Fuel prices feed into inflation in many ways causing a ripple effect resulting in inflation getting entrenched. For instance, the raging food inflation has a significant component of fuel as a drive through transportation and fertiliser costs. The Indian government clearly recognises that and hence last week cut taxes on fuel to do its bit to temper down inflationary pressures. This in some sense was releasing the buffer built up by hiking taxes when crude oil prices had moderated in the past. Elsewhere in the world, there has been a more or less direct corelation between crude oil prices and fuel (petrol/diesel/aviation fuel) prices. Not this time around though. As the chart in the article shows, whilst crude oil (WTI) has risen 13.1% since the Russian invasion, gasoline, diesel and jet fuel have risen 33%, 69% and 137% respectively. The author attributes this disproportionality to all time high refining margins – the share of profits retained by refineries who convert crude to such downstream products.
“From 1985 to 2021, the crack spread averaged about $10.50 a barrel. Even between 2004 and 2008, during the so-called golden age of refining, the crack spread never surpassed $30. It rarely spent more than a few weeks above $20. Last week, however, the margin jumped to a record high of nearly $55. Crack margins for diesel and other petroleum products surged much higher.”
What then explains these abnormally high refining margins:
“There are four main reasons behind the explosion in refining margins.
First, demand — particularly for diesel — has rebounded strongly, depleting global inventories. In some markets, like the U.S. East Coast, diesel stocks have fallen to a 30-year low. Despite rising prices and fears of an economic slowdown later this year, oil executive say they see strong consumption for now. “Demand is not that easily destroyed,” Shell Plc Chief Executive Officer Ben van Beurden told investors last week.
Second, the U.S. and its allies have tapped their strategic petroleum reserves to cap the rally in oil prices. That has provided extra crude, which has put a lid on WTI prices, but it hasn’t addressed the tightness in refined products. Only a small fraction of the emergency release is in the form of refined products, and only in Europe.
Third, and perhaps most importantly, refining capacity has declined where it matters for the market now, and the plants that are operating are struggling to process enough crude to satisfy the demand for fuel. Martijn Rats, an oil analyst at Morgan Stanley, estimates that outside China and the Middle East, oil distillation capacity fell by 1.9 million barrels a day from the end of 2019 to today — that’s the largest decline in 30 years.
The downward trend started well before the pandemic hit, as old Western refineries struggled to compete, environmental regulations increased costs and the unfounded fear of peak oil demand amid the energy transition prompted some companies to close plants. The fuel-demand collapse triggered by Covid-19 only turbo-charged the trend, resulting in dozens of refinery operations shutting down for good in Europe and the U.S. in 2020 and 2021. New capacity has emerged in China. However, Beijing tightly controls how much fuel its refiners can export so that capacity is effectively out of reach of the global market.
Fourth, are the sanctions and unilateral embargos — also known as self-sanctions — on Russian oil. Before the invasion of Ukraine, Russia was a major exporter not just of crude, but also of diesel and semi-processed oil that Western refiners turned into fuel. Europe, in particular, relied on Russian refineries for a significant chunk of its diesel imports. The flow has now dried.”
Whilst additional refining capacities are likely to come up but not soon enough. For now, killing demand seems to be the only way out. The likely recession engineered by central bank tightening should do the job.
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Note: The above material is neither investment research, nor financial advice. Marcellus does not seek payment for or business from this publication in any shape or form. The information provided is intended for educational purposes only. Marcellus Investment Managers is regulated by the Securities and Exchange Board of India (SEBI) and is also an FME (Non-Retail) with the International Financial Services Centres Authority (IFSCA) as a provider of Portfolio Management Services. Additionally, Marcellus is also registered with US Securities and Exchange Commission (“US SEC”) as an Investment Advisor.
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