Refineries May Dictate Crude Oil Prices in the Future

Crude oil prices cannot keep rising, can they? The laws of supply and demand simply don't allow that. While it's convenient to keep supply-side issues in the limelight, it defies logic to consider just one side of the coin. Issues pertaining to demand are actually rearing their heads, and this could change the dynamics of the oil and gas industry in the near future.

The problem no one's talking about
Refiners in the U.S. particularly are having a hard time passing on high input costs (read: high crude oil prices) to end consumers, despite 10-month highs in average gas prices at the pump. Why? Consumers are simply driving less. As a result, demand for gasoline is dropping, and we are actually witnessing the classical laws of supply and demand at work.

Prices at the pump have steadily increased since the turn of this year. They're now up by more than 18%. According to the latest available data with the Energy Information Administration, average retail gas prices for the week ending April 23 stood at $3.92.

Source: Energy Information Administration.

Well, not surprisingly, things are now reaching a breaking point. While the most recent data on gasoline demand isn't readily available, an interesting statistic caught my attention.

Source: Energy Information Administration.

Net production volumes of motor gasoline have been declining for the past few months. And so has total gasoline deliveries by refineries. So would it be far-fetched to conclude that demand for gas has been dropping off? Are people driving less now than they were three months ago?

The kitchen's getting hotter
However, one thing is clear: Refiners are undoubtedly feeling the heat from high input costs and lower sales volumes. Ultimately, gross margins get affected. In the fourth quarter, most of the refiners saw plunging margins. For Q4 2011, Valero Energy (NYS: VLO) , the largest independent refiner, clocked in gross margins at an abysmally low 2% -- down from 7.6% in the third quarter. Some of its refineries, like the Aruba refinery, source crude oil from the international markets, which is more expensive. Brent crude oil has been trading an average of $15 higher than the U.S-produced West Texas Intermediate for the last six months. Thus, refiners having access to the cheaper blend could take advantage of the spread. In the process, HollyFrontier (NYS: HFC) and Western Refining (NYS: WNR) -- both having refineries located in the Mid-Continental region -- had access to the WTI blend, lowering input costs. Not surprisingly, they enjoyed better gross margins in the fourth quarter, at 9.4% and 25.8%, respectively.

Sunoco (NYS: SUN) , on the other hand, is planning to exit from its failing refining business altogether. The company is already in the process of selling off its Northeast refineries located in Philadelphia and Pennsylvania. Starting in July, Sunoco intends to idle its remaining refineries permanently.

What does it all mean?
Where are crude oil prices headed? Loss of end-consumer demand due to skyrocketing prices has led to unprofitable refining businesses. The next seemingly obvious step is refineries curtailing input volumes in the U.S. to lower costs. Of course, this is easier said than done since refineries will have to operate at full cost. But crude prices can't keep going up indefinitely.

Additionally, for those harping on a growing demand for energy from emerging economies to push up oil prices, the ride is going to be much rougher. Whispers of a Chinese hard landing are getting louder. The BRIC nations are still looking sluggish, with any real growth in energy demand a long way off.

The Foolish bottom line
The basic laws of supply and demand will eventually catch up. A timeline is hard to predict, but I won't be surprised if crude oil prices retreat in the next six months. Upstream companies may soon have to face a reality check -- especially those companies who bank on higher crude oil prices to boost profits. Do you think crude oil prices will come down in the next six months? Sound off below.

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At the time thisarticle was published Fool contributor Isac Simon does not own shares of any of the companies mentioned in this article. The Motley Fool owns shares of Western Refining. The Motley Fool has a disclosure policy.
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