What it means
The petroleum industry is usually divided into three stages. Upstream covers exploration and production, midstream covers transport and storage through pipelines and tankers, and downstream covers refining and selling products to consumers and businesses.
Each stage has a different risk profile and a different way of making money. Crude oil is not one product, because grades vary in density and sulphur content.
Light, low-sulphur oil is easier and cheaper to refine into valuable fuels and therefore usually sells at a premium, whereas heavier, high-sulphur grades sell at a discount. Benchmarks such as Brent and West Texas Intermediate act as reference points for pricing around the world.
The price of petroleum is set by supply and demand, but also by geopolitics, producer decisions, inventories, currency movements and expectations of future growth. It can be very volatile, so producers, airlines, shipping lines and manufacturers often use futures and other derivatives to lock in prices and reduce uncertainty.
Finance teams therefore pay close attention to fuel hedging policies. For non-energy businesses, petroleum matters through its indirect effects.
Fuel is a direct cost for transport and logistics, and petroleum-based inputs are used in plastics, packaging, fertilisers and synthetic fabrics. A sustained rise in oil prices can raise costs across supply chains, while a fall can boost margins for fuel-intensive firms and reduce revenue for oil producers and their service companies.
Investors access the sector through shares in oil companies, exchange-traded funds and futures. Each route has different risks, as share prices reflect company management and costs as well as oil prices.
Longer term, the transition toward lower-carbon energy adds uncertainty about future demand, and regulation can change the cost of producing and using petroleum. Refiners watch the gap between crude cost and product prices, known as the crack spread.
This margin drives their profits more directly than the crude price alone.
In practice
Real-world examples.
Example
An airline with annual fuel costs of $600,000,000 uses futures to fix the price of half its expected fuel for the next year. If oil prices rise, the hedge offsets part of the extra cost, which makes its profit forecast more reliable.
Example
A packaging manufacturer notices that its plastic resin costs have risen by 15% following an increase in crude prices. The finance team adds a fuel and materials surcharge to customer contracts to protect its margins.
Example
A refinery owner compares the crack spread with its operating costs of $12 per barrel. When the spread is $25 per barrel, it runs the plant at full capacity, but if the spread falls near $12, it considers reducing output.
Formula
Calculation
3-2-1 crack spread per barrel of crude = ((2 x gasoline price per barrel) + (1 x diesel price per barrel) - (3 x crude price per barrel)) / 3
Suppose gasoline sells for $105 a barrel, diesel for $120 a barrel and crude oil costs $85 a barrel. The value of the products is (2 x 105) + 120 = 210 + 120 = $330. The cost of three barrels of crude is 3 x 85 = $255. The difference is 330 - 255 = $75, and dividing by 3 gives a crack spread of $25 per barrel of crude refined.Case study
Seen in the real world.
Northbay Freight is an illustrative, fictional trucking company with 200 vehicles. Fuel makes up about a third of its operating costs, but its customer contracts are priced a year in advance.
When oil prices rose sharply, margins fell from 8% to 3%. The finance director responded by adding a fuel surcharge clause to new contracts, linking it to a published diesel price index, and by hedging 40% of expected fuel use.
The following year, oil prices fell back, and the company kept most of the benefit because only part of its volume was hedged. The illustrative lesson is that managing fuel exposure involves both contract terms and hedging.
Watch out
Common mistakes.
- Treating petroleum as a single product with a single price, when grades, locations and refined products all price differently.
- Assuming a hedge removes all risk, when it only fixes the price on the quantity hedged and carries its own costs.
- Ignoring indirect exposure through plastics, chemicals and transport, which can be as significant as direct fuel costs.
Questions
People also ask.
What is the difference between petroleum and crude oil?
Crude oil is the raw material extracted from the ground, while petroleum is the wider term that includes crude oil and the products refined from it.
What are Brent and WTI?
They are benchmark grades of crude oil whose prices are used as reference points for contracts around the world.
Why do oil prices move so much?
Because supply and demand are slow to adjust, so small changes in expectations or disruptions can cause large price moves.
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