REFINING MARGINS AND CALENDAR SPREADS – AN INDEPTH LOOK AT CURVE STRUCTURES
Finished products are the ultimate driver of crude oil prices. They are the tail that wags the dog, the reason oil markets exist. Steady refining margins that hold constant despite crude oil’s up and down moves suggest that demand is inelastic at current prices. Refining margins that decline as input prices (crude oil) move higher suggest that demand is elastic, meaning that higher input costs can not be passed along to consumers.
It is within that backdrop that we look at gasoline and heating oil refining margins (aka, crack spreads) in the following charts.
As the US becomes the marginal producer of oil and of finished products, local US spreads lose their relevance as global market prices influence local dynamics. That being said, US refiners still garner the lion’s share of their profits selling their refined products to US consumers.
We know that refinery optimization is complex and simple benchmark futures don’t do a good job of capturing alternative sources of revenue from optimization, however, we consider the lowering of margins due to ‘technology gains’ to be unresolved at this point in spreads (meaning that we cannot draw upon technology as the only driver).
You might question this in the following charts. The first chart reflecting the refining margin for producing gasoline in the US over the last 2 years, and the second chart reflecting the refining margin for producing Ultra Low Sulphur Diesel (ULSD).
We COULD use a larger historical window than the 2 years used above, but since the US shift from a local market to a global market it renders such historical views less relevant. Figure 1 represents the US New York Harbor to WTI gasoline crack spread futures curve for each month in 2020. What’s of note here is the cluster of seasonality that exists in the gasoline market refinery spreads. This looks a lot like natural gas and the
seasonality of the summer (Apr-Oct) vs winter (Nov-mar) strips. In contrast, the ULSD crack spread futures are clustered together without a clear delineation between seasons (figure 2).
In the next 2 charts, we take the average of the Winter and Summer strips to eliminate the noise of the monthly curves (figures 3 & 4, blue is winter, red/pink is summer).
What we see is that refining margins at face value are lower than 2018 levels in both RB and HO. Is this due to technology gains the the refining process, prices of other refined products in the stream offsetting traditional product margins or a suggestion of elasticity at current refined product prices?? In earlier reports, we have shown the value of other distilled or refined products lagging, so a break-out winner in some other product isn’t our first thought.
Staying focused on simple crack spreads, we highlight in chart 5 the fact that while oil prices fell in the latter half of 2018 (black line), the subsequent recovery seems to be capped by summer gasoline crack spreads (pink line). Meaning that if refining margins can’t recover towards 2018 highs, oil prices can’t either.
Hence, the large rejection of WTI prices (black line) at summer RB refining margins (again, pink line). This could be why WTI calendar spreads have continued to weaken into expiration as we see in figure 6.
There was a very steep decline in WTI one-month calendar spreads last week. This weakness has now permeated the ULSD curve which were hesitant to react to movements in oil price structures, but at the end of the day ultimately sold off in similar fashion the WTI spreads (figure 7).
On the other hand, gasoline calendar spread have been more stubborn (figure 8).
The gasoline calendar spread curve has a very distinctive structure to it, highlighted by the bold pink and blue lines surrounding the rest of the curve. The seasonality of gasoline regulations in the US is marked by ‘summer’ blend and ‘winter’ blend (of which winter allows cheaper blending components to be blended into the finished product stream). This results in large contango between summer and winter blends and vice versa (pink line vs blue line). These two extremes in spreads are generally priced at blending component differences. If winter blending component prices weaken, the spread between winter and summer widens (which we are seeing).
As we now enter the higher cost summer blend season, gasoline crack spreads widen (blue dot vs green dot in figure 9).
This could be a buoy for oil prices in the US over the next few months, simply by the fact that the ceiling is raised. Without leadership from gasoline markets, oil prices are doomed. Figure 10 shows how month-1 refining spread futures tend to follow seasonality. Specifically, gasoline cracks are set to re-adjust to summer levels (pink line). If these margins can’t sustain at futures levels, WTI will need to move lower.
One final note on crude demand signals. As winter blend-stock nears an end, we see prices of cheaper octane blending alternatives start to struggle (figure 11). This is normal as inventories begin to switch over to more stringent summer blend-stock regulations which do not allow for cheaper components to be blended in to the final product.
The weakness seen in naphtha, natural gasoline and ethanol are weighing on WTI prices while we are in a blend-stock transitional period. This could change quickly in April as those prices are no longer as relevant to summer gasoline blend-stock.
One final point. Oil spreads continue to STRENGTHEN IN THE EAST, and WEAKEN AS YOU MOVE WEST (figure 12)
Brent one-month calendar spreads are caught between a rock and a hard place (the US and the Middle East). Something is different though. Brent 1-month spreads over the past several months have traded much closer to Middle-Eastern Oman spreads. Now they appear to be setting closer to US spreads than Eastern spreads. This is a worrisome development as Brent and Oman spreads have been a bullish force on US WTI markets. We will watch this development going forward.
The EIA inventory report for week ending January 3, 2020 reported total inventory BUILD of 15.60 million barrels with Crude oil posting a net BUILD of 1.10 million barrels.
Year-to-date, US inventories are now Down a mere (3.28) million barrels.
Inventory levels are a tough one to gauge at year-end due to LIFO and accounting activity. As expected, oil inventories ended the year lower than where they were at this time last year but, not by much.
Technical Levels to Watch this Week
Support: 63.94/ 62.09
March Brent experienced the same type of volatility as the rest of the energy complex last week. March Brent broke down from its steep rally all week to settle under the trend-line of 66.03 on Friday. Support is now found underneath at 63.94 then 62.09 with resistance at 65.78. Brent spreads have also broken down with April/May trying to hold .58 then .43 and resistance above at .70
Resistance: 59.68 / 60.00
After a tumultuous week, the crude market has broken down with regards to flat price and spreads. There is still one significant area of support which is found on the weekly bar chart at 57.31 for this week. We shall watch that level to see if the market can hold its’ head above that water line. If there is a bounce, resistance appears at 59.68 then 60.00. Before we test that level, we see the 50% retracement of 58.27 on the daily chart. Feb/March should continue its slide and go out trade in contango with March/April looking to test .07 soon.
It appears that the divergence we were worried about was justified. Except for Feb/March RBOB, the rest of the gasoline spreads stayed under pressure. This week however, we may see a pop in RBOB spreads. Lots of length entered March/April under -1845 and looking for a move back above -1800. There are some on the fundamental side who would argue that this spread has more downside. Feb RBOB has resistance above at 1.6747 with support near 1.6285.
Support: 1.9262 / 1.9157
Heating oil may have finally turned on Friday. Although, like the rest of the energy complex it took a hit after tensions in Iran eased and finally showed some signs of leading the market out of this downturn. Quick support at 1.9262 then 1.9157 with resistance above at 1.9714. March/April caught a bid late in the week as it continued to bounce off the 55 level. It will need to break through 78-84 in order to see some shorts liquidate.