By Brad Zigler
Oil's had an exciting week. How so? Well, the petroleum sector is finally sending definitive signals of an economic rebound.
The indication arises from the recent downward volatility in the cost of crude oil, together with simultaneous upside pressure in refined product prices. We're now seeing refining profits normalize to levels not seen since spring 2009.
You may well ask why you should care about refiners' earnings, but trust me, there's a way for you to piggyback on their good fortune to generate profits of your own.
Let's not get ahead of ourselves, though. We need to define a few terms first.
Crack Spreads
Refiners make money by "cracking" input crude oil into an array of distillate products, most notably gasoline and heating oil. Output yields—that is, the ratio of lighter to heavier distillates—will vary according to seasonal factors and available refining capacity.
At times, it's more efficient—i.e., more profitable—to weight refining runs toward lighter distillates. A fairly common type of operation, for instance, turns out two barrels of gasoline and one barrel of heating oil for every three barrels of crude oil input. Knowing a refiner's throughput, or "crack spread," allows us to approximate its gross profit margin.
The process is complicated, however, by the industry's pricing conventions. Crude oil is priced in dollars per barrel, while heating oil and gasoline are denominated in gallons.
A barrel of oil contains 42 U.S. gallons, so you can translate the throughput of a "3-2-1" operation as:
3 x 42 gallons (crude oil) = [2 x 42 gallons (gasoline) + 1 x 42 gallons (heating oil)] - profit
Applying current wholesale prices* into this equation, we can determine the refiner's gross yield as:
3 x $87.33/bbl = [84 x $2.5816/gal + 42 x $2.6627/gal] - profit
$261.99 (crude oil) = [$216.85 (gasoline) + $111.83 (heating oil)] - $66.70 (profit)
*We use NYMEX futures prices for real-time fixes on the crack spread, the nearby contract for crude oil and to better simulate the refiners' marketing cycle, the second-nearby contract for products.
Thus, with current prices, a refiner can crank out a $22.23 per barrel ($66.70 per 3 bbl) profit for a "summertime mix." With a crude input cost of $87.33, the refiner's gross margin is 25.5 percent (or $22.23 / $87.33).
Not surprisingly, margins expand and contract as input and output values vacillate. In February 2009, when crude prices reached their nadir at below $34 a barrel, the 3-2-1 gross margin briefly ballooned to more than 64 percent—even after cratering at 4 percent the previous October. Margins were relatively thin in 2009 and 2010, averaging less than 15 percent.
Gross (3-2-1) Refining Margin
Investors should remember two things about gross refining margins. First, there's no guarantee that any refiner will actually realize them. For that to happen, a refiner would have to rely exclusively on the spot market for purchases and sales, even though most use contracts for their input crude and distillate production. Even so, margins are worth watching, as they represent potential earnings available to operators.
Second, there's a seasonality to margins. A 3-2-1 refining mix, being tilted toward gasoline, naturally produces the fattest profits for refiners when motor fuel prices rise. That's typically in the winter-to-spring run-up to driving season. You can see the pattern of May peaks in the chart above.
Gross margins, however, can't be looked upon in isolation. To get a more complete picture of a refiner's earning power, you have to compare its margin to the cost of goods sold, or COGS. The COGS is determined by dividing a refiner's crack spread by its product sales proceeds. Using our example above, we can calculate the COGS in the 3-2-1 operation as:
$66.70 / ($216.85 + $111.83) = 20.3 percent
A refiner is truly flush when margins exceed the COGS by 5 percentage points or more—and that's the signal flashing now.
As of Wednesday, January 26, this spread tipped over the threshold—to 5.2 percent—for the first time since March 3, 2009.
Favorable spreads weren't long-lived in 2009; the last time this occurred lasted only 32 trading days between January and March. There was no such run in 2008. For 2007 and 2006, though, profits ran high for 101 and 94 trading days, respectively.
At times like now—and during those runs in 2006, 2007 and 2009—individual traders can ride refiners' coattails by trading crack spreads through futures.
Futures Spread Vs. Refiners' Shares
Simply put, trading a three-legged futures spread is the most direct way to capture expanding refining margins. One does this by selling crude oil contracts short and simultaneously purchasing gasoline and heating futures in the same ratio as the crack spread illustrated above.
Despite their different denominations—crude oil in barrels and refined products in gallons—the contracts are equivalent. A crude oil contract covers 1,000 barrels, or 42,000 gallons; the exact quantity controlled by gasoline and heating oil contracts.
This spread is afforded a 75 percent reduction in each leg's performance bond requirement and is margined as a single position by the exchange clearinghouse.
To get a sense of the returns that can be obtained from this trade, consider the 2006 crack season. On March 5, refining margins moved to a 5 percent premium to the COGS, when the crack spread was $15.39 a barrel. By early May, that spread widened to $24.21, yielding a $26,460 gain.
Spread trading necessarily requires a futures account, and futures trading isn't suitable for many investors. For those disinclined to trade futures, the purchase of refiners' shares—such as Valero Energy Corp. (NYSE: VLO) or Tesoro Corp. (NYSE: TSO)—may be more appropriate.
Valero Energy Corp. (VLO) Vs. Tesoro Corp. (TSO)
But the question stock investors must address is whether the refiner's improved margins are already priced into its stock value.
No matter what approach an investor takes—if any course is taken at all—the improvement in refiners' prospects is yet another sign that a recovery is finally taking hold.
Disclosure: None
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