Hengyuan Refining (3) - The Economics of Petroleum Refining

Publish date: Sun, 16 Jul 2017, 02:45 PM 

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1. Products Mix

Refineries process crude oils into a broad range of refined products. Transportation fuel such as gasoline, diesel and aviation fuel account for 75 percent of output. The remaining 25 percent comprise heating oil, lubricants, asphalt for roads and feedstocks for petrochemical industry, etc.

2. Crack Spread

In the oil refining business, the cost of inputs (crude oil) and the price of outputs (refined products) are both highly volatile. To do well, refineries must constantly find the sweet spots to operate. Crack spread is the difference between crude oil prices and wholesale petroleum product prices (mostly distillate fuels (diesel and fuel oil) and gasoline). Crack spread is positive most of the time. However, it went negative in 2008 temporarily.

A major determinant of a crack spread is the ratio of how much crude oil is processed into different refined products. Each type of crude more easily yields a different product, and each product has a different value. Some crude inherently produces more diesel or gasoline due to its composition. The most common ratio in the US is three barrels of crude to produce two barrels of gasoline and one barrel of middle distillates (or 3:2:1). In Europe, a 6:3:2:1 ratio is the most common (six barrels of crude produce three barrels of gasoline, two of distillates (diesel) and one of residual fuel). 

(The composition of outputs is called "Product Slate").

3. How Crack Spread Is Calculated In Real Life

As mentioned above, a refinery does not really have FULL flexibility to decide which product to produce. It is governed by the ratio it chooses. For example : if Refinery A chooses the 3:2:1 ratio, it will produce 2 barrels of gasonline and 1 barrel of diesel. Refinery A gets these products IRREGARDLESS of how good or bad their price is during that period. And that will have impact on its crack spread, which is calculated as follows :-

Refinery A's Crack Spread = (66.66% x Gasoline Crack Spread) + (33.33%  x Diesel Crack Spread)

The interesting thing is that even though gasoline and diesel are both petroleum products, their fortune can be hugely different during a particular period. For example, in June 2017, China imposed fishing ban on its fishermen (an annual event). This has caused demand for diesel to drop dramatically, causing diesel crack spread to shrink. In the meantime, demand for gasoil remains high and supports a strong crack spread. 

4. Product Slate and International Trade 

Local refineries often cannot economically meet demand in a given region for a certain refined product: they must import from other regions or countries. For example, European demand has gradually shifted due to the large-scale conversion of domestic vehicles from gasoline to diesel. As a result, European refineries have a surplus of gasoline and a shortage of diesel. They have responded by exporting gasoline to North America (primarily the US) and importing diesel from the US. Transportation costs will help determine whether matching production to demand in this way can be profitable in the long term.

The growth of international trade in refined petroleum products is partly due to the trend to build large, complex refineries that provides felxibility to accomodate various types of crude inputs and refined outputs. These ‘merchant refineries’, like those in Singapore and South Korea, are designed for producing and competing in global markets, not for supplying local markets. 

5. Conclusion

The economics of the refining business are complex. It is a capital intensive manufacturing industry operating between the two related but independent markets for crude oil and finished petroleum products. Profitable operations that deliver adequate returns on investment are a function of a complex set of variables underpinned by basic supply and demand dynamics, and shaped by competition that is increasingly global in nature. 

Refiners must strive to maximize their margins by optimizing a number of variables including: the type of crude feedstocks and products; energy requirements; plant complexity and efficiency; and logistics and transportation. They operate in a business environment that is dynamic, and that comes with varying levels of commercial, technical, regulatory and economic risks.