Prices for light and heavy crude oils and products are moving further and further apart. Over the past five years the differential, or spread, between the average price of the four main distillate products (motor gasoline, naphtha, jet kerosene and gasoil) and heavy fuel oil has trebled from around $10/bbl to over $30/bbl. As a result, refiners who can upgrade heavy feedstocks into light products are earning record margins, which in turn provide them with huge incentives to invest in more cracking and coking capacity. The question that arises is whether this new ‘golden age’ for refinery upgrading can last? Previous episodes of wide upgrading margins were short-lived and refiners are therefore naturally reluctant to commit the huge amounts of capital required to boost their upgrading capacity in case margins collapse again in the future. There are already plans to build significant new catalytic cracking, hydro cracking and coking capacity over the next five years and refiners are concerned that the extra upgrading capacity will undermine margins.
Refiners have noticed that there is a strong correlation between refinery upgrading margins and the price of crude oil (see Figure 1). For the past twelve years at least, changes in the upgrading margin have tended to track changes in the price of crude in all the major product markets around the world. Although the association between crude oil prices and upgrading margins is particularly obvious over the past five years, during which crude rose from around $25/bbl to around $60/bbl for Dubai crude, the relationship also applies to earlier years when crude prices fluctuated in a narrower price range.
There are sound economic reasons to expect the upgrading margins faced by refineries to be related to the level of crude oil prices. This view is supported by the results of simple regressions linking refinery product prices in the US and European products markets to changes in the price of Dubai crude. Because fuel oil demand is more sensitive than distillate products to price changes, it is easier for refiners to pass on increases in crude oil prices to consumers of distillate products than to users of fuel oil. This creates an inherent upward bias in the price of distillates relative to fuel oil and a natural tendency for upgrading margins to rise when crude oil prices head upwards. However, investment in upgrading capacity — especially deep-conversion plants such as cokers — reduces the upward bias by improving the flexibility of refinery yields in response to changes in relative product prices.
These conclusions have important implications for refinery investment, since they indicate that the general level of crude oil prices is probably the most important single determinant of upgrading margins. Although the complexity of the marginal refinery affects how upgrading margins respond to changing crude oil prices in different product markets, this may be less significant than the level of the crude oil price itself, which can trigger far-reaching changes in the structure of demand. If, as is the case today, OPEC remains determined to keep oil prices high in order to confine its sales to the premium transportation market, the ‘golden age’ of refining looks set to continue, for the market needs more upgrading capacity. However, if oil demand growth slows to the point at which OPEC can no longer maintain output discipline, the ‘golden age’ could come to an abrupt end as oil prices slump and upgrading margins collapse.