Refining operations set the stage for price dynamics that fuel global transportation supply chains. However, the process of creating petroleum products that move goods to market is often forgotten by shippers, carriers, and consumers alike. This reveals the importance of conceptual visibility, as understanding refinery fundamentals is advantageous in gaining insight into the drivers of industry-wide fuel spend.
Refinery Operations: Behind-the-Scenes of Fuel Production
Refineries depend on massive chemistry-driven manufacturing processes responsible for the physical and chemical transformation of petroleum products. They leverage boiling temperature, chemical and thermal processes, and purification techniques to remove impurities and convert the raw crude oil into desirable finished goods. Despite ever-changing government-mandated specifications, market demand, and encompassing production constraints, refineries have the end goal of producing salable products that optimize financial performance. Though crude oil holds marginal value in the grand scheme of the overarching refining industry, the products refineries can bring to market elevate and expose the underlying value of crude commodities. Ultimately, refineries are the key to exposing the value of a barrel of crude through the refined fuels they can produce, as price dynamics of refinery byproducts are an essential indicator of performance.
Refineries, and the portfolio of crude oils they process, are like human fingerprints in the sense that no two are alike. Refineries achieve differentiation based on the processes they can execute and the corresponding production capacity of those processes. The construction of refineries depends on the type of crude inputs, also referred to as the crude slate, available in each region, as well as the demand-driven quality and specifications of refined products desired in each geographic marketplace. The scatter plot below shows the average sulfur content and crude oil density for the West Texas Intermediate (WTI) and Brent crude benchmarks, in addition to the crude oil characteristics of the top 10 source countries of US crude oil imports. Generally speaking, light-sweet and heavy-sour, terms often used to describe crude oil quality, vary significantly by cost, as light-sweet and heavy-sour crudes are the costliest and cheapest types of respective crude oil. The countries shown below account for 93 percent of the total crude oil imports utilized by US refineries.
While the finished goods refineries bring to market vary depending on their production capabilities, the primary refined products sold by refineries include:
- Gasoline: often contains additives and performance enhancers the most significant refinery product
- Kerosene: used as jet fuel and as a blending agent for diesel
- Hydrocarbon Gas Liquids: used as fuel for heating and cooking, additives for gasoline, and feedstock for production of chemicals, plastics, and synthetic rubber
- Ultra-Low Sulfur Diesel: a cleaner-burning diesel containing 97 percent less sulfur than low-sulfur diesel that was developed to reduce emissions and support pollution control
- Other Distillates: heating oil, which is chemically comparable to diesel, is used primarily in the northeast region of the United States by residential and commercial consumers
- Residual Fuels: widely utilized by marine vessels
- Other Refined Products: butane, naphtha, other blending agents, etc.
Refinery Complexity: Measuring a Refiner’s Core Processes
Refineries are usually classified as simple, complex, or very complex depending on their conversion capacity and the types of processing that occur. Simple refineries typically include distillation units, complex refineries focus on cracking capabilities, and very complex refineries participate in coking processes.These complex and very complex refining processes ultimately enable refiners to reprocess heavy hydrocarbons, or fractions, into lighter, more versatile products that later evolve into desirable refined fuels.
Classifications of refineries allude to the quality of refined products they produce and are later influential in assignment of a refinery complexity score, based on the Nelson Complexity Index, on a scale of 1-15 (least to most complex). Most refineries in the United States possess the ability and capacity to process heavy crude oils that many other geographies are unable to convert because of the lack of complex transforming processes. The United States and North America’s refining infrastructure has historically boasted stronger complexity scores than other international markets, enabling the region to maximize gross margin and efficiently satisfy market demand. The chart below highlights refinery complexity by geography, revealing the US and North America’s competitive advantage in the refining space.
Refinery outages due to maintenance, weather, unforeseen technical errors, and other unexpected influencers all have the potential to lead to offline production, ultimately creating upward price pressure as supply decreases. The lack of output to the marketplace forces reliance on neighboring markets to help fill the supply void, later creating a far-reaching supply and demand imbalance that can drive prices upward for consumers. This in mind, the US refining infrastructure is the most advanced, complex and dense in the world, meaning lost output from outages is typically dispersed efficiently across the refining landscape. Aside from mass outages to key refining hubs, such as those experienced from Hurricane Harvey or other catastrophic events, small-scale refinery outages usually result in negligible price movements as a result of supply-demand pressure.
Crack Spreads: Connecting Refiner Margins to Prices
Crack spreads are another metric refiners are cognizant of, as higher spreads equate to stronger financial margins. Crack spreads measure the price differential (estimated gross margin) between the crude oil commodity that is inputted into the refinery and the selling price of the refined product. Supply and demand fundamentals that dictate market price behavior also, in turn, impact refinery crack spreads comparatively. As demand for refined products, such as diesel or gasoline, increase, prices also increase. This expands crack spreads, while oversupply can have an inverse effect as the value of refined products declines. Ultimately, a refiner is caught between two markets: the raw materials (crude oil) they need to purchase and the finished products (fuels) they bring to market.
One timely example of how industry events and demand for refined products influence crack spreads is the impending IMO 2020 Sulfur requirements. With the International Maritime Organization’s (IMO) regulations regarding sulfur requirements for marine vessels at the forefront of many fuel procurement decisions, crack spreads and the encompassing prices of refined fuels will be impacted. The chart below shows the futures ULSD to West Texas Intermediate (WTI) crack spread highlighting the IMO 2020’s peak. The increased demand for low-sulfur blend stocks, such as diesel, will drive prices of ULSD upward, and drastically change refining dynamics and pricing structures as the federal mandates approach.
Gaining cognizance of the procedural nuances that refineries regularly face leads to a better understanding of the crude oil and refined product industry. Multiple variables influence refining operations, with price implications of fuels that move consumer goods to market constantly subject to change based on refinery performance and key market fundamentals. With frequent changes to the crude oil and refined product industry, such as the upcoming regulatory amendments associated with the IMO 2020 mandates, it is important to be mindful of the upstream and downstream complexities that ultimately influence transportation fuel prices.
Interested in learning more about the fundamentals of the crude oil industry that lead into refining operations? Read about it in our Beginner’s Guide to Upstream Crude Oil Economics. To learn more about the global refining industry and how market dynamics impact fuel prices within your transportation network, contact the Applied Knowledge team directly.