| Wide cracks are beginning to appear in the refiners’ profit margins, known in the oil industry as “crack spreads”. Of late, demand for fuel has been hit by weak consumer spending and slump in automobile sales. The US gasoline crack spread — the difference between benchmark crude oil price and wholesale petrol prices — sunk to a 21-year low of (-) $6.70 a barrel last week and remains around (-) $4.43.
According to Alan Gelder, author of the Wood Mackenzie refining report, new refineries in Asia and West Asia are competitive in terms of earnings per barrel because they use sophisticated technology to convert very low-quality, cheap crude oil into high-end products, such as petrol and diesel. The boom in refinery building in West Asia is the result of increased demand and the intention of oil-producers to move up the value chain.
Asia and West Asia are fast emerging as the new world destinations for crude oil refining. Two-thirds of the world’s new refining capacity is expected to be located in in these regions. The US refining industry is responding to the weak outlook by discretionary cuts in output and running facilities below capacity.
Just a few months ago, crack spreads were strong and refiners were struggling to meet escalating demand, particularly from China and India. However, in the aftermath of the fast escalating world credit crisis, Wood Mackenzie, the Edinburgh-based industry consultants, have concluded that only 30 of the 160 refining projects announced since 2005, which should be completed in the next two to seven years, would now move as per schedule. Of the 30 refineries still on track, almost all have the backing of large national oil companies that are set to provide 11 million of the 12 million barrels of new refining capacity expected to come on stream. Saudi Arabia’s Saudi Aramco and China’s Sinopec will in aggregate account for 2 million of those barrels.
India has 149 million tonnes per annum of crude oil refining capacity (mpta). It plans to increase it by over 60 per cent to 241 mpta by the end of 2012. Over the past couple of years, the government has been promoting India as a ‘refinery hub’ and inviting global companies to invest. Although no foreign company, other than L N Mittal-promoted Mittal Investments, has as yet invested in the country, state-owned companies are investing Rs 55,000 crore to set up new refineries and expand existing ones.
Reliance Petroleum, a subsidiary of Reliance Industries (RIL), in which US oil major Chevron holds 5 per cent stake, has spent close to Rs 27,000 crore on the Jamnagar project and is likely to commission only half of its refinery’s capacity by end-December 2008, as demand for fuels such as naphtha and fuel oil has crashed across the continents. Four out of eight crude oil storage tanks have also been commissioned by Reliance.
Besides, a 400-mw captive power plant is ready to be commissioned. The refinery, which will add nearly 20 per cent to India’s refining capacity and make Reliance the largest crude oil refining company in India, will produce fuel oil and polypropylene only when the entire plant is commissioned. Essar Oil had also followed a similar strategy for commissioning its refinery. Essar commissioned its entire refinery six months after starting production.
Since the long-term average for ‘crack spreads’ is $6.32 a barrel, Deutsche Bank believes this crack in ‘crack spreads’, which are tradeable instruments, presents a “hidden treasure” opportunity. It has recommended that its clients buy the March RBOB gasoline crack, as it finds the negative gasoline cracks “clearly unsustainable”. Costanza Jacazio of Barclays Capital believes that US gasoline production is running ahead of last year’s levels and, therefore, the sharp compression of gasoline cracks into negative territory may continue. Barclays believes that the trend growth for demand, measured as the year-on-year change in a six-month rolling average for petrol consumption, is running at its lowest level since 1981. However, investors who bought into the ‘negative crack spread hypothesis’ earlier this year have already burned their fingers. In consonance with the downturn in the American crack spread, the European crack spread has tanked to a negative $8 a barrel, and Asian crack spread has also dipped into negative territory.
Refining margins on some products like petrol, naphtha and fuel oil have turned negative as demand has stalled and as the world teeters on the brink of a recession. These so-called ‘negative crack spreads’ have huge implications for India, which imports crude oil and exports petroleum products.
Since one barrel of oil yields a slate of products, the positive margins on some products have offset the negative margins on others to ensure that overall refining margins have remained in the zero-to-positive terrain. In October 2008, margins of state-owned refineries, without accounting for inventory losses, have been around the break-even point. The margins in the July-September quarter were between $2 and $3 a barrel. (The writer is the CEO of Global Capital Advisors. Financial Chronicle does not warrant the quality or accuracy of the article. It shall not be deemed a recommendation by FC for buying or selling or investment of any kind. Investments are subject to market risks. Past performance does not guarantee future success. It is advisable to seek advice from a qualified independent adivsor before investing) |