A Look into the Refining Process

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Refined petroleum products are fuels distilled from crude oil and other liquids (lease condensates, liquefied gases). After crude oil is removed from the ground, it is sent to a refinery where different parts of the crude oil are separated into useable petroleum products.

Source: CME Group

Some examples of petroleum products include gasoline, distillates such as diesel fuel, heating oil, and jet fuel, fuel oil, petrochemical feedstocks, waxes, lubricating oils, and asphalt.

Most refineries focus on producing transportation fuels, the largest use category for petroleum products. In 2016, approximately 50% of all refinery output in the U.S. was gasoline; distillate fuels (mostly ULSD, or Ultra-Low Sulfur Diesel) represented the second largest category at close to 30%.

Other uses of petroleum products include heating, paving roads, generating electricity and as feedstocks for petrochemical and plastics production. LNG is the liquefied form of natural gas.

How Does a Simple Refinery Operate?

All refineries have three basic steps: separation, conversion and treatment. During the separation process, the liquids and vapors separate into petroleum components called factions based on their weight and boiling point in distillation units. Heavy factions such as asphalt and residual fuel oil separate lower down in the distillation unit while the lighter fractions such as gasoline and naphtha vaporize and rise to the top.

Following distillation, heavy fuels can be processed further through cracking, alkylation and reforming to obtain higher-value products.

The final step in the refining process is to bring products up to pipeline and market standards through blending and treating. For instance, refineries and blenders combine gasoline blending components and ethanol to obtain finished retail gasoline.

Source: EIA

Trading Refined Products

NYMEX RBOB Gasoline futures and NY Harbor ULSD futures contracts represent the world’s largest and most liquid refined products markets.

RBOB Gasoline futures, the global benchmark for gasoline, traded at an average of more than 180,000 contracts per day in 2016. Refiners both in the United States and internationally follow RBOB futures prices and both commercial and non-commercial market participants hedge their exposure to gasoline price fluctuations by trading RBOB Gasoline futures contract.

NYMEX NY Harbor ULSD futures traded at an average of more than 156,000 contracts in 2016. It is the distillate fuel benchmark, through which traders manage their price risk in ULSD and associated distillate products such as jet fuel, heating oil and gasoil.

Hedging Risk Using Refined Products Futures and Options

The primary risk that traders seek to hedge is called the basis risk, which is the difference between the spot, or physical, market price of a commodity and its future price. There are other types of basis risk in energy markets, which include price differences between time, quality and location of a certain product.

Companies that are significantly exposed to the price of a particular commodity may choose to manage basis risk through buying or selling futures. The benefits of using exchange-traded futures and options contracts include:

  • Pre-defined and standardized terms and conditions, so there is no uncertainty about the underlying product
  • Price and trade on a transparent platform that is available to all market participants
  • Deep liquidity with many buyers and sellers participating in the market at competitive prices
  • Limited counter-party credit risk through centralized clearing

Who Trades Refined Products Futures?

Referred to as commercial participants or hedgers, airlines, retail fuel distributors (such as gas stations) and refiners are examples of companies that engage in various types of hedging as part of cost control and risk mitigation.

Non-commercial participants include banks, money managers and funds. These traders generally do not possess significant physical assets in the underlying markets but seek to gain exposure to price volatility as part of a broader trading strategy.

Refiners in particular are most concerned about hedging the difference between their input costs and output prices. Refiners’ profits are tied directly to the spread, or difference, between the price of crude oil and the prices of refined products — gasoline and distillates (diesel and jet fuel). This spread is referred to as a crack spread.

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Peter Knight Advisor


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