(John Kemp is a Reuters market analyst. The views expressed are his own)
* Chart 1: tmsnrt.rs/20WQt9F
* Chart 2: tmsnrt.rs/20WQzhl
* Chart 3: tmsnrt.rs/20WQE4M
By John Kemp
LONDON, Feb 25 (Reuters) - According to the U.S. government, there are over 1.3 billion barrels of crude oil and refined products in commercial storage around the United States, an increase of more than 300 million barrels in the last two years.
There is a tendency to assume all these barrels of crude and products are “excess” inventories, the result of overproduction, but most of them are held for operational reasons.
The best way to distinguish excess inventories from normal operational stocks is to adjust reported inventories for time of year, consumption of crude by refineries, and consumption of products by end customers.
Other things being equal, the more crude refineries process every day, the more crude they need to hold on site, at tank farms or en route to the refinery in pipelines and on ships to keep their distillation towers supplied.
And the more fuel supplied to customers, the more refined stock refineries, blenders and distributors need to keep on hand to deal with seasonal swings, maintenance and unexpected disruptions in the supply system.
Since the start of 2015, U.S. refineries have been processing record amounts of crude to meet strong demand for gasoline as continued growth, rising employment and cheap fuel prices have encouraged increased driving.
U.S. crude stockpiles are currently 47 percent higher than the average over the last 10 years but if stocks are adjusted for the higher rate of processing the surplus falls to around 34 percent.
The reported surplus in crude stocks over the long-term average is around 162 million barrels but if stocks are adjusted for higher processing the surplus falls to around 128 million barrels (tmsnrt.rs/20WQt9F).
U.S. gasoline stockpiles are currently 11 percent higher than normal for the time of year but if they are adjusted for strong gasoline demand then the surplus shrinks to 7 percent.
The reported surplus in gasoline stocks over the long-term average is 26 million barrels but adjusted for higher demand falls to 17 million barrels (tmsnrt.rs/20WQzhl).
Crude and gasoline stocks are somewhat less excessive than the unadjusted data suggests because refinery processing and gasoline consumption have been so strong.
But distillate demand has been much weaker than normal thanks to sluggish demand from the freight sector and El Nino.
Distillate stocks are much higher than the raw numbers suggest, once they are adjusted for the current weakness in demand.
Distillate stockpiles are currently 24 percent higher than the long-term average but once adjusted for weak consumption they are 43 percent higher than normal for the time of year.
The reported surplus in distillate stocks over the long-term average is 31 million barrels but adjusted for weak demand the surplus surges to 48 million barrels (tmsnrt.rs/20WQE4M).
At this time of year, U.S. gasoline stocks are normally around 26 days worth of consumption, and they are currently a bit higher at 28 days.
Distillate stocks should be around 32 days worth of consumption but are currently at a massive 46 days worth of demand.
Early U.S. oil refineries processed crude in batches, with each batch of oil loaded separately into a still, where it was heated until the distillates were boiled off, condensed and collected for sale.
Early refineries were really just simple distilleries: the equipment would be instantly recognisable to anyone who has been on a tour of a whisky distillery (“A practical treatise on coal, petroleum and other distilled oils”, Gesner, 1865).
The first U.S. refineries established during the 1860s and 1870s processed up to 2,000 barrels per day, though most were much smaller and produced less than 1,000 barrels per day (“Early and later history of petroleum”, Henry, 1873).
Refineries were geared to produce a middle distillate boiling around 300-600 degrees Fahrenheit which was sold as kerosene or paraffin oil and used for illumination.
Gasoline, with its lower boiling point, was too volatile to be used safely as lamp fuel and was mostly considered a nuisance and waste product.
U.S. oil refineries eventually switched from processing crude in discrete batches to feeding oil into distillation towers and drawing off the fractions in a continuous process.
Modern U.S. refineries process up to 600,000 barrels per day, 300-1200 times as much as the first batch-based plants, though a more typical refinery has capacity of around 100,000 to 200,000 bpd.
The objective has switched from producing kerosene for lighting to producing gasoline for use as a transportation fuel.
In the first decades of the 20th century, electric lighting began to reduce demand for kerosene while the massive expansion in car ownership stimulated consumption of gasoline.
From 1915-1920 onwards, refineries were increasingly geared to produce gasoline as the main product, while middle distillates became a by-product.
With the shift to continuous processing and the prodigious growth in demand for gasoline as a road fuel, the oil industry’s need to hold stocks of unrefined crude and refined products surged.
To ensure an uninterrupted flow of oil from the wellhead to the refinery and the end customer, stocks of crude and refined fuels are held at every stage along the supply chain.
Refineries hold substantial stocks of crude to ensure a continuous flow of carefully prepared (de-watered and de-salted) as well as blended crude into their distillation towers.
The industry also needs substantial stocks of refined fuels, lubricants and petrochemicals to ensure a continuous supply to distributors and end users.
Refineries hold crude and refined products to meet routine operational requirements as well as to deal seasonal variations in demand, planned maintenance and unexpected disruptions.
The amount of oil involved is enormous.
At the end of 2013, with the oil market more less balanced, more than 1.05 billion barrels of crude and refined products were being stored at refineries, distributors and oilfields as well as in pipelines and on tank farms.
By February 2015, with the oil market clearly oversupplied, crude and refined products in storage had climbed to more than 1.33 million barrels, according to the U.S. Energy Information Administration (“Weekly Petroleum Status Report”, EIA, Feb. 24).
In the last year, U.S. refiners have been fairly successful in matching gasoline production and stockpiles with demand. Gasoline production remains at the centre of their operational planning.
Crude stocks have continued to increase, reflecting worldwide oversupply, though stockpiles are rising somewhat more slowly than at the start of 2015.
But refiners lost control of distillate stocks in the second half of 2015 as freight demand slowed and El Nino ensured a warmer than normal winter across the United States and other parts of the northern hemisphere.
Winter heating demand across the United States has been around 17 percent below average, according to the National Oceanic and Atmospheric Administration.
And by the end of 2015, the volume of freight being moved across the United States by road, rail, pipeline, barge and air had fallen by more than 2 percent compared with the same period at year earlier.
Over the last four weeks, U.S. implied distillate consumption has averaged just 3.5 million barrels per day, which is 12 percent below the long-term average and 16 percent below the same period in 2015.
The fact that refiners have lost control of distillate stocks should come as no surprise because distillate is essentially a by-product of gasoline production.
Refineries have operated to maximise gasoline production but in the process created an enormous and growing oversupply of distillate.
There is some limited flexibility in the refining system to switch from distillate production to gasoline but it is typically only on the order of a few percentage points.
Massive overproduction of distillate has pushed gross refining margins for the fuel to the lowest level since 2010.
But refining margins for gasoline have been much healthier, at least until recently, which has encouraged refiners to continue maximising crude throughput.
As long as gasoline demand remains strong, refiners will continue to meet it, which is why the outlook for U.S. gasoline consumption is so critical for the oil market in 2016.