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Fundamentals of Crude Oil Pricing: Part IV

Posted on: November 2, 2008 - Email Article - Printable Version

Charles W. Petredis

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If you have not read parts one through three of this article, please visit the following pages for Part One, Part Two, and Part Three respectively.

Refiners and the Crack Spread

The general misconception that the demand of crude oil is that it comes directly from “whoever pulls it out of the ground to their cars.” Unfortunately this is flawed thinking as they neglect many steps in between the first and last steps. The refiners are the ones who actually control the demand of crude oil, not the consumers. Their demand for the most part is dictated by the “crack spread.”

The crack spread is the term that refers to the profit margin of refiners. It comes from the process of “cracking” a barrel of crude oil, or refining a barrel of crude oil into a useful output. In most cases, this output is either gasoline or heating distillate, although there are many different outputs. The most common crack spread is the 3:2:1 crack spread, or 3 barrels of crude is refined into 2 barrels of gasoline and 1 barrel of heating distillate. Again, there is more than just one crack spread variation. Crack spreads are always quoted using spot market pricing for the equations. Because of this, the crack spread is not always a 100% accurate indicator of refining activity. Unless a refiner is completely unhedged, their input and output prices are not going to be the same as the spot market prices. That being said, the crack spread is a pretty decent indicator of crude oil demand. The larger the profit margin is from the crack spread, the more demand there will be, and therefore, refining activity will pick up. The refiners are worried about making a decent profit margin due to the fact that they are also being squeezed by input prices (in the exact same manner that consumers are squeezed by input prices). Providing the general public with cheap gasoline is not the refiner’s chief concern.

Geo-political Tensions

There have been books of multiple volumes written on this topic, but I’ll try to keep it short and confined to only recent news. In general, geo-political tensions will cause the price of oil to go up because investors will attempt to price in the risk of potential supply coming offline in the future. This supply could be disrupted for a number of reasons, taxes, tariffs, elections, economic sanctions, embargoes, blockades, and in some cases war. A good example of this was the time period before the United States started their War on Terrorism. Oil appreciated on the news because investors suspected some sort of slow down in productions from the Middle East. It turns out they were right as Iraqi crude production was cut down by about 45% from its peak before the war. Investors also priced in extra supply coming on in the future once the oil majors began to announce new projects that they had signed with the new Iraqi government (Iraqi production by most estimates is now above the pre-war high).

Another appropriate example is when President Mahmoud Ahmenijhad of Iran began to threaten other countries and released the photo-shopped photos of the Iranian cruise missile tests. The price of crude oil futures appreciated on the belief that there would be supply shortages from a conflict in the Middle East in the near future. Geo-political tensions have historically been what has caused some of the largest swings in crude prices and I would expect this to continue into the foreseeable future.

Weather Threats

As we have seen recently, weather threats have a severe impact on commodities (and the energy sector as a whole). Hurricanes Gustav and Ike of 2008 are examples of counter-intuitive price movements in oil because of other overriding factors that were simultaneously taking place, so I would rather focus on Hurricane Katrina of 2005.

During Hurricane Katrina oil prices spiked for a number of reasons. Firstly, production both onshore and offshore was forced off-line cutting the supply. Because supply was cut domestically, there was also an added need for imported oil which meant that demand from the United States was driving the price even higher than normal. On top of that, crude prices were driven up because a great majority of the domestic transportation infrastructure (pipelines) in the southern United States was also offline. This event caused a panic and crude prices soared, which in turn caused many other commodity prices to soar. Many investors will attempt to price in the effects of upcoming weather events into the price of crude oil. This was seen with the run up in price before hurricanes that took place after Hurricane Katrina as investors learned their lesson.

Please join me for part five of this article that will be released on Tuesday, November 4th.

You can find Part Five of the article here.

- Charles W. Petredis

Disclosure: COP owns a stake in LUKOIL and the mutual fund the author manages as well as the author’s family is long COP. The author’s family is also long PBR.

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