This oil market signal indicates the economic rebound is here to stay. So what's the best way for traders to play it?
Oil's had an exciting week. How so? Well, the petroleum sector is finally sending definitive signals of an economic rebound.
The indication arises from the recent downward volatility in the cost of crude oil, together with simultaneous upside pressure in refined product prices. We're now seeing refining profits normalize to levels not seen since spring 2009.
You may well ask why you should care about refiners' earnings, but trust me, there's a way for you to piggyback on their good fortune to generate profits of your own.
Let's not get ahead of ourselves, though. We need to define a few terms first.
Crack Spreads
Refiners make money by "cracking" input crude oil into an array of distillate products, most notably gasoline and heating oil. Output yields—that is, the ratio of lighter to heavier distillates—will vary according to seasonal factors and available refining capacity.
At times, it's more efficient—i.e., more profitable—to weight refining runs toward lighter distillates. A fairly common type of operation, for instance, turns out two barrels of gasoline and one barrel of heating oil for every three barrels of crude oil input. Knowing a refiner's throughput, or "crack spread," allows us to approximate its gross profit margin.
The process is complicated, however, by the industry's pricing conventions. Crude oil is priced in dollars per barrel, while heating oil and gasoline are denominated in gallons.
A barrel of oil contains 42 U.S. gallons, so you can translate the throughput of a "3-2-1" operation as:
3 x 42 gallons (crude oil) = [2 x 42 gallons (gasoline) + 1 x 42 gallons (heating oil)] - profit
Applying current wholesale prices* into this equation, we can determine the refiner's gross yield as:
3 x $87.33/bbl = [84 x $2.5816/gal + 42 x $2.6627/gal] - profit
$261.99 (crude oil) = [$216.85 (gasoline) + $111.83 (heating oil)] - $66.70 (profit)
*We use NYMEX futures prices for real-time fixes on the crack spread, the nearby contract for crude oil and to better simulate the refiners' marketing cycle, the second-nearby contract for products.
Thus, with current prices, a refiner can crank out a $22.23 per barrel ($66.70 per 3 bbl) profit for a "summertime mix." With a crude input cost of $87.33, the refiner's gross margin is 25.5 percent (or $22.23 / $87.33).
Not surprisingly, margins expand and contract as input and output values vacillate. In February 2009, when crude prices reached their nadir at below $34 a barrel, the 3-2-1 gross margin briefly ballooned to more than 64 percent—even after cratering at 4 percent the previous October. Margins were relatively thin in 2009 and 2010, averaging less than 15 percent.
