3 &#58 2 &#58 1 … Get Cracking

Refining is a highly cyclical business, and not a sector I would recommend for the buy-and-hold investor. But traders who get their timing right can enjoy superb results, as has been the case for refining bulls over the past year.

refining stocks chart

Refiners make money by converting crude oil into finished products such as gasoline, diesel and fuel oil. A refiner’s profit margin is the difference between the cost of crude oil purchased and the price of finished products sold. This is what’s known in the industry as “the crack spread.” “Crack” refers to the fact that oil is being cracked, or split up, into the various refined products, and “spread” reflects the price spread between the raw material (crude) and the processed fuels.

refining products breakdown

Although a barrel of oil is refined into many finished products, the crack spread typically refers only to the crude oil input and the gasoline and distillate output. The most widely utilized crack spread for US refineries is called the 3:2:1, which estimates the profitability of converting three barrels of oil into two barrels of gasoline and one barrel of distillate (diesel, jet fuel, and fuel oil).

The crack spread is a rough approximation. Reality is more complex. For example, three barrels of light, sweet crude oil run through a typical US refinery will actually produce less than 1.5 barrels of gasoline, perhaps one barrel of distillates and, depending on the refinery configuration, the remainder could be lubricants, waxes, coke, asphalt and liquefied petroleum gases. (European refineries are configured differently to accommodate Europe’s higher demand for distillates.)

The price of crude oil is obviously a critical factor in the calculation of the crack spread, and it varies with the properties of the crude and the cost of transporting it to a refinery. Thus, crack spreads can span a wide range, and the profitability of a refiner will be strongly influenced by the selection of available crudes.

This is why East Coast refineries were shutting down last year to avoid losses even as Midwestern competitors were reporting record profits. The refineries in the Midwest had access to cheaper crude than those on the East Coast.

Light, sweet crudes with access to waterborne transportation are highly sought after, and are therefore generally more expensive. Examples include the Brent and the Louisiana Light Sweet. Crude extracted from remote fields must be transported to refineries at a higher cost and will therefore trade at a discount. As US oil production has ramped up over the past few years, West Texas Intermediate (WTI) began to trade a discount to the waterborne crudes like Brent.

Brent-WTI spread chart

Crudes from the Bakken area face even higher transport costs than the WTI and typically trade at a $2/bbl discount (although that differential has ranged from a $25-per-barrel discount to WTI in early 2012 to a $5-per-barrel premium in September 2012). The heavy crudes from western Canada are even more disadvantaged than those from the Bakken, and typically trade at a $20-$30/bbl discount to WTI.

Bakken-WTI spread chart

Geography is not the only factor that influences the price of crude oil. Crude can be light or heavy, sweet or sour, and it can be contaminated with various metals such as vanadium. Light, sweet crudes require the least processing, and historically more refineries were configured to process light, sweet crudes. These crudes have traditionally commanded the highest prices.

Heavy crudes require additional processing, in which the heavier hydrocarbons are cracked into smaller molecules. Sour crudes — those with a higher sulphur content — require hydrotreaters to remove the sulfur. More processing may be needed to remove the metals from crude oil. The more processing is required, the more complex — and costly — the refinery.

At present, the perfect refinery from an investor’s point of view would have the following characteristics:

  • Access to discounted crudes

  • The complexity to process heavy, sour crudes

  • Access to waterborne transport for finished products

For example, our ideal refinery would be sufficiently complex to process and advantageously located to secure the deeply discounted heavy Canadian crudes, but with a finished product pipeline to port facilities.

While no company can ever fully match this ideal, some are better positioned than others. Further, geographical diversification is important, because today’s conditions may change. If WTI were to trades at a premium to Brent in the future, for example, the definition of the ideal refinery would change.

In this week’s issue of The Energy Strategist, we will take a look at which refiners are poised to build upon this past year’s amazing run.