A Canadian who is asked about the primary source of crude demand will likely answer "transportation fuels" and be generally correct. But there's an important middle step missing in this response – one that is important now – because the more accurate answer is that the biggest source of demand for crude is the oil refinery industry, so that they can make fuels. Right now, there are signs that refinery demand is set to fall, and take the crude price with it.
Gasoline is the most important source of oil demand and inventories are currently at post-financial-crisis highs. The top chart compares the total U.S. gasoline inventories (as reported by the Department of Energy) compared with the crude price.
The oil price has generally moved in the opposite direction of gasoline inventories for the past decade, but not always. From late 2010 to mid-2012, for instance, the two lines on the chart moved mostly in the same direction (more on this in a moment).
In the past two years, the inverse relationship between gasoline inventories and the crude price has been extremely clear. Inventories have spiked significantly higher during periods where the oil price fell. When the oil price falls, refiners buy more, produce more gasoline and inventory levels climb.
Gasoline stockpiles hit a decade high of 258 million barrels in February of this year exactly at the time when the WTI crude price bottomed near $29.50 (U.S.) a barrel. The recent rally in crude occurred as gasoline inventories fell during their usual summer driving seasonal pattern.
The lower chart shows the profit margins available to refiners as they process on each barrel of oil. The index name is intimidating – "Bloomberg Nymex WTI Cushing Crude Oil First Month 321 Crack Spread" – but it's basically the amount of profit a refiner makes selling gasoline and other distillates on each barrel of oil.
The most notable segment of the chart is the period between August, 2011, and February, 2013, when refiner profits averaged an extraordinarily high $31 a barrel. This time frame roughly coincides with the segment in the top chart when the usual oil-prices-up/gasoline-inventories-down pattern broke down. Refiners were making so much money from each barrel of oil that relatively smaller moves in the crude price did not affect business activity and inventory levels.
The current crack spread, at close to $15 a barrel, is not far off the five-year lows. The much smaller profit margins for refiners means they are less motivated to buy oil in the market.
The current combination of high gasoline inventories and low crack spreads is significantly limiting U.S. oil demand and has been a major driver behind the oil price drop from $51.23 on June 8 to current levels around $46.50. The upside for the oil price is likely to remain limited, or possibly non-existent, for as long as this environment persists.
The good news for investors is that, as the charts show, gasoline inventories and particularly crack spreads can change violently and rapidly, and they may not have long to wait before the fundamentals behind crude demand improve. Until then, however, they should tread cautiously in energy-related investments.
Follow Scott Barlow on Twitter @SBarlow_ROB.