Oil price surge obscures emerging refinery cushion

By Jonathan Leff and Richard Valdmanis - Analysis

SINGAPORE/NEW YORK (Reuters) - Oil's thundering rally over the past six days may be masking a bearish turning point for the market -- the recovery in refining capacity, which could end a three-year squeeze on global fuel supplies.

If, as many analysts expect, refiners manage to bring new plants onstream on time next year, the world may enjoy its biggest margin of spare fuel supply capacity in years, relieving one of the major risk factors that has lifted oil prices.

It would also put the market's spotlight back on crude oil fundamentals, potentially improving OPEC's ability to put a cap on prices after years in which the promise of additional crude meant nothing to refiners unable to process.

"I think we're coming to a point where we're turning the corner to a crude push rather than a product pull, which obviously isn't good for margins," says Jeff Brown, managing director at FACTS Global Energy, a consultancy that advises oil companies about investments in the refining sector.

Traders say the past week's activity has shown that crude -- not oil products -- is in the driver's seat for now. U.S. crude catapulted 10 percent to a new record high of $88.20 a barrel.

The premium for heating oil futures over crude has dropped about $2 to nearly $10 a barrel as crude rallied; gasoline's premium has languished at only $4.

Even as the market seems to be signaling that fuel supplies are adequate, prices have roared higher on a surge in investment funds triggered by the threat of violence in northern Iraq and fears over insufficient crude oil supplies this winter.

"Speculation on crude is leaving fair value far behind," said Tim Evans, energy analyst at Citigroup Futures Research. "Demand is weak and crude oil could roll over and die at almost any juncture here."

The product lag is partly due to the seasonal autumn ebb in consumer demand, which could quickly reverse this winter.

But some analysts say it may also be the first sign that the world's refiners -- whose underinvestment laid the foundation for oil's meteoric rise -- are finally catching up with demand.

FACTS estimates that 2 million barrels per day (bpd) of basic crude refining capacity and 1.5 million bpd of cracking capacity -- upgrading products into premium fuels such as gasoline and diesel -- will come onstream in Asia and the Middle East in 2008.

That outstrips regional demand projected to grow by 1.2 million bpd, good news for an oil market on edge over a shortage of refined fuel supply, bad news for refiners such as Valero Energy Corp (VLO.N), Europe's Total (TOTF.PA) or Japan's Nippon Oil Corp (5001.T) who have enjoyed booming profits.

LONG IN COMING

The capacity growth is no surprise -- the margin boom since 2004 provoked a wave of very public investment in the notoriously cyclical sector, especially in Asia and the Middle East.

The situation has already improved from a low point in 2005, when global refining capacity exceeded oil demand by only 3.4 percent, less than half the "supply cushion" that existed in 2001, according to BP's Statistical Review.