As a generalisation, agricultural commodity prices are driven by the weather, energy prices are driven by politics, and metal prices are driven by economics. It takes political finesse to get Saudi Arabia and Russia to co-operate in reducing oil production, in order to “rebalance” the global oil markets. Or it takes the suicidal policies of the late Hugo Chavez to drive Venezuela – the country with the greatest oil reserves in the world – to bankruptcy.
But, as always, there are exceptions to those generalisations. When Harvey careened through the Mexican Gulf, it disrupted US Gulf Coast refineries, infrastructure and supply chains, and significantly affected the price structure of the energy markets, namely the ‘crack spreads.’ [See Figure 1: ‘Gulf of Mexico and US oil infrastructure’]
Technical JargonI have previously written about technical jargon used in the energy sector (“Oil entrails” – ‘Divining Omens’ July 18, 2014, and “Lost in a foreign land” – ‘Lost in a Foreign Land’ September 28, 2016). The ‘crack spread’ is a perhaps one of the more exotic, but no less technical terms used in energy trading. It refers to the differential between the price of crude oil and the price of products derived from the processing of crude oil.
In petrochemistry, cracking is the process of breaking long-chain hydrocarbons (which do not flow easily and are difficult to ignite) into short hydrocarbons by using high temperatures, high pressure and catalysts. The process of refining crude oil is thus said to ‘crack’ crude oil into refined products such as petrol (gasoline), kerosene (jet fuel), diesel and fuel oil. [See Figure 2: ‘The cracking of crude oil into refined products’ ]
The situation on the ground
Harvey is reported to have impacted approximately 20% of the US refining capacity, exacerbating the build-up of crude oil inventories. However, trains, planes and automobiles do not run on crude oil – they run on diesel, kerosene and petrol respectively. The presidential release of crude oil alleviates neither the refining bottleneck nor the fuel shortage at the bowser – it still has to be refined.
In addition, many of the US refineries are due to close for their annual maintenance, after the summer driving season. They will very likely take this opportunity to remain closed and perform routine maintenance.
Situation on the markets
This (i) relatively abundant crude oil supply but reduced crude oil demand from the refineries, and (ii) shortage of refined products emanating from the refineries but stable demand from consumers, has led to a significant divergence in the price of crude oil vs. the prices of the refined products. The difference between these prices is known in the energy markets as the ‘crack spread’. Figure 3 above illustrates the crack spread, or difference in pricing between petrol and oil in 2017, the last price spike being the result of Hurricane Harvey.
Refineries profit margins
This crack spread is perhaps of arcane interest to the broader community, but it is critical to the oil refineries. Crude oil represents the bulk of their variable input costs, and the refined products the bulk of their output prices. The difference (the crack spread) represents the bulk of their profits. The refineries are thus active hedgers of the crack spread, usually buying futures on crude oil and selling futures on the refined products.
As most meteorologists and TV stations know only too well, the weather is notoriously hard to predict. But it can have a significant effect on the price of many commodities – including the crack spread!
For further insight into the impact on commodity prices, listen to Andy’s latest radio interview.Podcast: Should you be aware of the crack spreads?