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Oil Processing Spreads Hanging In There As Winter Approaches, And That Is Good News For Oil Bulls

by: Andrew Hecht
Andrew Hecht
Commodities, long/short equity, medium-term horizon, long-term horizon

Processing spreads give clues about demand.

The gasoline crack is a lot higher than last year.

The heating oil crack is even higher.

Refining spreads and oil stocks point to a new 2017 high in crude oil.

The potential for a spike on geopolitics.

Crack spreads represent the refining margin for processing raw crude oil into oil products like gasoline and distillates. When it comes to analyzing the fundamentals for the energy markets, crack spreads can offer important clues about two significant factors. First, crack spreads are real-time indicators for the profitability of those companies involved in processing crude oil into oil products. The refining business has always been volatile for oil companies from a revenue-generating perspective. The wider or higher the crack spread, the more money a refinery tends to make so long as it operates. The higher the price of gasoline, heating oil and other distillate products compared to the price of crude oil, the more profits refiners tend to generate.

Meanwhile, refineries are capital intensive businesses and when the crack spreads fall below break-even levels processing crude oil into products can quickly become a losing proposition for refiners. Since crack spreads trade on the New York Mercantile Exchange and market participants can calculate their value from knowledge of the current product and crude oil prices, it is easy to track refinery profitability throughout the trading day.

The second significant factor that oil processing spreads tell us is that they are also a real-time indicator for the demand of oil products. Demand for oil products translate to demand for raw crude oil which is the primary input. The current state of the crude oil cracks spreads is telling us that crude oil is going higher and will likely challenge the 2017 high.

Processing spreads give clues about demand

Crack spreads often give us insight into the path of least resistance for crude oil prices. We are all consumers of energy and crude oil. We fill our cars with gasoline, heat our homes during the winter season, and buy products that come to market via trucks, planes, and ocean vessels that all require oil products for the energy to operate. Since crude oil is the primary input in the production of these energy products we are direct or indirect consumers of the energy commodity. Therefore, when the prices of gasoline and heating oil outperform the price of crude oil, it is often a signal of stronger demand.

Conversely, when oil products are weak compared to the price of crude oil, it tends to be a sign of slack or declining demand for the energy commodity that is the input in their production. This year, the prices of both gasoline and heating oil are high compared to where they were last year with crude oil trading at close to the same price as last year at this time. Source: CQG

As the weekly chart of NYMEX crude oil futures highlights, WTI crude oil traded in a range from $49.47 to $51.93 per barrel during the week of October 17, 2016. So far this week, the range has been between $51.21 and $52.37 per barrel which is very close to last year's price. Therefore, the difference between the gasoline and heating oil crack spreads in the middle of October in 2016 and 2017 is a significant sign of demand for oil products at this time.

The gasoline crack is a lot higher than last year

The peak season for gasoline demand ended on Labor Day weekend in early September. While the gasoline processing spread has moved lower over recent weeks, Gasoline crack spreads are still a lot higher this year than they were last year at this time during the offseason. Source: CQG

As the weekly chart of the gasoline crack illustrates, during the week of Oct. 17, 2016, the range in the processing spread was from $11.39 to $13.32 per barrel. This week, the refining spread has traded from $15.98 to $17.47, over 30% higher in the middle of October in 2017 compared to the same period in 2016.

While the gasoline crack spread is currently stronger than last year, the difference in the heating oil refining spread is even more impressive.

The heating oil crack is even higher

While gasoline is a seasonal oil product, the time of the year has less of an effect on the heating oil spread. Heating oil is a distillate product and often serves as a proxy for jet and diesel fuels. Therefore, it is more of a year-round commodity when it comes to demand. Source: CQG

As the weekly chart of the heating oil crack spread shows, during this week last year, the range in the processing metric was from $15.07 to $16.22 per barrel. This week the spread has traded in a range from $23.41 to $24.67 per barrel. The heating oil crack spread is over 50% higher this year than last.

Another important point to mention is that while WTI NYMEX crude oil tends to be the petroleum of choice when it comes to the production of gasoline, it is Brent crude oil that tends to favorable for the production of distillate products. Source: ICE

As the weekly chart of Brent crude oil futures illustrates, last year during this week, Brent was trading at a midpoint value of $52 per barrel. This week, the midpoint on Brent has been around $58. Higher Brent has not depressed the price of heating oil crack spreads; in fact, the distillate crack spreads are stronger than gasoline cracks.

Both crack spreads are telling us that the demand for oil products is higher at this time compared to the same period last year. Additionally, both processing spreads are higher than levels seen at this time of the year in 2014 and 2015.

Refining spreads and oil stocks point to a new 2017 high in crude oil

Since crude oil is the primary ingredient in gasoline and heating oil, the higher level of crack spreads is likely a sign of higher demand for the raw energy commodity. Over recent weeks, we have seen a huge recovery in the prices of oil-based equities which is also a sign of strength in the energy sector during the fall season of 2017. Source: Barchart

As the one year chart of the S&P 500 Energy Sector SPDR (XLE) highlights, the basket of stocks that represent the oil patch has rallied from lows of $61.80 on August 21 to $68.26 as of October 17. While the XLE peaked at $78.45 on Dec. 12, 2016, and entered into a bear market throughout the first eight months of 2017, it turned higher in late August. The XLE ended its pattern of lower highs and lower lows on Sept. 22 when it broke above the July 28 high at $67.13 per share. Both refining spreads and oil equities are supportive for the price of crude oil. Source: CQG

As the weekly chart highlights, NYMEX November crude oil futures closed on Tuesday, Oct. 17 at $51.88 per barrel. The price range for the energy commodity in 2017 has been from $42.05 to $55.24 per barrel with the highs coming at the very start of the year in January. The trend in oil stocks after the upside break and the strength in oil product refining spreads are pointing to a continuation of higher highs in the price of crude oil and an eventual challenge of the highs for the year at $55.24 per barrel. Open interest, the total number of open long and short positions in the NYMEX crude oil futures market has been increasing steadily with the price of the energy commodity. Higher open interest alongside higher price is typically a bullish sign for a futures contract.

The potential for a spike on geopolitics

The world remains a dangerous place. Last week, President Trump refused to certify the Iran nuclear nonproliferation agreement and has sent it back to the Congress for a final determination. The move has increased tension between the U.S. and Iran. At the same time, the blockade of Qatar by Saudi Arabia and their allies in the Gulf States continue to threaten stability in the Middle East. Moreover, a continuation of dangerous rhetoric between the U.S. and North Korea over their provocative actions over recent months has put the world on the verge of a nuclear conflict. The geopolitical state of the world has not been this tense since the Cuban missile crisis in the early 1960s.

OPEC will meet in Vienna on Nov. 30, and the market is expecting the oil cartel to extend production cuts to the end of 2018. At the same time, the current geopolitical landscape has increased the potential for conflicts around the world. Crude oil is highly sensitive to events in the Middle East, and the potential for a price spike on any unexpected developments remains high.

Crude oil appears to be on a path to challenge and test the 2017 highs at $55.24 per barrel on the nearby NYMEX futures contract. Perhaps the most significant sign these days is the strength in the crack spreads compared to where they have traded over the past three years at this time of the year.

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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: The author always has positions in commodities markets in futures, options, ETF/ETN products, and commodity equities. These long and short positions tend to change on an intraday basis.