This glut of WTI-related crudes proved to be a windfall for refiners, as they bought crudes at discounts based on the WTI  and sold the finished product at prices more tied to Brent. There are two reasons that finished products more reflected Brent pricing than WTI pricing. First, Brent better reflected the input costs of the marginal East Coast refiners and, more importantly, refiners could export their production, while the ban on exports of crude oil has remained. Thus, WTI prices have more closely reflected the balance of US demand and production, while finished product pricing depended in part on global demand. Exports of refined fuels grew rapidly, helping to keep prices elevated.

Your Mileage May Vary

So the Brent-WTI differential became a rough proxy for a refiner’s margins, and the refining industry’s profitability. In reality things are more complex, and regional crude pricing can take on great importance. For instance, Bakken crudes have from time to time been deeply discounted to WTI, providing a lift for Midwestern refiners with access to that feedstock above and beyond what’s been reflected in the Brent-WTI differentials.

During the first quarter of this year the Brent-WTI differential averaged $9.35/bbl, a steep drop from the levels of two years ago. During that same quarter, East Coast crack spreads — that is the difference between purchased crude and the price of finished products — averaged $8.39/bbl. The Gulf Coast fared a bit better with margins of $10.86/bbl, West Coast refiners were getting $14/bbl, but the Midwest crack spreads averaged $21.18 for the quarter. That is an outstanding margin for a Midwestern refiner, and it is primarily a result of oil production in the Bakken, Eagle Ford and the Permian Basin. Thus, a geographically diversified refiner or one based on the East Coast would fare very differently than a Midwest-centered competitor.

For many years the Brent-WTI differential wasn’t significant, nor particularly informative. Its significance evolved as it began to reflect changing oil production conditions in the US. Likewise, today the Bakken-WTI differential may point to very high Midwestern refinery profitability even as the Brent-WTI differential moderates. To the degree that the WTI continues to approximate refiners’ costs and the Brent their finished product prices, the Brent-WTI differential can still provide important clues about the profitability of an “average” refinery.

Or at least that has been the case for the past four years. If the Brent-WTI differential is $20, then the refining sector is doing well and most refineries are making money. But an East Coast refinery with no access to WTI crudes may still go out of business while Brent-WTI differentials are very high, because it isn’t benefiting from that differential. It’s buying crude at Brent prices and selling product at Brent prices.

Likewise, if the differential shrinks to zero then refining conditions are not that good for the average refiner. In that case, best to avoid coastal and geographically diversified refiners, but some regional players with access to the cheaper Bakken or heavy Canadian crudes may still do very well in those circumstances.

As market conditions change, other benchmarks may take on greater significance. As noted above, recent Midwest refining margins have been surprisingly strong relative to those on the Gulf Coast. One thing this tells us is that Midwest refiners have seen some significant discounts on Bakken crude relative to WTI, but why didn’t the Gulf Coast see something similar?

A New Differential Arises

It just so happens that another benchmark has become an important indicator of Gulf Coast refinery profitability over the past couple of years. Just as Brent and WTI have historically traded in lockstep, Louisiana Light Sweet (LLS) on the US Gulf Coast used to track Brent pretty closely. Of a similar quality to Brent crude, LLS historically traded at a small premium, which was mainly a reflection of the transport costs to bring Brent crudes into the Gulf.

But the flood of domestic crude is reaching the Gulf Coast in ever greater volumes, and the LLS premium to Brent has vanished. LLS began to track WTI more closely in 2013, and some analysts have suggested that the historical price relationship to Brent will be broken as long as there is excess crude on the Gulf Coast and no export market for it. (Some shippers are moving this oil by barge to other areas, and even Canada — where crude can be legally exported.)

Conclusions

The implications for investors are as follows. While benchmarks like Brent and WTI — and their differentials — can serve as a rough guide to the profitability of refiners, there is great diversity within that sector. When investing in refiners — or in the crude oil producers that supply them — it is important to understand which crudes they tend to use (or produce), the current discount to benchmark crudes, and whether factors such as new pipelines or other shipping routes will likely affect these prices in the near future.

The strong first-quarter Midwest crack spreads augur well for top Midwestern player and Aggressive Portfolio holding Marathon Petroleum (NYSE: MPC) along with regional players Western Refining (NYSE: WNR) and HollyFrontier (NYSE: HFC), which we continue to recommend (albeit at half of the original position size for HFC.