In Oil Refining, It’s All About Margins

by | published March 22nd, 2010

As the price of crude oil moves above $80 a barrel, consumers are wondering just how far gasoline prices can go.

Now is the time for such questions.

It’s during the month of March that the market begins to readjust inventory and production in advance of the summer driving season. This usually means moving from heating oil to gasoline.

Actually, the real issue is what refined products will be emphasized in the production process. To put it bluntly, U.S. refineries have insufficient capacity to handle all needs.

And that could make you some serious money.

Where the Real Oil Profits Are – It Might Surprise You

The oil majors – the big boys who own everything from oil fields to refineries to retail outlets – do not make most of their money drilling oil or even selling gasoline. The real profits are in the refinery margin, the difference between what crude oil costs and what they can charge for the refined product. To expand profits, all they have to do is improve the refinery margin.

Welcome to the paradoxical world of cutting refinery capacity while demand increases. That’s bad news for consumers but potentially very good for investors.

Refinery margins have taken a hit recently. The financial crisis caused a protracted cut in demand for oil. However, as demand returns, so will rising profitability from the refinery margin.

And there are now multiple indications that it is coming back. As demand increases for all manner of refined products, gasoline and diesel will head the list. Available refinery capacity will be hard-pressed to meet it.

Yet, for some time, U.S. refiners have employed less than 80% of capacity in a concerted attempt to keep prices high. Now the likes of Chevron Corp. (NYSE:CVX), Royal Dutch Shell (NYSE:RDS), Valero Energy Corp. (NYSE:VLO), ConocoPhillips (NYSE:COP), BP (NYSE:BP), and Total S.A. (NYSE:TOT) have closed, sold, or reduced capacity at facilities both here and in Europe.

The European scene is important for the U.S. market, first, because what happens to majors there has an impact here. And second, because 25% of the gasoline produced in Europe is exported to America. In short, as we continue to reduce domestic capacity, we rely more heavily on oil product imports when demand increases.

And that is where trade-offs among the three distillate categories becomes a major factor.

The three kinds are distinguished by heaviness, with heavier product usually having lower value.

  • Light distillates include gasoline and naphtha, a product used in all kinds of petrochemical applications and as feeder stock for high-octane fuels.
  • Middle distillates are diesel, kerosene, high-end kerosene (jet fuel), and low-sulfur-content heating oil.
  • Heavy distillates include lower grades of heating oil all the way down to asphalt and residuum, the sludge that remains when just about everything else is taken out.

In reality, valuation is a marketing judgment that varies throughout the world.

In the U.S., we put a greater emphasis on light distillates – like gasoline. The price at the pump has become a major political issue. As one of my colleagues in the industry is fond of saying, “Light distillates vote.” Higher gas prices and shortages are a guaranteed ticket to get thrown out of office (one among many these days).

But fading supply also compels refineries to prioritize available capacity. For this reason, U.S. diesel prices have been higher than gasoline for some time. Middle distillates are short-changed to produce more gasoline.

In Europe, the focus is in the other direction. The major western European countries consume far more diesel each day than we do. That is because Europe has made a choice to tax gasoline to discourage auto travel while increasing reliance on diesel.

As refinery capacity comes under pressure, choices must be made as to which market demand sectors are met. To put it simply, we will need to choose between gasoline and diesel.

And once demand comes back online, refineries in the U.S. will not be able to satisfy both. Reliance on European gasoline imports will also come under pressure. Refinery closures there, combined with increasing exports to Asia and western Africa, will force the U.S. to look elsewhere for imported product. That will drive prices up further.

Here Is Where the Money-Making Part Comes In

There are two medium-term moves developing for the average investor, both extending as we move into the next three to four months.

The first bridges the European and U.S. markets as a whole. Here we are interested in those companies that can best navigate the production and import/export dimensions of the relationships between the two regions. You need the big guys who control a percentage of both markets. Three fit the bill: BP, Shell, and Chevron.

The second allows a play between the availability of gasoline and diesel. Since 2007, NYMEX has allowed the trading of low-sulfur diesel fuel futures, priced at a stable market premium to low-sulfur heating oil. This makes sense because both are produced together. However, the average investor is not likely to be dealing heavily in futures contracts, which tend to emphasize the shorter end of the curve. You also need to be able to profit from longer market trends.

What we can do here instead is to employ a series of ETFs to replicate the spread between crude oil prices moving into the refinery process and the products coming out.

That means holding puts and calls on the following: the United States Oil Fund (NYSE:USO), approximating spot crude sales in next (“near”)-month contracts; the traditional iPath GSCI Crude Oil Total Return (NYSE:OIL), providing the same with some hedging in U.S. Treasuries; the United States Gasoline Fund (NYSE:UGA), near-month gasoline sales; and the United States 12-Month Oil Fund (NYSE:USL), providing a longer-term view. USL, by the way, has had the best tracking success of the actual underlying market of any oil-based ETF.

While there are proprietary and privately traded diesel-only vehicles, there are no sufficiently liquid ETFs. However, two other funds provide exposure and sufficient flexibility to allow diesel plays off of gasoline and general crude movement.

One is the United States Heating Oil Fund (NYSE:UHN), acting as a clone at discount to actual diesel pricing. The second is one of my favorite energy ETF exposures: the PowerShares DB Energy Fund (NYSE:DBE). It’s based on the Deutsche Bank Liquid Commodity Index-Optimum Yield Energy Excess Return. It allows investors to participate in futures contracts movements in West Texas Intermediate Light Crude (the NYMEX base), dated Brent (the London and European base), heating oil, natural gas, and RBOB gasoline (“reformulated gasoline blend stock for oxygen blending,” the new NYMEX benchmark gasoline contract).

In other investment strategies, such as offsetting funds pegged to hydrocarbons with those reflecting alternative energies, DBE becomes a very useful balancing position. It is also based on a European-U.S. energy index.

The key is to be able to move as the commodity prices move. Combining (pairing) ETFs allows such movement.

You still need to decide which direction the underlying commodity market is likely to move, and these positions will require attention, but an initial entry would be long positions in OIL and USL and short-term exposure in USO and UGA, while holding DBE and UNH as your hedging vehicles.


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