Diesel shortage Moram
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Why the Diesel shortage is here to stay

Introduction to diesel shortage

The underinvestment in refining capacity and refinery closures that we have witnessed in the US and Europe for the last years, along with the huge number of operation disruptions this year have resulted in the scarcity of diesel and refined oil products that we have today. 

In this article, we are going to focus on the US situation as we spot some investment opportunities in this country. However, we need to have in mind that due to the fact that oil products can be put on ships and moved thousands of miles, this is a global and interconnected market.

The huge dependency that Europe had (has) on Russian refined products and the consequent ban on them has hugely tightened the European markets. As a domino effect, it impacts the US as it has a higher demand to export its refined products from Europe. Furthermore, the US has also banned refined Russian products which meant a significant amount of imports. Both movements have impacted local prices.

The role of India and China is also determinant. Both of them are the most important refined products importing countries. They are in part beneficiating from the European ban on Russia as they are buying (mainly India) these products. In fact, the dynamics of this global crisis and how the refined products & crude oil products flows are changing after the Russian-Ukrainian war is quite interesting. We will talk about it in another article if there is interest in the topic.

EU imports ban on Russian products - Moram

Record gasoline prices in summer

Earlier this year, in summer, gasoline and diesel prices reached historic highs prices. It raised all political alarms and gasoline prices became a top national matter. Diesel is more important for the economy but people in the US drive gasoline cars, being more vote-sensitive. So from a political perspective and having the mid-term elections in November, it was the focus of the White House. After several weeks of very high gasoline and diesel prices, prices fell due to unprecedentedly high refinery utilisation and some demand destruction. However, gasoline and diesel have followed very different paths since summer. Diesel prices are close to all-time highs and gasoline prices have moderated considerably.

A quick reminder that a barrel of crude oil can be “cracked” into different products, from home heating oil/diesel to gasoline / other products. Oil refiners can choose (well, depending on the refinery Nelson factor) to produce one product or another. They tend to produce the products the in highest demand at the time. This generally means gasoline (which accounts for roughly half of overall oil-product consumption) takes precedence over diesel in the driving season (summertime). This trend usually peaks on Labour day. After that, the production of diesel/heating oil increases and refining margins tend to draw in along with the nights.

Diesel, the real problem

This winter looks different. Crack spreads are at unusual levels for this time of the year. The 3-2-1 crack spread (margin of taking 3 barrels of crude oil and transforming them into 2 gasoline and 1 diesel) is close to record levels (June 2022).

Nevertheless, there is something relevant to point out. This is all about diesel. While gasoline prices collapsed in August as demand fell due to high pump prices, diesel cracks rose this month to more than $80 a barrel and US diesel fuel stocks reached the lowest level since 2008.

There are some reasons to explain this:

  • Diesel demand in the US has recovered quicker than gasoline from the impact of the pandemic, draining stocks.
  • Foreign demand for diesel is very strong. The high natural gas prices across the world along with several outages are making refineries in other parts of the world produce less than usual. It makes American diesel exports run at an unusually high level.
  • The US also has a lower refining capacity than before. According to the Department of Energy (DOE), the US refining capacity is 17.9 MM Boe (down from 20MM before Covid almost to the level it was at the beginning of 2010). U.S. consumption during that period rose to about 20.5 million barrels per day from about 18.6 million.
  • Russia’s invasion of Ukraine and the consequent sanctions from the US to import Russian oil.  The US was importing a significant amount of Russian fuel oil before the war, which its Gulf of Mexico-based refiners turned into diesel. 

Moreover, all of that happened during the months of the year that were supposed to build Diesel inventories. Because, as you can imagine, Diesel demand is expected to be quite strong during wintertime as diesel is used as backup power and heating fuel, apart from its normal uses in transport and industry. A lot of diesel will be used for power generation, as well as for heat generation in the industry, commercial, residential and other sectors

US Crude Inventories - Moram
Source HFI Research

The refining industry is printing money

If there is an industry which is making profits from it, it is the refining industry. Overall, every single refiner in the US is making tons of money because of the huge crack spread margins. 2Q22 was one of the best quarters on record for the industry. And the 3Q22 and 4Q22 look very similar. This week $PBF reported another jaw-dropping net income figure (3Q22). And it is expected that the rest of the industry shows extraordinary figures.

For anyone who is not familiarised with the industry, some of the most relevant US players are:

  • Valero Energy – $VLO, $48 Bn Market cap (Pure player)
  • Marathon Oil – $MRO, $20.5 Bn Market cap (E&P player & Refiner)
  • Marathon Petroleum – $MPC, $56Bn Market cap (Refiner & Retailer)
  • CVR Energy – $CVI, $4 Bn Market cap (Refiner & Fertilizer)
  • PBF Energy – $PBF, $5.65Bn Market Cap (Pure player)
  • Delek Energy – $DK, $2.1Bn Market cap ( Retailer & Refiner)

The economics of the industry are quite straightforward. Crude Oil is the feedstock they need (so it is a cost) and gasoline/diesel (product) is the revenue. Then, you also need to factor in the consumption of natural gas to run the refinery,… As Crude Oil is in $/barrel and Gasoline / Diesel are in $/gallon. A quick math to calculate the 3-2-1 crack spread is: 2* gasoline price * 42 + diesel price* 42 – 3* WTI. There is more crack spreads not only 3-2-1 but this is by far the most popular.

Apart from the evident positive signs for the industry. We would like to highlight that there is a potencial risk that the administration ban refined-product exports from the US. This would reduce considerably both crack spreads and retail prices. However, the consequences for Europe & other US allies would be catastrophic. We believe that this is not going to happen. But we need to point it out.

Vertex – The end of the hedges in the most possible bullish environment

As the divergence between Diesel and Gasoline has stretched considerably and it is probable that it continues into the winter period. It is logical to think that refiners producing Diesel will benefit the most in this environment.

Thinking about how to play this trend (and being aware of our high tolerance to risk). We came to Vertex Energy. We know well this company as we invested back in May, and they mixed up with bad hedges and bad communication to the market. And it is evident that human beings love to trip over the same stone twice. We hope not to suffer the same fate again

In brief, $VTNR is a small-cap company. They acquired a refinery with a capacity of 75000 boe/d (27% distillate, 24% gasoline, 17% Jet Fuel). They took over the Mobile refinery on the 1st of April 2022 and hedged 50% of its production at a low price. Moreover, they had problems with the supply and offtaking agreement signed with Macquarie. As a consequence, they managed to do the unthinkable, losing money in 2Q22.

Three months after the 2Q22 report release, the stock price is still depressed as the market lost confidence in the company. Fortunately, the hedges finished on 30th September and it has encouraged us to take a look at the company again.

We made some calculations:

Source: Moram

The magnitude of the money that they are printing in this environment for an $800MM fully diluted market cap company is remarkable. And because of the 2Q22 report, and consequent market sentiment, the gap with its peers is enormous. We believe that the end of hedges plus the 3Q22 results can act as a catalyst for the company and replicate the violent upside movements that it did earlier this year. Nevertheless, it is a high-risk-reward bet. There are other interesting options within the sector to play the trend without being so exposed to volatility such as Valero Energy.

Apart from it, there is a Renewable Diesel project (8-14k boe/d capacity) starting 2Q23 that will bring additional cash flows to the company starting soon (we are not analysing the impact of the RD project in this article but it is the real reason behind the acquisition of Mobile refinery from Vertex). 

Our thoughts about the diesel shortage

We believe that the crack spreads are going to remain unusually high during the coming months due to the factors explained in the article. The refining sector is going to benefit from it considerably. We see Vertex Energy as the black sheep of the sector due to its past performance. However, we believe that if the management is able to communicate clearly the 3Q22 results and there are no more hedges in place. The share price can re-rate notably.

As we see a significant potential upside, but we also remain cautious due to 2Q22 earning call performance and the volatility tied to $VTNR, our exposition is via calls.

Note: In this article, we pretend to explain our views about the diesel situation and the refining industry. As always, we are transparent with our thoughts & positions. However, this does not constitute any investment advice.

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