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Increasing Output and IMO 2020: Oil Price Outlook Stays Low as Headwinds Abound

This past Thursday, China hinted at potential progress on making a trade deal with the U.S., marking the latest in a rollercoaster of positive and negative signals to the market. Although nothing concrete can be said about progress in ending the trade war, oil prices did spike above $62 per barrel in the hopes that trade volume will increase, thus creating more demand for oil.

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Oil giants face bearish sentiment

The price of oil, according to the Brent Oil benchmark, has been declining from its four-year high in 2018, and this is mostly reflected in revenue declines among major oil producers. For example, Royal Dutch Shell PLC (NYSE:RDS.A) (NYSE:RDS.B) posted third-quarter revenue of $86.6 billion compared to $90.5 billion in the previous quarter, despite increasing its net income to $5.9 billion from $2.9 billion. Global liquids realized price for the company's oil sales have decreased 11% since the previous year, from $65.13 in third-quarter 2018 to $58.18 for third-quarter 2019.

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ConocoPhillips (NYSE:COP) stated in its third-quarter report that "year-over-year adjusted earnings decreased due to 18% lower realizations and increased exploration expenses, partially offset by higher volumes." Revenue was $7.8 billion compared to $7.9 billion in the previous quarter, and crude oil sold in an approximate range of $45 to $75 per barrel.

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In spite of the decline in oil prices, Occidental Petroleum Corp. (NYSE:OXY) was able to post higher revenue during the quarter, but this came at the cost of plunging its net income into the negative range. This is primarily due to Occidental's acquisition of Andarko during the quarter; with Andarko assets included, Occidental's daily net oil, liquids and gas production increased to 1.15 million barrels per day compared to 681,000 barrels per day during the prior-year quarter.

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In general, increasing worldwide oil output driving down oil prices has led to sector-wide bullish sentiment, as shown in the chart below of major oil company stock prices. One notable exception is Valero Energy Corp. (NYSE:VLO), which was declining like the rest until IMO 2020 was confirmed.

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IMO 2020

IMO 2020 is the nickname for the International Maritime Organization's mandate that the more than 39,000 ships and tankers that sail through international waters must switch to using scrubbers or low-sulfur diesel fuels beginning in January 2020. This regulatory change will be hugely profitable for complex refineries like Valero, which explains the sudden deviation of its stock price from the sector trend. Though U.S.-based oil companies such as Exxon Mobil Corp. (XOM) also have more complex refineries compared to their counterparts in other oil-producing nations, Valero is considered to have a higher percentage of refineries that are equipped to meet the upcoming need for low-sulfur fuels.

More specifically, IMO 2020 reduces the maximum fuel oil sulfur limit from 3.5% to 0.5%, an 80% reduction. To meet this need, ocean-crossing vessels will need to add scrubbers (if they haven't already) and switch to using more refined middle distillates for fuel. Middle distillates are heavier than gasoline products but lighter than bunker fuel. Currently, the heavier bunker fuel oils used in the marine sector account for approximately half of all oil burned for energy in the world, and beginning Jan. 1, demand for heavier fuels will be switched out completely for middle distillate demand.

Everyone is reluctant to cut oil production

In October, OPEC's largest producers agreed to consider making deep production cuts due to an oil glut, which is being caused largely by fracking in the U.S., increased production in several other countries and increasing trade tensions. Additionally, there is IMO 2020 to consider, which will drastically alter the oil demand in coming years. It is likely that the value of crude oil will drop drastically when the regulatory change takes effect, while the value of middle and lighter distillates will increase. Overall, the price of marine transport is predicted to increase.

Saudi Energy Minister Prince Abdulaziz bin Salman has said it is his "job" to keep oil surplus at bay, and OPEC has already cut crude oil production due to an agreement with Russia last year. However, as OPEC's December meeting approaches, its members are showing increasing reluctance to go through with deeper cuts, as doing so would decrease their own sales volumes.

"A rollover of current cuts for the rest of 2020, with an emphasis on compliance by all members, is the path of least resistance," Harry Tchilinguirian, head of commodity markets strategy at BNP Paribas SA in London, said.

Meanwhile, the U.S. shows no signs of holding back on its fracking oil production. U.S. oil production is predicted to overtake OPEC's by 2024. OPEC expects to decrease its oil production from 35 million barrels per day in 2019 to 32.8 million barrels per day in 2024, while non-OPEC production, led by U.S. shale, is predicted to increase from 64.4 million barrels per day in 2019 to 72.2 million barrels per day in 2024.

When you consider that 82% of U.S.-produced oil is refined into lighter and middle distillates compared to an average of 63% globally, it becomes clear why the nation is increasing its oil output. The U.S. is in the most advantageous position to profit off impending increases in middle distillate demand and prices, meaning that U.S. oil stocks such as Valero and Exxon are worth keeping an eye on.

Disclosure: Author owns no shares in any of the stocks mentioned.

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This article first appeared on GuruFocus.