The crack spread

I posted a blog entry on January 19 on the increasingly uneconomical industry of petroleum refining in the US. A consequence of refineries moving offshore due to shrinking profit margin are higher prices across the energy complex.

According to the Energy Information Administration's (EIA) "Derivatives and Risk Management in the Petroleum, Natural Gas, and Electricity" publication, a "crack spread" is the following:

Refiners’ profits are tied directly to the spread, or difference, between the price of crude oil and the prices of refined products. Because refiners can reliably predict their costs other than crude oil, the spread is their major uncertainty. One way in which a refiner could ensure a given spread would be to buy crude oil futures and sell product futures. Another would be to buy crude oil call options and sell product put options. Both of those strategies are complex, however, and they require the hedger to tie up funds in margin accounts. To ease this burden, NYMEX in 1994 launched the crack spread contract. NYMEX treats crack spread purchases or sales of multiple futures as a single trade for the purposes of establishing margin requirements. The crack spread contract helps refiners to lock-in a crude oil price and heating oil and unleaded gasoline prices simultaneously in order to establish a fixed refining margin. One type of crack spread contract bundles the purchase of three crude oil futures (30,000 barrels) with the sale a month later of two unleaded gasoline futures (20,000 barrels) and one heating oil future (10,000 barrels). The 3-2-1 ratio approximates the real-world ratio of refinery output—2 barrels of unleaded gasoline and 1 barrel of heating oil from 3 barrels of crude oil. Buyers and sellers concern themselves only with the margin requirements for the crack spread contract. They do not deal with individual margins for the underlying trades.

Traders are profiting from the closure of American refineries, as the crack spread is widening. However, the bottom line to US consumers and businesses are higher energy prices going forward.

http://www.bloomberg.com/apps/news?pid=20601109&sid=amg1Ou18W4wY&pos=15

US refineries

I had a couple discussions last week with two men who work in refineries, one in Louisiana and Texas. Apparently, it's becoming increasingly difficult to operate a petroleum refinery in the Gulf states due to environmental pressures, shrinking profit margins and regulatory restrictions.

Refineries are an important link in our nation's energy chain, where crude oil is processed and refined into byproducts such as gasoline, diesel, asphalt base, kerosene, heating oil, and liquefied natural gas.

The US already imports too much crude oil from foreign countries, some with unstable governments, putting us at geopolitical risk. If more domestic refineries are forced offshore, we will become increasingly dependent on foreign sources of energy. Crude oil AND refined products would need to be imported. This will increase our exposure to supply shocks, and it will also inject a hidden, permanent tax on our energy sources.