Oil refining is one of the most important business segments in the energy industry. Big oil companies such as ExxonMobil Corp (NYSE: XOM), BP (NYSE: BP) and Chevron (NYSE: CVX) generate most of their profits from the exploration and production; however, refining accounts for an average of 20 to 30 percent of these outfits’ long-term operating profits. And smaller names such as Marathon Oil Corp (NYSE: MRO) depend even more on refining margins.

Oil refining and marketing is essentially the only business segment for a handful of so-called independent refiners such as Valero Energy Corp (NYSE: VLO) and Holly Corp (NYSE: HOC).

Income-oriented investors should also pay attention to trends in the refining industry; popular energy-focused MLPs Kinder Morgan Energy Partners LP (NYSE: KMP), NuStar Energy LP (NYSE: NS) and Magellan Midstream Partners LP (NYSE: MMP) transport, store and blend gasoline, diesel fuel and other refined products.

Understanding the oil refining business is essential to evaluating the outlook for these three groups, but refining remains among the most misunderstood segments of the energy business.  The main problem: Unlike most energy-related industries, refiners don’t necessarily benefit from higher oil prices.

It’s best to think of refining as a manufacturing business–refiners buy raw materials and fabricate products for consumers and businesses. In the refining business, the raw material–known as feedstock–is crude oil, and the manufactured products include diesel, gasoline, jet fuel and heating oil.

As with any manufacturing operation, rising raw materials prices translates into rising costs. Because refiners must buy crude as feedstock, rising oil prices eat into profit margins. At the same time, refiners benefit from higher prices for their products.

In other words, refiners make money on the spread between the cost of crude oil and the value of their refined products. For refiners to make money when oil prices rise, the prices of gasoline and diesel fuel must increase at a faster pace. By the same logic, refiners also make money when oil prices decline, provided that the prices for refined products hold up.

Oil Refining: Crack Spreads

In the refining business, profit margins depend on the relative prices of crude oil and refined products. The crack spread is a basic measure of these relationships and is a good starting point for any analysis of the industry. One of the most commonly quoted crack spreads, the 3-2-1 crack spread, tracks the profitability of producing two barrels of gasoline and one barrel of heating oil from three barrels of crude. The table belows details how that spread is calculated.


Source: Bloomberg

To perform these calculations, I used September 2010 futures contracts traded on NYMEX for all three products. Both gasoline and heating oil contracts are priced in US cents per gallon; to calculate the spread, I converted these prices into dollars per (42 gallon) barrel. I then multiplied the per-barrel gasoline price by two because the 3-2-1 crack spread assumes we’re making two barrels of gasoline and one barrel of heating oil.

As crude oil represents a cost for the refiners, it factors into the crack-spread calculation as a negative number–in this case, three barrels of crude oil cost $243.90.

Adding up the value of two barrels of gasoline to one barrel of heating oil and subtracting the cost of three barrels of crude yields $25.74. But this is the margin based on three barrels of crude. By convention, the 3-2-1 crack spread is quoted in terms of dollars per barrel; I simply divided the result by three to obtain a spread of $8.58 per barrel.

You can play with the numbers in this table to see what a change in commodity prices does to margins. For example, let’s assume that crude oil jumps $3, but the price of gasoline and heating oil remain the same. This scenario would reduce the crack spread to $5.58 per barrel–that is, an increase in crude prices without a corresponding move in prices gasoline and heating oil is a negative for refiners’ profit margins.

Refining operations weighed on first-quarter results for most of the integrated oil companies but acted as a tailwind in the second quarter. The 3-2-1 crack spread goes a long toward explaining this shift: The average spread in the first quarter was about $9 a barrel, compared to about $12.30 a barrel in the second quarter. And in the second quarter of 2009, the 3-2-1 crack spread averaged $9.91; year-over-year comparisons are favorable.

Oil Refining: Light-Heavy and Sweet-Sour

The 3-2-1 crack spread calculates margins based on crude oil, gasoline and heating oil futures contracts. Although blends of gasoline and heating oil differ across the US, these refined products are basically the same. That’s not the case with crude oil: Between 150 and 200 varietals of oil actively trade around the world, many of which have unique properties and different price dynamics.

Most investors have heard the term “light, sweet crude.” In this case, “sweet” refers not to taste but to the sulfur content of crude oil; sweet crude oil doesn’t contain much sulfur, whereas sour crudes have relatively high sulfur content.  Because sulfur is a pollutant and must be removed during the refining process, sweet crudes tend to command higher prices than sour crudes.

The term “light” refers to the specific gravity of the oil, or its heaviness relative to water. From an investing standpoint, however, the important thing to remember is that light crude oils are easier to refine into gasoline than heavy oils and tend to fetch a higher price.

The NYMEX crude oil contract is based on a grade of crude oil known as West Texas Intermediate (WTI). WTI crude has a standard API gravity of 39 degrees and a sulfur content of 0.34 percent. Oil with API gravity above 31 degrees is considered light, and crude with less than 0.5 percent sulfur is dubbed sweet. WTI is light, sweet crude oil.

Maya is a Mexican oil benchmark that’s based on the quality of oil that comes from Mexico’s largest field, Cantarell. For those unfamiliar with the importance of Cantarell and the field’s alarming production decline, check out the Dec. 30, 2009, issue of The Energy Letter, Down Mexico Way: Oil and Politics South of the Border. Maya crude has an API gravity of 22 and a sulfur content of 3.3 percent–it’s heavy, sour crude oil.

This WTI-Maya differential is a key refining fundamental and is pictured in the graph below.

Source: Bloomberg

Why is the WTI-Maya differential important? Refiners don’t necessarily buy WTI for feedstock; a refiner could purchase Mexican Maya, Brent from Europe or varietals from Africa, the Middle East and Russia. The 3-2-1 crack spread we calculated earlier only applies to a refiner buying WTI and may make little sense for a refiner processing other grades. If a refiner were to purchase a different crude oil feedstock at a $10 discount to WTI, its profit margins would be significantly higher than the standard 3-2-1 NYMEX crack spread implies.

Of course, there are catches. First, not all refineries are capable of processing heavier and sourer grades of crude. Many US-based refiners operate complex refineries capable of handling a large variety of crude oils, as the country has long imported heavy and/or sour crude from Mexico, Venezuela and other countries. But not all refiners boast these capabilities; companies with less-sophisticated equipment may not be able to take advantage of the cost advantages that accrue from refining heavy, sour crude.

In addition, light, sweet crude usually yields higher outputs than heavier, sour crude. Operating costs are also higher for companies that must run the advanced equipment necessary to process inexpensive varietals.

But none of these factors change the basic equation: Higher differentials between grades of crude spell better profitability for refiners. The WTI-Maya spread coupled with the 3-2-1 crack spread provide a fairly accurate picture of what profit margins in the refining industry look like, at least directionally.

Oil Refining: Geography
Regional exposure is important because, as every consumer knows, gasoline and diesel prices vary widely in different parts of the US. This is also true internationally, even if we adjust for differences in local tax regimes.

For example, on the East Coast, US-refined gasoline may compete with products imported from Europe. European refiners may export gasoline if margins are more attractive in the US. Also, the cost of sourcing crude can vary widely in different areas, depending on factors such as which pipelines serve a particular region and proximity to key oil important terminals. Demand also varies regionally depending on local economic conditions. Finally, some regions of the US are chronically short of refining capacity–there simply aren’t enough refineries locally to satisfy demand. Less competition can also spell higher profit margins.

As of the close on July 20, crack spreads on the West Coast were as high as $16.50 a barrel, compared with $7 to $8 a barrel in parts of the Gulf and East Coasts. This West Coast advantage has been consistent for most of 2010.

Source: Bloomberg

The blue line represents the 3-2-1 crack spread obtained by refining Alaskan crude into gasoline and heating oil (diesel) for delivery to Los Angeles. The red line represents the approximate margin obtained by refining WTI crude into gasoline and heating oil for delivery to New York Harbor.

Keep in mind that these margins are approximations based on publicly available data about the prices for various refined products and grades of oil. Despite these shortcomings, the graph tells a lot about regional profitability–at least directionally.

Generally speaking, when looking at US refiners, the highest-quality plays are firms with complex refineries capable of handling a wide variety of oil feedstock and those with diversified geographical exposure. On a short-term basis, companies with exposure to West Coast refining margins are likely to show more upside than firms with heavy exposure to the East Coast.

Oil Refining: Supply and Demand

Demand for refined products and refining capacity are two additional fundamentals to watch. To gauge US refined product demand, I examine data released by the Energy Information Administration (EIA) each Wednesday. Although much of the focus is on the change in oil and refined products inventories, the EIA also releases data showing the change in overall oil demand over a four-week period versus the year ago period. Here’s a look at oil demand trends since 2000.

Source: Energy Information Administration

You can easily pick out the two recessions that occurred during the period covered by this chart. In 2001 the drop-off in demand was noticeable but short-lived; the downturn in demand from mid-2008 through early 2009 was far more severe.

That being said, a recovery is clearly underway in the US. According to the most recent data from the EIA, total crude oil demand is up roughly 2 percent from a year ago, led by a 10.2 percent jump in jet-fuel demand and a 2.7 percent increase in distillate consumption.

The solid year-over-year growth in distillate fuel demand primarily reflects strength in diesel consumption. Refined products pipeline operator Magellan Midstream Partners LP announced in its second quarter earnings conference call that its overall volumes were up 7 percent over the second quarter of 2009, led by strong demand for diesel shipments, especially on the West Coast. Diesel is the main fuel for the railroads and trucking firms; growth in diesel demand is typically consistent with an uptick in economic activity.

News of increased demand for refined products is a positive for the refiners.

Supply in the refining business is a function of capacity and capacity utilization, a measure of the percentage of total refining capacity actually in use at any given time. High capacity utilization is usually a sign of tight refining markets and rising profit margins.

Capacity utilization stood at 91.2 percent at the end of July. High capacity utilization is normal at this time of year because it’s a period of higher gasoline demand. Levels above 90 percent are considered to be strong, and the most recent reading is well above the 84.5 percent capacity utilization at the same time in 2009 and the near 88 percent utilization logged in 2008. Still, this figure is less than the utilization numbers in summers prior to the financial crisis.

Some of the tightening in refining margins in 2010 is a function of stronger demand for crude oil and refined products this summer. Another factor at play is that refining margins collapsed in late 2008 and early 2009, so many firms rationalized their portfolio of refineries by shutting down underperforming facilities. The loss of total refinery capacity has also helped to tighten capacity utilization to some extent.

Oil Refining: How to Play It

Oil refining has been on a rollercoaster ride over the past few years. From 2004 to 2007, crack spreads generally trended higher to the point that some analysts have dubbed this period the “Golden Age of Refining.” Over most of this time, capacity utilization was high, profit margins were fat and refiners enjoyed near record spreads between sweet-sour and heavy-light grades of crude oil.

The deep recession of 2008-09 changed all that. US oil demand was hit harder than at any point since the recession of the early 1980s. Even as US demand for refined products fell, strong demand for oil from the emerging markets began to push crude prices higher again in early 2009, compressing refining margins.

The good news: Valuations are attractive. Refining margins are improving as demand picks up and refining capacity tightens. Meanwhile, most refiners are trading at depressed valuations, a hangover from the 2008-09 bear market. And spreads between heavy and light crude oils should begin to widen into 2011 as oil demand picks up.