Baker & O’Brien, Inc.’s 2022 Q3 PRISM™ update shows 2022 Q3 refinery margins came down from 2022 Q2’s record highs. Average U.S. refining cash margins for the quarter remain very robust at $22.30/b, over $16/b higher than the margins seen a year ago.

Events in Europe (discussed in the Special Topic) drove U.S. cash margins more than changes in U.S. refining fundamentals. 2022 Q3 U.S. refining margins fell on relatively flat utilization and lower crack spreads compared to 2022 Q2. Total U.S. light product demand increased during the quarter on higher jet demand with flat gasoline and diesel demand.

U.S. Refinery utilization increased by 2.4% year-over-year even though product demand decreased. The continued post-pandemic recovery in jet fuel demand was offset by the gasoline and diesel demand reductions, resulting in lower aggregate U.S. refined product demand.

Other Key Refining Margin Metrics fell from their 2022Q2 all-time highs. Product crack spreads fell, with PADD 1 and PADD 3 seeing the most compression in 2022 Q3. The light-heavy crude oil price spread (WTI-WCS) continued to strengthen, supporting margins of coking refineries that process heavy sour crude oil.

Special Topic: Crackers and Crack Spreads

The Special Topic in last quarter’s Refining Industry In Focus reviewed the role that unprecedented natural gas prices played in driving product cracks and refinery cash margins to record levels. But what actually drives product cracks to such high levels? In this Special Topic, we take a closer look at the fundamental economic relationships between converting vacuum gas oil (VGO) to diesel, gasoline, and product crack spreads (the price difference between refined products and Dated Brent).

Since early 2020, several unusual and impactful events have whipsawed the crude oil, petroleum products, and natural gas markets (collectively, “the market”). These events were sufficiently diverse to reveal fundamental linkages that explain the historical pricing context that can be used to project future crack spreads. The first major event at the beginning of January 2020 was the International Maritime Organization implementing a new rule (IMO 2020) mandating the use of very low sulfur (less than 0.5 wt.% sulfur) fuel oil (VLSFO) for ocean-going vessels, rather than high sulfur fuel oil (less than 3.5 wt.% sulfur). The next major event was the start of the COVID-19 pandemic, which heavily impacted refined product demand, driving down crude oil prices and refined product crack spreads to very low levels. The table below categorizes crack spreads for periods associated with these two events and for periods associated with four additional events between January 2020 and September 2022. The time periods are categorized as market layers and described in more detail below. Each market layer conveys a different set of market fundamentals that are analytically useful for understanding the relevant market crack spread drivers.

Several factors increased crack spreads (green shading), others reduced crack spreads (red/yellow shading), while some were neutral (gray shading).

The relevant question is – what fundamentals drive the diesel and gasoline crack spreads in different periods? This brings us to Crackers and Crack Spreads. The key conversion unit feedstock is VGO with less than 0.5 wt.% sulfur, which refiners convert to diesel or gasoline. However, after IMO 2020, in addition to being a cracking unit feedstock, 0.5wt.% S VGO became a major blending component for the newly created VLSFO market. So, VGO’s blending value, as a VLSFO bunker market component, now sets its floor price. VGO’s ceiling market price limit continued to be typically set by breakeven economics for either VGO hydrocracking (HCU) or Fluid Catalytic Cracking (FCC). In general:

• HCUs primarily use hydrogen to convert VGO to diesel
  • HCU margins are affected positively by high diesel prices and negatively by high natural gas prices (so high hydrogen costs).
• FCCs primarily convert VGO to gasoline plus some gas
  • FCC margins are affected positively by high gasoline prices and positively by high natural gas prices.

In a sense, the fuels market is engaged in a tug of war with limited supplies of VGO available for conversion and VLSFO bunker blending. The European HCU units need it to produce diesel, and United States Gulf Coast (USGC) FCC units need it to produce gasoline. In addition, bunker blenders use VGO to balance light and heavy VLSFO blending components. Baker & O’Brien developed indicative yields and variable operating costs for HCU and FCC units for Europe and the USGC to determine VGO conversion margins and breakeven values. The aim is to support a fundamental approach for contextualizing historical crack spreads and forecasting future crack spreads based on specific market assumptions. The table below adds the indicative conversion margins for six market periods. These margins, combined with several other market assumptions, can be used to quickly develop short-term or long-term forward views.

The conversion margins for each market layer can be summarized as follows:

• IMO 2020: Requirement for ships to use VLSFO bunker drives higher VGO and ULSD prices Low FCC margins due to high VGO prices but stronger HCU margins due to high ULSD prices.
• Pandemic: USGC margins approach zero with European margins higher (VGO price difference).• Pandemic: USGC margins approach zero with European margins higher (VGO price difference).
• Pandemic Recovery: Gasoline leads recovery, gasoline margins above diesel. FCC favored, natural gas in Europe begins to rise, European HCU margins are low.
• Russia Rations Gas: Gas prices in Europe spike to $29/MMBtu, and the cost of producing hydrogen surges. Diesel prices increase to maintain a diesel supply by keeping European HCU margins above breakeven. FCCs in Europe benefit from high gas prices. Stronger product crack lift USGC FCC and HCU conversion margins.
• Russian Invasion of Ukraine – Initial Supply Shock: Elevated European natural gas prices and expectations of a Russian diesel embargo raise conversion margins in Europe to remarkably high levels. USGC HCU margins raise, but FCC margins remain moderate as U.S. gas prices are relatively unchanged.
• Nord Stream Pipeline Reduction/Stoppage: First, Russia significantly reduced natural flows in Nord Stream 1, which later suffered a mysterious explosion in late September. Natural gas prices spike to extremely high levels, but diesel and VGO supplies adjust to take pressure off conversion margins.

The recent French refinery strike that began on September 27, 2022, provides a perfect scenario for testing the conversion margin approach for predicting October 2022 market crack spreads. On October 7, 2022, natural gas [1] is trading at $47.50/MMBtu, and it appears that the strike will persist. So, a new October 2022 forecast for natural gas, diesel, and gasoline is needed. The strike has resulted in the following scenario: high natural gas prices in Europe, a highly undersupplied diesel market, and a marginally undersupplied gasoline market.

The primary forecasting factors to be considered are European and USGC Conversion margins, the USGC/Europe diesel arbitrage, the floor VGO price associated with VLSFO blending, and VGO conversion unit breakeven values.

Based on the historical precedents and the crack spreads, the fundamental modeling approach predicted October 2022 prices that closely matched actual monthly averages, as shown in the table below. The main difference is that actual European natural gas prices were lower due to the high amount of natural gas inventories.

"Crackers and Crack Spreads” approach makes it possible to develop comprehensive refinery margin and fuel price forecasts consistent with market fundamentals. Critically, it calculates the relative production economics of gasoline and diesel, enabling forecasting of diesel to gasoline price spreads. Natural gas price, while not previously seen as a critical input to refining forecasts, has become a key factor to include in forecast modeling.

[1] As set by the Dutch Title Transfer Facility (TTF) price