Surging U.S. oil supplies may soon struggle to find a buyer, and Morgan Stanley believes that could create winners in the stock and commodity markets.
Output from American shale oil fields has pushed U.S. crude production to all-time highs. But Morgan Stanley warns that the nation's shale wells are mostly yielding a type of light oil for which domestic refiners don't have much use.
Most American refineries are configured to process heavier crude grades, creating a mismatch with the growing supply of light shale oil being extracted in places like the Permian Basin in Texas.
"Our thesis is that the US refining system is close to being maxed-out on the amount of shale oil it can process," wrote Morgan Stanley equity analysts, led by Martijn Rats, the head of the bank's European oil and gas research team.
Refiners have compensated by blending the super light shale oil with gunkier grades, but those heavy crudes are in short supply, says Morgan Stanley. Output from heavy crude producers Venezuela and Mexico is falling, and pipeline bottlenecks are keeping it from being shipped from Canada.
That means more shale barrels will have to be exported, but Morgan Stanley sees trouble here, too.
Few opportunities overseas
The bank estimates U.S. shale could at best address 15,000 barrels a day of overseas demand. If shale oil output jumps by 1 million barrels per day, it would have to capture 7 percent of this overseas market.
The overseas market for super light U.S. shale oil is even lower. It's likely capped at roughly 6 million barrels a day, Morgan Stanley says. That same 1 million-barrels-per-day increase would mean shale would have to capture 15 percent of this market.
Since the end of the ban on U.S. crude exports 2015, most shipments have found their way to Europe, a market where the long-term forecast for oil demand is "modest at best," says Morgan Stanley. While U.S. crude is making inroads in China, the world's oil demand engine, it faces stiff competition from entrenched exporters from the Middle East.
Making matters worse, Morgan Stanley expects so-called middle distillates like diesel and jet fuel to account for most of the growth in oil demand, and light crudes aren't ideal for making these products.
This all leads Morgan Stanley to its takeaway: In order to gain market share around the world, traders will have to offer a discount on U.S. light oil.
Morgan Stanley's winners
That's good news for some refiners that process light crude. Morgan Stanley said Delek, HollyFrontier and Andeavor are all positioned to benefit.
Canadian oil sands producers, which blend their heavy crude with lighter grades, will also stand to reap rewards from discounted U.S. light oil. Cenovus Energy and MEG Energy have the most exposure to light oil prices, according to Morgan Stanley.
North Dakota's Bakken shale drillers produce crude that's better suited to making middle distillates, so Morgan Stanley highlights Continental Resources, Oasis Petroleum and Whiting Petroleum as potential outperformers among independent shale drillers.
Morgan Stanley also favors drillers with more transportation options that make it easier to export, including Encana Corp, Occidental Petroleum and Pioneer Natural Resources.
"Continental Resources straddles both of these buckets and is therefore our most preferred way to retain exposure to the positives of US shale while minimizing the risk associated with a potential oversupply of ultra-light crudes," the analysts wrote.
In the commodities market, Morgan Stanley anticipates relative strength in international benchmark prices and futures that let traders bet on the difference between crude oil and middle distillate prices, known as crack spreads. It expects weakness in gasoline cracks in the United States.
