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Refining 101

An oil refinery is a manufacturing facility that uses crude oil and other feedstocks as a raw material and produces a variety of refined products. The actual mix of refined products from a particular refinery varies according to the refinery's processing units, the specific refining process utilized and the nature of the feedstocks. The refinery processing units generally perform one of three functions:

  • Separation of the different types of hydrocarbons contained in the feedstocks,
  • Conversion of separated hydrocarbons into more desirable or higher value products, and
  • Chemical treatment of the products to remove unwanted elements and contaminants such as sulphur, nitrogen and metals.

Refined products are typically differing grades of gasoline, diesel fuel, jet fuel, furnace oil and heavier fuel oil, and lube stock.

Refining is primarily a margin based business in which the feedstocks and the refined products are commodities. Both crude oil and refined products in each regional market react to a different set of supply/demand and transportation pressures and refiners must balance a number of competing factors in deciding what type of crude oil to process, what kind of equipment to invest in and what range of products to manufacture. As most refinery operating costs are relatively fixed, the goal is to maximize the yield of high value refined products and to minimize crude oil feedstock costs. The value and yield of refined products are a function of the refinery equipment and the characteristics of the crude oil feedstock while the cost of feedstock depends on the type of crude oil. The refining industry depends on its ability to earn an acceptable rate of return in its marketplace where prices are set by international as well as local markets.

Demand for refined oil products has significantly increased in recent years due to the industrialization of countries such as China and India. As economic conditions improve in these countries, demand for gasoline and diesel continues to rise due to rising transportation usage and power generation requirements. In the United States, the demand for gasoline continues to rise while Europe is experiencing rapid growth in demand for diesel. Over the long term, refining margins and crude oil prices are typically correlated as both are driven by the demand for refined petroleum products.

Until recently, global investment in refining capacity has been restrained as weak refining margins have not supported investment in either capacity increases at existing refineries or the construction of new refineries. From the early 1980's through the early 1990's, global refining capacity fell as uneconomic refineries were shut down in the face of low margins. Since then, global refining capacity has grown, predominantly through capacity creep, but at a pace insufficient to keep up with the growth in global demand for refined products. Given the lead-time required to engineer and construct new refining facilities and resistance to refineries being built in many areas, it is expected that the global refined product market should be strong for several years.

Refining Margins

Refining margins or ‘crack spreads’ are terms used to describe a benchmark indication of the margins made by refiners that process a specific type of crude oil into an assumed selection of refined products. A common refining crack spread is called the 2:1:1, which mirrors the gross margin that would be realized by a refiner if they purchased two barrels of light, sweet crude oil (based on the benchmark West Texas Intermediate or WTI) as feedstock, and produced one barrel of gasoline and one barrel of diesel. Since sour crude oil traditionally sells at a discount to WTI, the margin for sour refiners tends to be more favorable and is called a "sour crack spread".

Examples of a 2:1:1 crack spread and a sour 2:1:1 crack spread are below, assuming a WTI oil price of US$90/barrel, a gasoline price of US$99 per barrel and a diesel price of US$114 per barrel.

1 barrel of WTI crude oil purchased for $90/ barrel

($90.00)

50% of one barrel of gasoline produced & sold for $99

$49.50

50% of one barrel of distillate produced & sold for $104

$52.00

Equals 2:1:1 crack spread

$11.50

North Atlantic is a sour refinery, so our feedstock costs are different from the 2:1:1, and our margins include more products than a 2:1:1 crack spread contemplates. Each barrel of sour crude oil that we process is refined into three different products, weighted approximately as follows: 32% gasoline, 41% diesel and 27% heavy fuel oil (which trades at a discount to WTI).