Oil Refining Update Part I: Narrowing Crack Spreads
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Independent oil refiners utilize a business model that is inherently vulnerable to fluctuations in the prices of its sole input – crude oil – and its various outputs – primarily gasoline and fuel oil. The differential between the price of crude and the prices of gasoline and fuel oil is thus the profit margin on crude refining – referred to as the crack spread (named because the refining process involves “cracking” crude into various products). In the first months of 2012, a widening crack spread improved the potential profitability of oil-refining activities, yet there is reason to believe that this trend may reverse itself due to a glut of refining capacity in Europe, increasing capacity in Asia, and recent restarts at several idled facilities in North America and Europe. In addition, the sustained and substantial price differential between WTI and Brent crude prices is significantly altering the landscape of U.S. refining.
The Crack Spread
The crack spread is a theoretical calculation of oil refining profitability based on the quoted futures contracts of refineries’ feedstock (crude oil) and final products. The 3:2:1 ratio is the most common production assumption underlying the crack spread. The ratio states that for every three barrels of oil input, two barrels of gasoline and one barrel of fuel oil are produced as outputs.Thus, the most common crack spread calculation can be simply stated as:
((2 x 42 x price/gallon gasoline) + (1 x 42 x price/gallon fuel oil)) – (3 x price/barrel of oil) =
Crack spread per 3 barrels → divided by 3 = crack spread
Note: Gasoline and fuel oil is denominated in gallons rather than barrels. Since there are 42 gallons of oil in a single barrel, the price per gallon is multiplied by 42.
More specifically, utilizing futures contracts as the baseline gasoline and fuel oil prices and WTI as the price/barrel of crude oil the equation is stated as:
(((2 x RBOB price x 42) + (1 x HO x 42)) – (3 x CL price)))/3 = Crack spread
Note: RBOB refers to gasoline futures and HOM2 refers to heating oil contracts both traded on NYMEX.
Thus, the theoretical profits of the oil refining industry are a function of gasoline and heating oil futures prices (outputs) and crude oil futures prices (inputs).
Variants of the 3:2:1 Crack Spread
Significantly, the crack spread is meant to be a baseline for refining profitability rather than as a hard and fast rule. There are other common ratios including 5:3:2 and 2:1:1; all are imperfect assumptions. Companies can vary production according to global price variations and individual refineries can vary output according to regional price variations. To complicate matters further, the crack spread calculated using WTI futures prices is inaccurate for companies that use different baseline feedstock prices. Refineries are also constrained by how “light” and “sweet” their feedstock is and what technology is used to break down crude into end products. The “sweetness” of crude oil is determined by sulfur content while a wide variety of benchmarks delineate “heavy” vs. “light” crude based on API gravity. Heavy, sour crude is more costly to refine and yields more unproductive byproducts than light, sweet crude and hence, usually trades at a discount to the latter.
Hedging the Crack Spread
Major integrated oil companies, which by nature control the entire supply line of upstream and downstream production, benefit from the hedging inherent to their business model. For integrated oil companies, such as Exxon Mobil (NYSE: XOM) and Chevron (NYSE: CVX), refining margins do not impact profitability because overall margins are determined by selling price of ultimate outputs less the total cost of production. However, independent refining companies, such as Valero (NYSE: VLO) and Tesoro (NYSE: TSO), purchase their feedstock from external producers, which make them vulnerable to crude price fluctuations. In order to hedge these fluctuations, independent refiners can buy crude futures and sell finished product futures. (In the theoretical example, outputs consisted solely of heating oil and gasoline, but a wide variety of other outputs are also sold and their price movements can be hedged). NYMEX also offers standardized virtual crack spread products that allow refiners to hedge both inputs and outputs simultaneously. Companies can also utilize tailored over-the-counter contracts for more specialized hedging requirements (e.g. if a refinery uses an uncommon baseline crack spread). Although independent refiners can hedge some the risk from short term input and output price fluctuations inherent in their business model, the sector is still beholden to their price movements in the long run.
The Crack Spread in the Short Run and the Long Run
A recent spate of actual and scheduled refinery shutdowns over the past several months significantly reduced refining capacity in Europe and the United States, driving theoretical crack spreads to their recent highs in mid-April. Charts for the crack spread using WTI prices from Jan 2006 through April 2012 and April 2011 through April 2012 are below.
Yet several new players have recently made forays into the refining market while a number of temporarily shutdown refineries are due to go back online in coming months, increasing supplies and putting pressure on margins.
Capacity growth in Asia, Latin America and the Middle East is booming. In December 2011, IEA predicted that global refining capacity is expected to grow by a net 8.7 million barrels per day while demand is forecasted to grow by only 7 million barrels per day. All of the capacity growth is expected to occur in non-OECD countries. To further complicate matters for Western refining companies, newly built refineries enjoy some combination of the benefits of greater economies of scale, more efficient technology, and less stringent environmental requirements. European refining capacity is contracting rapidly in response to falling demand. Despite these developments, strategically positioned U.S. refineries may thrive in coming years due to the Brent-WTI spread.
Picking Winners and Losers: The Brent-WTI Spread
Historically, WTI and Brent crude prices track each other well, often within plus/minus $3 per barrel. WTI is considered slightly superior and more often than not traded at a slight premium to Brent. However, in the past few years Brent futures have traded at significant premiums to WTI futures.
The main reason for the price differential is increasing production of tar sands and shale oil in North America, which is creating a bottleneck at the primary delivery point for WTI crude in Cushing, OK. (Some analysts have cited currency fluctuations and unrest in the Middle East as secondary causes of the price differential. However, Eurozone economic weakness should have the opposite effect: A weakening Euro and cheaper Brent prices relative to WTI prices. Moreover, there is currently little unrest in the Middle East with the exception of Syria.)
The supply glut is depressing crude acquisition prices for refineries located in the mid-west and rock mountain regions. However, refineries on the Gulf Coast (PADD 3), the West Coast (PADD 5), and especially the East Coast (PADD 1) do not enjoy easy access to supplies in inland regions (PADD 2: Midwest and PADD 4: Rocky Mountain).
Since 2010, the differential in refiner’s input costs across PADD regions has grown substantially. On the East Coast especially, where many of the recently idled refineries are located, companies are generally forced to import Brent crude, resulting in drastically higher input prices and lower margins. When calculated using crude input prices for the various PADD regions (according to the EIA for February 2012) and current futures prices on NYMEX in February 2012, the profitability differential is huge.
The Brent-WTI spread is driving a shift in the landscape of U.S. refining. Part 2 will examine the effects of the spread on the five PADD regions and detail possible developments that may alter the course of this shift. For more information on this topic and others, visit WealthLift to connect with a vibrant community of investors and finance enthusiasts.
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