Another piece from my oil & energy archives. Chris Hairel — an MSB alum — recaps the the oil-to-gas value chain.
Good background reading as gas prices soar.
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Originally posted Aug. 27, 2008
In an earlier post “Thinking about $4 per gallon gas”, I wondered why oil companies waited so long to push prices up to $4 — the apparent price that the market will bear — and why they don’t just let the price stick at $4 now that it has been tested.
Chris Hairel , MSB MBA alum, sent me a nice recap of the oil to gas value chain.
Bottom line: cost-plus pricing in a very competitive market.
Worth reading …
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The downstream refined products value chain — from crude oil to retail gasoline and other oil-based products — has six segments, each with its own unique industry structure, pricing levers and regulation:
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Refineries – the key asset in the business where the object is to maximize the economic value added of the refined products.
Refineries are basically price takers since their company trading group supplies them with crude oil and the projected prices for refined products.
Working with the trading group, the refinery is charged with turning that crude oil into the most profitable collection of products given the quality of the crude and the capabilities of the refinery.
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Bulk Markets – The trading group assumes title of the product as it leaves the refinery and arranges transportation to the terminals based on projected demand in the rack (or wholesale market).
Along the way the traders seek to increase the realized price for their products, react to supply disruptions or unexpected demand.
Bulk is a relatively efficient market with good price transparency based on key trading hubs like New York Harbor, Houston and Chicago.
The NYMEX futures market provides a facility for hedging and for paper speculation. Trading parties include oil companies, major users of petroleum products, independent pipeline companies and speculators.
Pricing is market-based and profit-optimized by the traders.
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Pipelines – Interstate pipelines with multiple customers are regulated by the Federal Energy Regulatory Commission .
Their tariffs (i.e. prices) are set based on a government sanctioned rate of return. So. pricing is essentially a cost-plus process.
Pipeline owners are not permitted to share information about who else is using the pipeline with their affiliated companies, nor can they give (or take) preferential treatment with respect to supply allocation or delivery scheduling.
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Rack Markets and Terminals – Rack markets cover the wholesale market for a city.
Prices in rack markets are set daily for the next day. The marketing group for an oil company looks at demand by channel of trade (i.e. branded, unbranded, spot), recent price history in the area and the supply situation.
The pricing mechanism itself may be based on an index, a cost plus or other model, but there’s some leeway on the decision under certain circumstances. For example, pricing is actually used as a key demand management lever since companies can purposefully price themselves out of the spot or unbranded channel in order to save product for branded customers.
Despite what the pricers do, most transaction pricing is determined by long term contracts. These contracts usually allow customers to “swing” their volumes. A customer may commit to buying an average of 5,000 gal a day, but the contract management process will look at the monthly volume and divide by 30 – the customer can usually manage their buying pattern to buy more on days when gas is cheap and less when it’s more expensive. .
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Secondary Transportation – These are the tanker trucks that move product from the terminal to the retail station. The logistics are typically handled by jobbers or independent marketers that almost always price on a cost-plus basis.
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Retail – Retail gas stations typically price on a cost-plus basis with a slim retail margin added on.
The bulk oil stations’ profits isn’t from the gasoline ! Gas is simply the “leader” product that attracts traffic (literally) which often loads up with high margin coffee, soda, cigarettes, etc.
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Retail gasoline prices
Retail gasoline prices tend to respond quickly to market forces for 3 reasons: (1) cost-plus pricing, (2) retail competition, and (3) fear of government intervention.
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(1) Cost-plus pricing
Since cost-plus pricing is prevalent at all stages of the value chain, refined products’ prices and crude oil prices tend to move together.
Refiners’ margins are often forecasted using what’s called the 3-2-1 spread. Take the price difference between three WTI NYMEX contracts and the sum of two NYMEX gasoline contracts plus one heating oil contract – then trade accordingly.
When crude falls. the entire complex floats down with it since the bulk market is fairly efficient and the downstream segments all use a cost-plus pricing model.
If domestic bulk markets fail to react to lower crude prices, several large players can bring product in from Europe to capture the arbitrage.
Since the vast majority of transactions are priced on a cost-plus basis, companies compete on their ability to “buy right”, on the efficiency of their operations, and their opportunity for more profitable ancillary sales. .
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(2) Retail CompetitionFew prices are signaled to potential customers more visibly than gasoline prices.
There are often 2 or 3 gas stations on a corner, so consumers are tempted to chose the cheapest one even if it’s only a cent or two cheaper per gallon. The conventional wisdom is that brand loyalty is low.
The same price pressures evident in the wholesale rack markets since unbranded retailers have the option of buying from multiple terminals. If Shell is less expensive than Exxon on a particular day, Shell gets the sale in the unbranded and spot channels of trade.
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(3) Threat of Regulation
A third force is the threat of government action.Pricing through the entire oil value chain is very transparent. Timely price data available from multiple sources for every segment of the market (DOE data, NYMEX, bulletin board exchanges, broker quotes, daily PLATT and OPUS surveys, AAA retail surveys, etc.).Oil companies generate two-thirds of their profits from crude oil production and refining. The wholesale and retail marketing and distribution parts of the business is generally considered mote of a cost of going business (i.e. overhead) than a profits source. So, oil companies would rather play it safe (from government regulators) than try to eek out an extra half percentage point of profit at the wholesale or retail level.
The Homa Files 