Energy Investing: Strong Prospects for Petroleum Refiners


Refining stocks have been on fire this year; shares of the five major US independent refiners are up an average of 24.3 percent year to date, significantly outpacing the 13.4 percent gain posted by the S&P 500 Energy Index. Strong fundamentals in the refining industry have also provided an important tailwind for major integrated oil companies such as Chevron Corp (NYSE: CVX) and ExxonMobil Corp (NYSE: XOM). Refining generally accounts for 20 to 30 percent of the Super Oils’ revenue mix.

A recent issue of The Energy Strategist advised subscribers to take some profits off the table after the recent run-up in refining-related stocks. Meanwhile, the refining business–hard hit by the 2007-09 recession–continues to bounce back with a vengeance.

I’ve written about the basic fundamentals of the refining business on a few occasions in The Energy Letter and The Energy Strategist. Here’s a brief primer on the industry and a look at the fundamentals driving the stocks’ recent rally.

Refining: A Fundamental Primer

Many investors find the dynamics that drive the refining industry counterintuitive; unlike most energy-related industries, refiners don’t benefit from higher oil prices. In fact, rising oil prices are a big negative for refiners: The rally in oil prices from under $40 per barrel in late 2008 to over $100 today has been a significant headwind for the group’s profit margins.

It’s best to think of refining as a manufacturing business where refiners buy raw materials and fabricate products for consumers and businesses. In the refining business, the raw material–known as feedstock–is crude oil, and the manufactured products include diesel, gasoline, jet fuel and heating oil. You don’t fill your car or boat with crude oil but with products refined from oil.

As with any manufacturing operation, rising raw materials prices translates into rising costs. Because refiners must buy crude as feedstock, rising oil prices eat into profit margins. At the same time, refiners benefit from higher prices for their products.

In other words, refiners make money on the spread between the cost of crude oil and the value of their refined products. For refiners to make money when oil prices rise, the prices of gasoline and diesel fuel must increase at a faster pace. By the same logic, refiners also make money when oil prices decline–assuming the prices for refined products hold up better.

In the industry’s parlance, this basic spread is known as the crack spread. One of the most commonly quoted crack spreads is the 3-2-1 crack spread that tracks the profitability of producing two barrels of gasoline and one barrel of heating oil (distillate) from three barrels of crude. The table details how that spread is calculated.

Source: Bloomberg

Source: Bloomberg To perform these calculations, I used April 2011 futures contracts that trade on the New York Mercantile Exchange (NYMEX). Both gasoline and heating oil contracts are priced in US cents per gallon; to calculate the spread, I converted these prices into dollars per (42 gallon) barrel. I then multiplied the per barrel gasoline price by two because the 3-2-1 crack spread assumes we’re making two barrels of gasoline and one barrel of heating oil.

As crude oil represents a cost for the refiners, it factors into the crack-spread calculation as a negative number–in this case, three barrels of crude oil cost $314.30.

Adding the value of two barrels of gasoline to one barrel of heating oil and subtracting the cost of three barrels of crude yields $60.39. But this is the margin based on three barrels of crude. By convention, the 3-2-1 crack spread is quoted in terms of dollars per barrel; I simply divided the result by three to obtain a spread of $20.13 per barrel.

The graph below tracks the 3-2-1 crack spread over the past few years.

Source: Bloomberg

The key trend to note here is that the current NYMEX 3-2-1 crack spread is near the high end of its multiyear range; refining margins in the US are currently extremely attractive.

Refining: Widening Spreads Support Margins

Over the past few issues of The Energy Strategist and Energy Investing: Answers to Common Questions, I highlighted the importance of watching Brent crude oil prices rather than the traditional West Texas Intermediate (WTI) crude oil that underlies NYMEX futures prices.

Brent crude has commanded a record premium–sometimes more than $20 per barrel–to WTI in recent weeks. This is a highly unusual pattern. Historically, the WTI has traded at a slight premium to Brent because WTI is slightly lighter (easier to refine) and contains less sulfur than Brent.

There are a few reasons for the aberrant trading behavior. The most important is that there is excess supply of crude oil at the official delivery point for WTI, the Cushing Hub in Oklahoma. Supplies of oil at Cushing have swelled, thanks to higher US oil production and a new pipeline that transports crude from Canada.

According to the US Energy Information Administration (EIA), domestic oil production rose by more than 400,000 barrels per day in 2009. Total production in December 2010 came in roughly 175,000 barrels per day higher than in the prior year. The graph below provides a closer look.

Source: Energy Information Administration

The recent uptick in US oil production represents a departure from the long-term trend; by and large, domestic output has declined since the 1970s. Prior to two years ago, 1991 marked the last annual increase in US oil production. In fact, production continued to grow despite the Obama administration’s moratorium on drilling in the deepwater Gulf of Mexico.

The main driver of increased US oil production is a renaissance in US onshore drilling. Producers are aggressively drilling in US unconventional fields such as the Bakken Shale of North Dakota, covered at length in the Jan. 21, 2011, issue of The Energy Letter, Drilling for Profits: Bakken Shale. Another hot oil drilling region right now is the Permian Basin of Texas and New Mexico. In both the Bakken and Permian, producers have found that the combination of horizontal drilling and fracturing can dramatically improve the productivity of their wells.

Some subscribers have asked if these shale oil plays will end US dependence on imported oil. The answer is a resounding NO. There remains a wide gap between US oil consumption of around 20 million barrels of oil per day and production of less than 6,000 barrels per day. However, drilling activity in these fields could arrest the decline in US oil production and help offset the dip in US deepwater output. In short, these fields will stop US import dependence from growing.

The US refining industry has enjoyed a major boost from the uptick in US domestic production and its effect on WTI oil prices. The 3-2-1 crack spread calculation is based on NYMEX-traded prices for gasoline, heating oil and crude oil. The NYMEX contract price is based on WTI prices, not Brent.

A refiner using Brent rather than WTI would face dramatically different profitability. With Brent crude oil trading at roughly $114 per barrel, the crack spread declines to $10.30 per barrel. Higher feedstock costs without a corresponding move in prices gasoline and heating oil is a negative for refiners’ profit margins.

US distillate prices (the price of heating oil and diesel) historically follow international market conditions. As I pointed out in Forget $5 Gasoline: Demand for Diesel is Driving Oil Prices, diesel accounts for a bigger proportion of the transportation fuel mix than in the US. When diesel prices spike in Europe, US-based refiners take advantage by exporting diesel. International and US distillate fuel prices tend to reflect international oil supply and demand conditions, meaning that they bear a closer correlation to Brent than WTI.

Meanwhile, US gasoline prices have also followed international oil markets to an extent. Although the relationship isn’t as close as it is for distillates, US demand for gasoline is picking up. Inclement weather weighed on gasoline consumption over the winter, but that seasonal headwind should abate as the summer driving season approaches. As I pointed out in last week’s issue of Personal Finance Weekly, we’d need to see a far larger spike in prices to impact US demand meaningfully. Last week’s inventory data from the EIA showed a large drop in gasoline inventories, a development that traditionally bolsters US gasoline prices.

This is bullish for crack spreads. US refiners can buy regional grades of crude such as WTI, Mexican Maya and oil from the Bakken region at a sizeable discount to Brent crude.

At the same time, US distillate prices–and to a lesser extent, US gasoline prices–benefit from tighter supply and demand conditions in international markets. That means the price of the products refiners sell is rising faster than their raw material costs. Refiners’ profit margins have gone through the roof.

The Energy Strategist