Walking in Refiner's Moccasins

By Brad Zigler

Real-time Monetary Inflation (per annum): 4.3%*

A year or two ago, oil companies were easy targets for consumer opprobrium. Record profits were scored by the majors while drivers were left steaming at the pump over ever-rising prices.

This year, it's different. At least the record profit part. Big Oil earnings have declined significantly - on the order of 70% or more - in the second quarter as independent refiners see their margins squeezed as well.

Refining's a cyclical business. Sometimes profits are fat; other times they're slim. And at times, things get so bad it's not worth lighting up the boilers. The best profits are reaped when distillate product prices are high and crude oil input costs are low. As we've seen in "Time For Crack Spreads?" it's in the fall when the so-called crack spread starts to widen. Crack spreads represent the gross profit obtained from purchasing crude oil feedstock and selling refined products such as gasoline and heating oil.

Trade the crack spread over a few seasons and you'll soon see how capricious refining profits can be. This year, the volatility in a 2-1-1 crack spread (two crude contracts versus one each of heating oil and gasoline) has been 144%. To date, the spread's up 9.5% this year, but it's swung widely from gain to loss and back again, up 130% at one point, then running a 26% loss at another. The 2-1-1 crack's reward-to-risk ratio of .07 pretty much sums up the year-to-date performance.

Less volatile has been version of the crack spread that employs exchange-traded funds on oil and distillates instead of futures. For example, you can simulate the cost structure of a 2-1-1 refinery operation by purchasing the ProShares UltraShort Dow Jones-UBS Crude Oil Fund (NYSE Arca: SCO) along with shares of the United States Gasoline Fund (NYSE Arca: UGA) and the United States Heating Oil Fund (NYSE Arca: UHN). A share-for-share package this year would have produced an 8.2% return with only 29% volatility. The ETF spread's reward-to-risk factor, at 0.28, is four times better than its futures analogue.

Crack Spread: ETF Vs. Futures

The mildness in the ETF package's volatility makes timeliness less critical when establishing a seasonal crack spread. The consequences of being too early or late are far less onerous compared to futures. To boot, no margin is required.

So when you're thinking of taking a walk in a refiner's shoes this fall, think of getting fitted for ETFs first.

*Note: To provide a longer-term perspective, we've pushed back the base for our real-time monetary inflation indicator to May 2006. The base previously was January 2008. The indicator represents the average annual rate of monetary inflation over the period. The current 12-month inflation rate is -1.5%.

Comments

[BullnBear:]

I like your concept and the math works for getting an ETF crack spread set up.

This is a period of time where it appears that the refining margins will be rough but at the same time you will probably begin to see consolidation in the industry. This is probably overdue in some instances and being on the sidelines could prevent the potential for growth based on future value in my opinion.

I believe that refiners in niche markets, (the southwest for example), have the potential of being acquired or merging to form solid long term companies, the names that I think of are Western Refining and Tesoro. I’m long Western Refining just for this reason, I don’t have a position in Tesoro at this time but that will probably change.

Great article again and thanks for the crack spread set up.

Aug 12 02:15 AM

[A Barrel Full:]

I know of a company that got killed trading gasoline crack spreads in 2008. There was no peak in the summer, like there always is, and their trades were all loss making.

This year the world has a surplus of middle distillates, so one should be very careful about expectations for the usual peak period.

Aug 12 03:37 AM