By Liam Denning, 26 July 2015

Oil prices will weaken further once summer’s peak gasoline demand rolls over

If you want to understand why oil is back below $50 a barrel and likely headed much lower once summer ends, start with PetroChina’s stock prices.

Mainland-listed shares in China’s national oil champion are up 27% so far this year, while their Hong Kong-listed equivalents are down 9%. The former have, of course, been juiced by Beijing’s desperate measures to prop up the mainland stock market. The latter are more reflective of what is really happening with oil supply and demand.

China is showing signs of strain. While official gross-domestic-product data continue to helpfully meet Beijing’s targets, other numbers—and the stock-market panic— point downward. The latest, preliminary reading of the Caixin China Manufacturing Purchasing Managers’ Index hit a 15-month low. The State Council promptly announced measures to boost trade. Broad-based drops in the prices of industrial commodities from iron ore to copper serve as warnings of cooling China growth.

Oil hasn’t escaped. If current futures prices hold, Brent crude will average about $57 a barrel in 2015, down 42% from 2014’s average and the lowest in a decade. U.S. benchmark West Texas Intermediate’s implied average is about $51.40, which would be the lowest since 2004.

Yet even those averages look vulnerable; they rely on both grades rising through the fall and winter. For example, Brent futures for December trade at almost $57 a barrel, versus a current price of less than $55. Analysts are more optimistic, with a consensus forecast for the fourth quarter of around $65, according to FactSet.

So much for summertime thinking. Demand for gasoline, which peaks around now, is the biggest support to oil prices today. And it comes with a sting in the tail.

As refiners take advantage of cheaper crude, turning it into gasoline to meet demand, they are also producing a lot of distillate. That is a catchall term for other products, chiefly diesel, which is heading into storage. In its latest monthly report, the International Energy Agency showed stocks of middle distillates in the industrialized world in May were higher for that month than in each of the past three years. It said that “middle distillate spot prices posted the sharpest falls across all surveyed markets in June.”

Distillate refining margins in Asia already have fallen to about $8 from almost $11 a barrel a month ago. This is partly because new refining capacity in the Middle East geared toward diesel production has opened up and added to the glut.

Another factor is China, whose net exports of diesel hit a record in June, notes Citigroup. Diesel is the biggest refined product in China’s mix, reflecting economic growth that has been tied to heavy industry. But demand has topped out there as Beijing tries to pivot the economy toward consumers.

The danger is that economic weakness adds further pressure, pushing more barrels of distillate into the market even as the world’s seasonal demand for gasoline wanes. At that point, refiners looking to maintain profit margins would slash bids for crude oil, below even today’s already depressed levels. Stocks of oil majors—maybe even PetroChina’s steroidal A-shares—would surely follow.

Extracted in full from The Wall Street Journal.

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