PETROLEUM REFINERY MARGINS:Operational and Financial Strategies

byStephen M. Haik

EMBA 762: Corporate Risk Management

A. B. Freeman School of BusinessTulane University

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Petroleum Refinery Margins

• Gross Margin =Price of Gasoline & Heating Oil – Cost of Crude Oil

• Projected Operating Margins based on spot price forecasts for gasoline and crude

• Using futures - Lock in prices in the futures markets for buying crude and selling gasoline and heating oil in tandem. Called the CRACK SPREAD

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Unique opportunity in Futures Markets

• Futures Markets prices imply refinery margins 85% above experience and expectations

• Ensures Net Income well above forecasts.

• Lock-In?

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Financial Margins

• 10-7:3 (10 barrels of crude vs. 7 gasoline & 3 heating oil)

Futures prices, all prices in dollars per barrel

Historical Dec

Spot Futures

+ Gasoline (dollars/barrel*7) = $26.5 $33.4

+ Heating Oil (dollars/barrel*3) = $24.9 $34.7

- Crude Oil (dollars/barrel*10) = $22.7 $28.8

Implied Refinery Margin = $3.4 $5.0

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Petroleum RefineryCrude Margins

$0

$1$2

$3

$4$5

$6

$7$8

$9

$10$11

$12

Jan-96 Nov-96 Aug-97 Jun-98 Mar-99 Jan-00 Oct-00 Aug-01 May-02 Mar-03 Dec-03

$ / B

BL

Historical Data

NYMEX Futures

Corp. Predictions

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Financial Vs. Operational Margin

• NYMEX Offers $6.94/bbl average margin for April – December 2003 or next 9 months

• $6.94/bbl monthly average refinery margin has been exceeded only 2 times in past 85 months (1996-2002)

• Actual refinery margins average $3.35/bbl historically

• Conservative projection (for planning) – Refinery margins expected to remain around $3.75/bbl, April – December 2003

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Profitability Implications

• 50% of Rated Crude Capacity Allows the Opportunity to make $103 MM over expectations for the remainder of 2003

• 80% of Rated Crude Capacity Allows The Opportunity for $166 MM Over Corporate Estimates for the remainder of 2003

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Scenario Analysis

1) Crude and Product prices change in tandem (i.e. margins unchanged)Crude Products Margin

Time 0 $36 $42 $6Time X $46 $52 $6 Value +$10 -$10 $0• Spot margins $10/bbl, Lock in margins $10/bbl, LOSS/GAIN = $0/bbl• Total Margin: $6/bbl refinery margins + $0/bbl from futures contracts = $6/bbl

2) Crude prices decrease more that product prices (i.e. margins widen)Crude Products Margin

Time 0 $36 $42 $6Time X $30 $40 $10 Value -$6 +$2 -$4• Spot margins: $10/bbl, Lock in margins: $6/bbl account, LOSS = $4/bbl• Mark-to-market cash flows will need to be met• Total Margin: $10/bbl refinery margins - $4/bbl from futures account = $6/bbl

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RISKS

• Actual margins may widen:

– Profits less than what they would have been (still higher than historical experience)

– Cash flow risk from marking-to-market

• Must process no less than the quantity of crude/products traded to enjoy the $6.94/bbl locked in margins (else it is speculative)

• Futures transaction requires monitoring. For example, do not use crude contracts during future’s expiration month as seller can force delivery

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SHOULD WE HEDGE?

• Volatility in the oil markets makes margins volatile. Shareholders know the exposure and factor it in their investment strategies.

• However, periods of low profits can be expensive. Reduce investment opportunities or increase bankruptcy costs.

• More importantly, do we know something that could lead us to believe that we can convert periods of low profitability to periods of high(er) profitability. Should we act on this belief and hedge strategically?

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Summary

• Purchasing crude and selling gasoline and heating oil futures in equal volumes secure the refinery margins

• Oil market volatility is hedged by trading a balanced account of refinery feeds and products

• Unique opportunity for securing profitability above projected and historical levels using futures strategy

• Risks are manageable

• $100 million opportunity above current projections

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