When U.S. investors look at the oil market, they tend to ignore the crack spread -- but more and more researchers are urging them to reconsider.
In this segment from Industry Focus: Energy, two Motley Fool analysts explain what a crack spread is, what kinds of companies it's most relevant for, why it vacillates as much as it does, why it exists, where it is today in the cycle, some advice for investors looking into companies whose profits are most linked to the crack spread, and more.
A full transcript follows the video.
This video was recorded on April 6, 2017.
Sean O'Reilly: So, last couple shows, we chatted about oil price and inventories. Despite the drop in shale production over the past few years here domestically and OPEC's cuts or whatever, Cushing inventories are still high. And every week, you get a couple little builds in there, and it's like, what's going on here? However, as was first touched upon by Tyler Crowe a month or so ago, when I had him call in from Malawi, this week, we have a string of articles from places like Bloomberg that U.S. traders might be focusing on the wrong data. More specifically, there's a Bloomberg article, "Oil Traders Are Looking at the Wrong Inventory Data," and it was written by Jason Schenker. He's the president and founder of Prestige Economics LLC, and he talks about product inventories like gasoline. For the layman, this is, plus oil, is used for plastic.
Taylor Muckerman: Generally, I would say most everything you touch throughout the day, your Tupperware, your car tires, some of your clothes, the soles on your shoes, yeah.
O'Reilly: What do you know about my -- no, I'm kidding. He also in the article talks about something called the crack spread, which I hope you can add some light on. We haven't mentioned this much on the show, but what is a crack spread, Taylor?
Muckerman: It's getting down into the nitty-gritty. It's really important for people who are looking at refiners. Basically, to make it as simple as I can make it, it's the margin that refiners are going to make from the cost of a barrel of crude oil to the cost that it takes to produce oil.
O'Reilly: Why does that vacillate? I'm surprised that it changes, quite frankly.
Muckerman: The price of oil, obviously, fluctuates. When it's $100 a barrel, obviously, a refiner's costs were a lot higher. So they elevated the price of gasoline. You're basically trying to take the barrel of oil equivalent of gasoline, have that price set, and then have the price that they paid for that oil, subtract it so that you get the margin. Hopefully for the refiners, the cost that they're selling a barrel equivalent of oil or gasoline or refined product is higher than they're paying for a barrel of oil. And they call it the crack spread because you're basically cracking oil up, the individual hydrocarbons into their end uses as refined products.
O'Reilly: Why does this exist? I remember when oil prices were literally plummeting in late 2014, they were talking about how the oil majors that owned refineries, they're going to do OK -- "OK" being a relative term, compared to a straight-up producer -- because the crack spread was widening. Is that because oil prices, their base commodity that they're cracking into -- is it falling faster than the end products they're selling?
Muckerman: Yeah, I feel like if you've ever looked at oil prices rising and falling, it's kind of a lag before gasoline prices follow suit.
O'Reilly: Is that the cause of the crack spread?
Muckerman: The cause of the crack spread is the vacillation of prices at different times. There's a history there where you see the crack spread, in 2011 and 2012, the crack spread was a little positive for the Gulf conventional gasoline crack spread. But earlier on in February 2011, you saw negative crack spread. I think it's less important for long-term investors because it's cyclical, and it does change over time. But obviously, if you're looking for short-term investment in a refiner, you're going to want to know what the crack spread is, what the projections are.
O'Reilly: He basically says that crack spreads are on the rise, at their highest levels since early, a year ago, 2016. He basically implies that that's an incentive for refiners to go grab all the oil that's in inventory and make it into stuff.
Muckerman: You would imagine so, because you never know when prices are going to rise. If you listen to a few recent projections from investment bankers, BNP Paribas said they could see $70 oil by the end of this year.
O'Reilly: That'd be fun.
Muckerman: Another bank that escapes me said $60 oil within the next three months. It's these spikes that catch the refiners off guard. If you have sustained pricing, then they can plan a little bit better for it. But it's this uncertainty.
O'Reilly: And that's when the crack spread drops, I assume?
Muckerman: You become more profitable if you can sustain low oil prices, and then you can push out lowering gasoline prices. Eventually, though, your customers are going to be like, "Well, you're getting your input costs a little cheaper, so how about you hook us up with a little bit of that margin you've been benefiting from?" But we should mention, end product inventories are down, so refiners could be buyers in the short term, especially with the summer driving season coming up.
O'Reilly: Which is basically what he was talking about.
Muckerman: Yeah. It's just the less heralded inventory levels, because oil is the base cost, that's what gets it all started, so that's the headliner.
O'Reilly: Of course, at the end of the day, just focus on good companies.
Muckerman: Yeah, you can also focus on, if you look at where the refineries are getting their oil from. A lot of mid-con refiners here right along the Cushing area and the Gulf Coast generally getting some cheaper oil, and the lighter sweet crude oil, which is easier and less costly to refine. You look at you getting Gulf oil from out in the Middle East, or if you're getting Mexico oil or heavy oil sands oil from Canada, it costs a little bit more to refine.
O'Reilly: So it's cheaper?
Muckerman: The oil itself is cheaper, but the cost for the refiner is a lot higher, because it's a lot dirtier, and it necessitates more refining than the light sweet crude. Generally, the U.S. is producing light sweet crude, and everywhere we import it from is producing the heavier crude.