td>$58B</td> <td>-8.6%</td> </tr> <tr> <td>Phillips 66</td> <td><span>$8bbl</span></td> <td>$47B</td> <td><span><span>$6.3bbl</span></span></td> <td>$43B</td> <td>-9.3%</td> </tr> <tr> <td><span>Royal Dutch Shell</span></td> <td>$8bbl</td> <td>$117B</td> <td><span><span>$6.3bbl</span></span></td> <td>$112B</td> <td>-4.2%</td> </tr> </tbody> </table>

Obviously the two smallest companies by revenue - Chevron and Phillips - have seen the biggest impact to their revenues. Exxon has taken the biggest hit in dollar terms due to its huge size.

This table highlights how significant the changes in the refining margin can be. With the refining margins forecast to fall even lower next year there could be a surprise around the corner for oil investors. 

Unless of course demand for oil and petroleum picks up - or there is another year of supply constraints.

RupertHargreav has no position in any stocks mentioned. The Motley Fool recommends Chevron. The Motley Fool owns shares of ExxonMobil. 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. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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