Oil & Gas/ Refining/ Refining margins 2 comments

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I learnt a lot about the refining industry during my research on SPC which I subsequently invested in at the early part of 2005. Readers of my hotstocksnot blog know when I exited: not really at the highest price; however it was clear in December 2005 that refining margins had reached a turning point in their upward trend.

Refining margins is the difference in value between the products produced by a
refinery and the value of the crude oil feedstock used to produce them. They can be classified into simple and complex refining margins. Most older refineries are configured as simple refineries, which means they only undertake first-run distillation that converts crude oil into a combination of light distillates -- liquid petroleum gases (LPG), naphtha, and gasoline; middle distillates -- jet fuel, kerosene, diesel; and heavy distillates --- residual fuel oil. Complex refineries, such as SPC, house catalytic crackers that can reprocess the heavier distillates into additional lighter distillates (heating oil, gasoline and diesel), which are more desirable, to maximize the output.

Obviously, complex refineries are able to earn higher refining margins, and so we have the so-called (complex) hydrocracking margins and (simple) hydroskimming margins, which can vary by about US$5 a barrel. It is not rare that simple margins turn negative.

As much as, if not more than, any other business, the refining industry is a study in supply and demand dynamics. Refining margins is basically a measure of the balance between the demand for oil products, versus the supply of crude oil, in the same way that average selling prices (ASPs) are a measure of the demand-supply balance between end consumers and upstream suppliers in the hard disk drive industry (or any other manufacturing industry, for that matter). Different demand-supply scenarios generate varying impact on the refining margins:

Demand-pull: When end demand for oil products (such as for transportation, plastics, power generation, heating) is high, it will pull prices, including margins, upwards along the entire supply chain. A side-effect, of course, is rising input (crude oil) prices. This is what has transpired over the last two years due to a rising Northeast Asia.

Cost-push: High input prices becomes a primary driving factor, not a side-effect. If this is not able to be balanced by a corresponding upward price adjustment in the oil products market due to weak end-demand, it will crimp refining margins on both ends: high input prices, stagnant output prices. This scenario appears to be panning out for SPC as we speak; oil prices remain high due to political problems in the Middle East (Iran and the uncertainty generated by the Hamas victory) but end product demand growth might be stagnating.

Refinery capacity supply: Apart from the input supply and output demand, there is the factor of supply of processing plants (ie. refineries) themselves to consider. Tight refinery capacity obviously creates bargaining and pricing power. This situation was exposed in its entirety in the wake of Hurricane Katrina last year which knocked out spare capacity and caused margins to spike.

References:
(1) Bear Stearns research report on SPC, dtd 2 Feb 2006
(2) CIMB-GK Goh research report "Regional Oil and Gas Report, dtd 2 Sep 2005