What it means
Crude oil as it comes from the ground is a mixture of many different substances that cannot be used directly in an engine. A refinery heats the crude and separates it into fractions that boil at different temperatures, then converts and treats them to make finished fuels and chemical feedstocks.
The more complex the plant, the more heavy and low-value oil it can turn into high-value products. A refinery is a processing business rather than a producing one.
It does not need to own oil fields, and its profit depends on the spread between input and output prices more than on the absolute level of oil prices. A rise in crude prices can hurt a refiner if product prices do not follow, and can help if they rise faster.
Costs fall into two groups. The largest is the crude itself, which is a variable cost, and the second is a heavy base of fixed costs for labour, maintenance, energy and capital investment.
Because the fixed costs are large, a refinery needs to run close to full capacity to earn a good return, and utilisation (the share of capacity actually used) is a key measure. Refiners also face regular shutdowns for maintenance, which are called turnarounds and can last several weeks.
During a turnaround the plant earns nothing but still pays its staff and debt costs, so finance teams plan cash around them. Margins are usually quoted through a crack spread, which compares the price of crude with the price of the products made from it.
A common shorthand is the 3-2-1 crack spread, which assumes three barrels of crude become two barrels of petrol and one barrel of diesel. Real margins depend on the actual crude blend and product mix, so the benchmark is a guide and not a promise.
In practice
Real-world examples.
Example
A coastal refinery that buys imported crude sees petrol prices fall faster than crude prices over two months. Its crack spread narrows from $24 to $12 a barrel, and its monthly cash flow halves. The treasurer draws on a credit line to cover the gap.
Example
A chemicals group owns a refinery next to its plastics plant. The refinery supplies naphtha, a light liquid used as a raw material, to the plant at a transfer price set each month. Management reviews the price carefully so each unit's profit reflects its true economics.
Example
A private buyer evaluates a small refinery for sale. The analyst looks at utilisation, the complexity of the plant and the next scheduled turnaround, and applies a lower valuation because a major $60 million overhaul is due within two years.
Formula
Calculation
3-2-1 crack spread = (2 x petrol price + 1 x diesel price) - (3 x crude price)
Gross margin per barrel of crude = crack spread / 3
Suppose crude costs $70 a barrel, petrol sells for $90 a barrel and diesel sells for $90 a barrel.
Product value = (2 x 90) + (1 x 90) = 180 + 90 = $270
Crude cost = 3 x 70 = $210
Crack spread = 270 - 210 = $60 per three barrels, so $60 / 3 = $20 per barrel of crude.
A refinery processing 100,000 barrels a day earns a gross margin of 100,000 x 20 = $2,000,000 a day. If operating costs are $8 a barrel, they total 100,000 x 8 = $800,000, leaving 2,000,000 - 800,000 = $1,200,000 a day.Case study
Seen in the real world.
Stonebridge Refining is an illustrative, fictional business with a single plant that processes 80,000 barrels of crude a day. In a quarter when diesel demand weakened, its margin fell from $16 to $9 a barrel while fixed costs stayed the same.
The chief financial officer calculated that 80,000 barrels at the lower $7 a barrel decline cost the company $560,000 a day, or about $50 million over the quarter. She advised the board that cutting costs alone would not close the gap, and that the plant should shift its mix towards higher-value products.
Management brought forward a small upgrade project and scheduled the turnaround for the weakest demand period. The illustrative lesson is that refiners cannot control the spread, so they manage what they can: utilisation, product mix and the timing of shutdowns.
Watch out
Common mistakes.
- Assuming a refinery profits whenever oil prices rise, when its margin depends on product prices relative to crude prices.
- Judging a plant on revenue alone, when refineries have very high revenue and thin margins because crude is such a large share of cost.
- Forgetting turnaround periods in cash forecasts, since a plant that is shut for maintenance still carries heavy fixed costs.
Questions
People also ask.
What is a crack spread?
It is the difference between the price of crude oil and the combined price of the refined products made from it, and it is the most common shorthand for refining margin.
Why does plant complexity matter?
A more complex refinery can process cheaper, heavier crude and turn it into more valuable products, which usually earns a higher margin than a simple plant.
Is a refinery the same as a petrochemical plant?
No, a refinery makes fuels and other oil products, while a petrochemical plant uses some of those outputs as raw materials to make plastics and other chemicals.
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