July 28, 2015
The quarter’s end is a good time to confront what we had expected would happen on the oil and fuel markets with what actually happened. And this past quarter was certainly interesting in its diversity.
During the quarter and after it ended, a number of developments took place that had a profound impact on the expectations of economic growth in the US, Europe and China. These included dramatic negotiations between the Greek government and its creditors that produced a fragile, last-minute agreement (July 13th), a deal with Iran signed on July 14th by the US, Great Britain, France, Germany and Russia, following two years of arduous negotiations, which lifted the economic sanctions against Iran in return for the country limiting its nuclear programme, and uncertain growth prospects for the Chinese economy, which is in desperate need of deep structural reforms rather than another stimulus package. As these developments unfolded, they prompted changes in estimates of future oil and fuel demand and caused financial flows on the currency and commodity markets to fluctuate.
Fuels and crude oil are entirely different commodities
Fuels (such as naphtha, diesel oil, and heavy fuel oil) are commodities and, in common with crude oil, their prices are quoted (or determined) on global commodity markets. The fuel markets, however, have their own dynamics, independent of the forces that drive the oil market. Although fuels are derived from crude oil, they form separate markets, because they are completely different commodities used for very different things. Having a vast and highly liquid market, oil is a financial asset which is in great demand at times of prosperity. Fuel markets are also unlike one another, with gasoline markets behaving differently than diesel oil markets, because the two commodities have different applications. Diesel oil is the primary fuel for heavy transport, where its competitor and closest alternative is LNG, rather than gasoline. Gasoline, on the other hand, is used for light transport and as a fuel in petrochemical production, where its main rival is natural gas. Due to certain supply and demand factors characteristic of these two very distinct commodities, the prices oil and fuels often move in opposite directions.
Margins or price scissors
Refiners buy crude oil at market prices, crack it into fuel products, which they sell at prices also dictated by the market. The differential between the price of benchmark crude (Brent in our case) and petroleum products extracted from it (e.g. gasoline or diesel oil) is called crack spread. By weighting crack spreads by the product slate typical of a region or refinery, we arrive at a model refining margin. Just to clear things up, margin is an unfortunate word in this context as it implies a mark-up on costs, which is usually determined by the producer. This is how it used to work before crude oil and petroleum products began to be traded on commodity exchanges, when the prices of fuels had been set by oil companies. Today the term can be misleading. A refinery could not ask a price for its fuel products above the market price, because no one would buy them. It could not sell them cheaper, either, because revenues below achievable levels would be unacceptable to shareholders. In a nutshell, petroleum product prices, and hence model refining margins, are imposed on refiners by the two unconnected oil and fuel markets. To my mind, price scissors would be a more accurate term than margin. Margin (multiplied by the number of barrels of product sold) must cover total OPEX and generate profits, which are a long-term source of financing business growth.
Links between oil and fuel markets
Does the fact that fuel products are made from oil not create any links between the prices of the two? The links do exist, of course, and the global refining industry’s cost curve is their conceptual illustration. The idea is that the price of a homogeneous product, like gasoline or diesel oil, should be such as to ensure that the least efficient refinery which still finds demand for its products operates at a profit. The cost curve determines the crack spread/model margin which depends on the refining technology used. For a given oil price level, this margin determines the floor price of fuels below which the least efficient refineries on the market begin to run at a loss. When market forces cause the refining margin to shrink below the floor, the least efficient refineries yield under the market pressure and go out of business.
For instance, the end of 2013 and the beginning of 2014 saw an oil price hike reflecting a “fear premium”. Fuel prices did not follow an uptrend, though, due to weak demand in the Atlantic region. As a result, unprecedented declines in refining margins forced many refiners out of business. Orlen’s refining margin in the fourth quarter of 2014 was a mere USD 0.7/b, with the oil price at USD 109/b. Bankruptcies and forced shutdowns of European refineries led to reduced supply, which gradually lifted the prices of fuels and refining margins. Orlen’s refining margin grew to USD 1.3/b in the first quarter of 2014 and to USD 2.5/b in the quarter after that, with oil prices virtually unchanged (at USD 108/b and USD 109/b, respectively).
Where price scissors (margins) are wider than the floor refining margin, technological considerations lose relevance. This has been the case since July 2014, when oil prices began their march downward. The impulse of Libyan oil coming back on the market (http://ffbk.orlen.com/blog/what-s-up-with-the-oil-market ) had nothing to do with petroleum products, so there was no reason for fuel prices to drop. Just the opposite, European refiners, who suffered a heavy blow from margins having fallen below the profitability floor, needed to go back to normal, which they could do with slipping oil prices. With oil prices retreating by the month and with improved refining margins, refineries increased throughput, which in the case of European refineries, thus far facing the problem of excess capacity, was both easy and profitable (lower fixed costs as a percentage of total costs led to improved operating efficiency). After the opportunistic rise in production was placed on the market, the prices fell. And since the situation changed for the entire refining sector, the gradually increasing supply of fuels had to ultimately push market prices down. From June 2014 to January 2015, when Brent oil price hit a low (USD 48/b, down 57%), the market prices of naphtha and diesel oil slid by 55% and 48%, respectively. In the same period, refining margins grew. Orlen’s model (market) refining margin went up from USD 4.8/b in the third quarter of 2014 to USD 5.0/b in the following quarter.
What was happening with retail prices during that time? In June 2014, motorists in Poland paid an average of PLN 5.39 per litre of Eurosuper gasoline and PLN 5.24 per litre of diesel oil. In January 2015, the prices fell to PLN 4.41 and PLN 3.48, with the price of gasoline down 18% and the price of diesel down 17%. Why did they fall at a slower pace than the prices quoted on international markets? Trade on international markets is in “pure” petroleum products, containing no biocomponents or quality-improving additives (which are more expensive and mixed to blends in various proportions, depending on the type of final consumer), while retail prices are charged on final products. In the process of prices being transmitted from global markets, through wholesale, to retail, price fluctuations are evened out due to customer proximity (consumers dislike price hikes, while wholesalers and retailers dislike price drops, so movements in wholesale and retail prices are less sharp and less frequent). These factors are always at play. However, in the period we are looking at, it was the appreciating US dollar that had the greatest impact on retail prices in złotys. The dollar strengthened by 14% against the euro and by as much as 21% against the złoty.
What happened in the second quarter of 2015?
The price of Brent trended upwards from January to April, with the trend reversed in early May. There were several reasons behind the reversal. Besides the factors mentioned earlier, such as concerns over demand continuing its strong momentum from the first quarter of the year and Iran’s expected return to the global oil market, it also turned out that, seeking support from production costs, oil prices rebounded too fast from their January low, limiting the scale of the much-needed reduction in excess supply (http://ffbk.orlen.com/blog/are-crude-oil-prices-rebounding). The effect of price stimuli coming from the oil market (oil price quotes are in US dollars) was dampened by the appreciating dollar (http://ffbk.orlen.com/blog/cheap-oil-and-strong-dollar). In May the rising price of Brent crude slowed down to USD 64.3/b (up 34% on January). In June the price edged down to USD 62/b, with the downtrend continuing into July (with the average price at July 17th of USD 58/b).
By contrast, fuel prices have been trending upwards since January. The prices of naphtha and diesel oil quoted on international markets climbed 46% and 26%, respectively, from January to May 2015. This rise was buoyed up by the expected growth in demand, reinforced by the positive effects of lower oil and fuel prices, which feed through into the economy with a delay of two to three quarters. In June gasoline prices advanced by a further 2.7%, while diesel oil prices dropped 3.7%. It is interesting to note the asymmetry in the market prices of gasoline as compared with diesel oil, which was particularly pronounced in June. It followed from strong demand from the petrochemical industry following the end of the planned maintenance season, further bolstered by the approaching driving season in the US, which coincided with the end of the planned maintenance season in refineries and sizeable demand for gasoline blending components.
Refining margins kept widening with the global market prices of fuels growing faster than oil prices. Orlen’s model refining margin rose from USD 7.5/b in the first quarter of 2015 to the record 9.8% in the second quarter. The rising global market prices of fuels, which pushed margins higher, were also the main reason why retail prices started to march back up again from a low recorded in January 2015. In June drivers paid PLN 4.93 for a litre of Eurosuper gasoline (up 11.8% on January) and PLN 4.74 for a litre of diesel (up 8.2% on January). These price rises would have been less substantial if the US dollar had not strengthened by 1%.
Wide margins are a reason to rejoice for refiners, but they are not to stay for long and are likely to contract to some extent. According to our own oil and fuel market outlook (http://ffbk.orlen.com/blog/waiting-for-expectations-how-will-the-oil-supercycle-end), after excess oil supply has been absorbed by the market and relevant adjustments have been made on the supply side, oil prices will enter a lasting uptrend, rising faster and sooner than fuel prices, which will again depress margins. In the next six to eight quarters, we are likely to witness oil prices rising and falling in search of a balance and fuel demand adjusting to lower prices.
In the last 12 months, 10%, or PLN 0.5 per litre, has been shaved off the prices of Eurosuper gasoline and diesel oil. The prices would be 25% lower if it were not for the stronger dollar. Strong refining margins, combined with the fact that European refining capacities are yet to be fully utilised (working at full capacity, Orlen refineries are an exception here), encourage refiners to increase throughput, while more fuels supplied to the market are a sign of potential future price cuts. In the next three to six months, provided the Greek crisis is contained, the US dollar should stop gaining in value and correct lower. Polish motorists hoping for lower pump prices may well see their expectations materialise.