refiner’s standpoint (for examples, see the Wednesday Weekly Oil Roundup editions of Brad’s Desktop).
The thinking behind this approach is simple. Better-informed consumers are less likely to be surprised by shifting price trends in crude oil and refined products, such as gasoline and heating oil. Investors, too, are better served if they understand the price pressures at the refining level.
The presentation of these indicators, however, prompts more than a little head scratching among new readers. “What’s the significance of the differential in refining margins?” asks one reader. Another inquires: “Why should I care about a three-month roll in WTI futures?”
So, just as we did with our Friday Inflation Scorecard columns (“Deciphering The Inflation Scorecard: Why Gold?” and “Deciphering The Inflation Scorecard: Part 2“), we’ve put together a guide to our Wednesday Weekly Oil Roundup indicators.
Oil Refining Margins – Not all refiners are alike. Refiners make choices about the products they turn out based on equipment availability and market demand. Some refiners may concentrate on the production of lighter distillates, such as gasoline, while others tend to produce higher proportions of middle fuels, such as diesel and heating oil.
For lighter distillate refineries, a 3-2-1 “crack” is used as the standard mix: three barrels of crude oil yields two barrels of gasoline and one barrel of heating oil.
Refiners leaning toward middle distillates are proxied by a 2-1-1 crack: two barrels of crude oil yields one barrel each of gasoline and heating oil (heating oil and diesel are chemically similar and likewise priced alike).
Gross refining margins are derived by dividing the proceeds of product sales by the cost of the crude oil inputs. When the economy’s perking along, selling gasoline is favored over diesel and heating oil, since consumers tend to drive more, increasing gasoline demand. Petrol consumption, in contrast, declines in bad times, along with motor fuel prices.
Thus, the peaks and valleys in the margin differential often confirm broad economic trends. 3-2-1 runs will tend to move to a premium over 2-1-1 operations in boom times and reverse to a discount in downturns.
Refining Margin Differentials Vs. S&P 500
Average Daily Volume and Open Interest – Week-to-week changes in volume give shape to a price trend. An increase in volume adds strength to a trend, while a decline makes it suspect.
Open interest represents the number of unliquidated contracts, or potential volume, extant. When open interest builds, traders flood into the market, while declining open interest denotes a liquidating market. Stronger price trends—both bullish and bearish—are accompanied by rises in volume and open interest.
CBOE Oil Volatility Index (OVX) – The Chicago Board Options Exchange tracks the implied volatility embedded in options on the United States Oil Fund (NYSE:USO) in its OVX index. The index is a clue to traders’ near-term expectations. The number—currently 27.28—represents the annualized expected volatility in USO prices over the next 30 days. A relatively low reading means options are “cheap,” favoring their purchase, while high values make it more attractive to sell. Generally speaking, as oil prices fall, volatility tends to rise, while it declines in a bull market.
ETF Daily News Notes Some other Oil Related ETFs: iPath S&P GSCI Crude Oil (NYSE:OIL), PowerShares DB Oil (NYSE:DBO), ProShares Ultra DJ-UBS Crude (NYSE:UCO), PowerShares DB Energy (NYSE:DBE), United States 12 Month Oil (NYSE:USL), PowerShares DB Crude Oil Dble (NYSE:DTO), ProShares UltraShort DJ-UBS (NYSE:SCO), United States Short Oil (NYSE:DNO), PowerShares DB Crude Oil Long (NYSE:OLO), United States Brent Oil (NYSE:BNO), PowerShares DB Crude Oil Short (NYSE:SZO), United States Heating Oil (NYSE:UHN), Oil Services HOLDRs (NYSE:OIH).
CBOE Oil Volatility Index (OVX)
Protective Put Prices – The CBOE Crude Oil Volatility Index derives its value from a universe of calls and puts. The Oil Put index, though, only considers put prices as the cost of insurance on a long oil position. An upward spike in the index often precedes a significant price break, while low values suggest trader complacency with oil prices.
Heating Oil/Gasoline Spread – A spread represents a paired futures position—long one contract, short another. Spreads capture a developing discount or premium between the two contracts.
Conventionally, the first contact specified is bought, the second sold. Thus, the HO/RB spread consists of buying heating oil and selling RBOB gasoline. Heating oil tends to move to a premium over gasoline in winter and early spring, but generally loses ground to trade at a discount in the summer driving season.
Heating Oil (HO)/Gasoline (RB) Cracks
Corn/Ethanol Crush – The U.S. manufacture of ethanol—an alcohol additive to motor fuel—is based upon corn. Rising corn prices reduce the crush yield if ethanol prices fail to rise apace. At times, the correlation between corn and ethanol prices rise, at other times it falls.
Presently, inflation in corn prices outstrips that of ethanol, reducing refiners’ yields. Thus, the price of gasoline and ethanol can be compared to determine the relative attractiveness of adding alcohol in the fuel mix.
Brent/WTI Premium/Discount – The benchmark grade for European crude oil is Brent—which is extracted from North Sea oil fields—while the U.S. uses West Texas Intermediate crude. The U.S. grade is lighter and sweeter—meaning it is less viscous and lower in sulphur—than North Sea oil and, consequently, it tends to trade at a premium. Supply considerations, however, can cause a disruption in the normal spread. Presently, a relative glut of WTI to North Sea oil has caused Brent to trade at a substantial premium to WTI. To a certain point, this improves the competitiveness of Canadian oil (the U.S.’ largest foreign supplier).
WTI Contango/Inversion – The spread between the price of the near-month NYMEX contract and the one for delivery three months later reflects the market’s perceptions about oil supply. When near months bid higher than the price of later deliveries, there’s not enough product to carry over—a condition known as “inversion,” or “backwardation.” This tightness in supply usually translates into high overall prices. The converse—where lower prices in front months and progressively higher prices in distant deliveries, often known as “contango”—describes a market well-supplied with oil.
You should now have a handle on our Wednesday numbers. Hopefully, this little primer will help you make sense of our weekly reports on this critical market sector. Your questions, of course, are still welcomed.
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