Crack Spread 101 (Part 6: Recent trends in crack spreads)

Continued from Part 5

Recent crack spread trends

Around the time of the 2008 financial crisis, crack spreads collapsed because demand for products such as gasoline suffered due to the weak economy. However, since around early 2011, well-positioned refiners began to see improving earnings. A major reason for this change has been the divergence between WTI (West Texas Intermediate) and Brent crudes. Refiners that had access to WTI or similarly priced crudes saw increased gross refining margins due to WTI’s relatively cheaper price, while they were still able to sell finished products at relatively higher prices, which broadly improved earnings.

2013.07.22 - Gulf Coast 3-2-1Enlarge Graph

WTI Cushing traded significantly below Brent crude for much of 2011 through mid-2013. However, throughout 1H13 and early July, the spread between WTI and Brent closed dramatically so that the two crude benchmarks now trade close to par. The WTI-Brent spread was at its widest point of ~$20 per barrel in mid-February, and it has closed in to roughly zero since then. Meanwhile, many refiner stocks that had taken advantage of discounted WTI prices have also seen their stocks fall. In mid-February, HollyFrontier Corp. (HFC) was trading at ~$55 per share, and the stock currently trades at $43 per share. Western Refining (WNR) traded as high as ~$39 per share in early March, and now trades around $29 per share. Meanwhile, the broader market has mostly appreciated. The S&P500 traded around 1500 in mid-February and is currently near 1700.

What to watch for in crack spreads

For the near future, one of the major trends to watch for in crack spreads is the WTI-Brent spread. Plus, broadly speaking, a refiner’s access to price-advantaged crude will improve its operating margin. For instance, Tesoro Corp. (TSO) has a refinery in Washington, but the company began replacing some seaborne West Coast barrels with much cheaper crude railed from North Dakota. This trend has been gaining traction because significant production growth in the inland United States has caused price differentials between crudes of different geographies to vary more than in the past. So, although TSO’s Washington refinery is on the West Coast, TSO doesn’t necessarily have to purchase all of its crude from West Coast sources and the West Coast crack may not be the best indicator of profitability.

Other factors to watch for include demand for refined products, such as gasoline and diesel, and these depend on economic health. Higher refined product demand supports prices and improves crack spreads.

Investors with major holdings should watch crack spreads. Though the spreads may not perfectly represent refiners’ gross margins, they’re a good indicator of where a refiner’s profits will go directionally.