Adam Czyzewski

The performance of oil companies in Q3 2014 was strongly affected by an increase in refining margins, which was primarily attributable to a surprising decline in crude oil prices. How will oil prices and margins change in the future? Not long ago, I explored the reasons behind the dip in crude oil prices. Now, I would like to take a closer look at refining margins.

The financial performance of companies operating in the petrochemical industry – which transform one commodity, such as crude oil, into another commodity, such as diesel fuel, gasoline and heavy fuel oil – is strongly dependent of the difference between the market price of petroleum products and the price of the crude consumed to produce them. The difference is what we call a margin.

When talking about individual products we use the term ‘crack spread’ (price of diesel oil minus price of crude, price of gasoline minus price of crude, etc.). In reference to a refinery’s entire product output, however, the term ‘refining margin’ is used. As product composition of output is adjusted according to demand structure and product prices, which are not fixed, as well as depending on product yield from individual crude types, refineries calculate model refining margins, which are based on constant product shares, average in past periods.

It should be noted that short-term margin fluctuations are something to be expected as fuel prices are strongly affected by the seasonality of consumer demand, which has no bearing on the crude oil market. Temporary / seasonal production stoppages at refineries (maintenance shutdowns) also affect fuel prices by reducing fuel supply and oil consumption. In consequence, fuel prices are out of phase with oil prices when it comes to short-term fluctuations, often changing in opposition to each other, which may result in margin ups and downs.

Let’s look at PKN Orlen’s model refining margin in 2014. Initially negative in January (USD -0.10/b), the margin grew to USD 4.3/b in April, then shrank to USD 1.5/b in May, and remained at that level in June, but only to rise again in September (to USD 5.5/b). When we relate these fluctuations to changes in crude prices, we will see that the rising crude prices were accompanied by falling margins, and vice verse – when oil prices fell, margins went up. Knowing that crude prices reduce margins, this is no surprise.

However, margins behave like this (i.e. react strongly to changing crude oil prices) only in very specific circumstances:

  • when crude oil prices change abruptly, increasing in reaction to actual or anticipated supply disruptions (fear premium) or decreasing as a result of production growth, which is considerably less common, and
  • over the short term, when product prices have not yet adapted to new crude prices.

In some respects, crude oil is a financial asset, and its price is affected, through financial markets, by unexpected changes more strongly and rapidly than the price of fuels (products of crude processing), which typically react no sooner than when actual changes materialise.

In situations where global GDP and liquid fuel demand projections fall down abruptly, as it is happening now (the same took place in 2012), crude oil prices react by decreasing more sharply and quickly than the prices of petroleum products, which change gradually and over longer periods of time.

Knowing this relationship, one can expect that an actual decline in crude oil prices (if it is sustained) will likely result, within a period of several months, in lower fuel prices, which will in turn cause margins to shrink. The opposite holds true as well: if the price of crude goes up, due to geopolitical factors or other reasons, refining margins will decrease at first, and after some time fuel and petroleum product prices will follow the new oil price trend, resulting in higher margins.

Over longer time periods, the refining margin ceases to be a simple price difference and becomes a parameter tied to technologies used in the global petroleum industry: margins are set in relation to the most expensive technologies required to meet global fuel demand. In such a situation, the petroleum industry’s cost-based fuel pricing mechanism kicks in, setting the marginal cost of processing crude oil according to the formula: crude price + technological margin (for the least efficient producer / technological process). Growing fuel demand creates room on the market for less efficient refiners, and it is them who ultimately set the market price (production must be profitable over the long term). When new, more efficient refineries enter the market, on the other hand, supply increases, margins go down and the marginal cost of producing fuel is reduced, forcing less efficient refiners out of the market. To remain on the market, refineries must produce fuels at the lowest possible cost. An unexpected increase in margins is always good news, but it must not be taken as a foundation for the future.


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    1. I am of the opinion that oil market is characterised by a high uncertainty and multiple equilibria. If so, it is hard to think about a steady state. But in the realm of a conventional thinking, which underlines conventional models (reverting to the mean), I would agree with you. Other things equal, oil prices were too high and margins too tight.

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