A refinery has a perpetual risk to what’s called the refinery margin. A refinery purchases crude oil from the open market and runs this through the refinery process to yield refined products and is therefore making a profit if the refined products value in the open market is greater than that of the crude oil price used as feedstock.

Therefore, products – crude = the gross refinery margin. A refinery is therefore always long this margin, in the sense that it will always need to sell this margin, and if refinery margin prices fall it will lose money. Conversely, the refinery will make more the higher the margin gets. A refiner then has to manage all the operational costs to ensure that this margin is still positive after including all of the costs associated with the operation.

A refinery hedge is therefore selling the products – crude differential in the derivative market. The refinery will need to choose a basket of product contracts that best represents the underlying physical refined products it produces and sells in the open market, such as diesel, gasoline and fuel oil. It will then need to choose the crude oil contract that most accurately tracks the price of the crude oil it consumes.

Once these contracts have been chosen, the refinery will need to determine the volume for each refined product contract according to the volume it produces. Once it has worked this out, it can sell these product differentials to the crude oil derivative in equal volume to get a refinery margin hedging contract suitable for its needs. It then needs to choose the time for which the refinery wishes to protect itself against adverse movement.

Example:

An independent refinery in Italy determines its refinery operations are costing around $2 per barrel to operate. It has been noticed that the refinery margin in the open market is very close to the operational costs, and is not making much revenue, however the derivative market is showing the refinery margin for the average of next year, in 2025, is $4 per barrel.

The refinery therefore decides that $4 per barrel is attractive, and rather than wait for the open market to determine what the margin will be, it decides to hedge this favourable margin on a derivative basis now and have a degree of certainty of the future cash flow.

The refinery determines it has a refinery yield (products created by volume) of the following.

1 Barrel of CPC crude yields:

• Residual Low Sulphur Fuel Oil: 30
• Diesel: 15%
• Naphtha: 20
• Gasoline: 30%
• Liquid Petroleum Gases: 5%
• Gasoline: 30%

As the refinery is in Italy and sells the refined products in the open market locally, it needs to find the oil swap most associated for Italy in the derivatives market. There are Mediterranean contracts for High Sulphur Fuel Oil, but very illiquid ones for Low Sulphur Fuel oil, therefore it determines the Northwest Europe Low Sulphur Fuel oil contract is suitable for its fuel oil hedge requirements, and it is very correlated to the Mediterranean contracts. The same is true for the LPGs, and so determines NWE Propane is a suitable derivative contract for this refined product.

For Diesel, Naphtha and Gasoline, there are suitable Mediterranean pricing contracts, and therefore the refinery chooses these as suitable hedges. Finally, the crude oil it purchases, CPC crude, is priced against the North Sea benchmark derivative Dated Brent. There is a CPC derivative, but again it is very illiquid and will be hard to get a price for the hedge close to fair value. The refinery therefore determines Dated Brent is the most suitable oil swap contract.

To get the margin into one overall bespoke refinery margin, the refiner needs to sell all these oil swap contracts in each product against Dated Brent oil swaps in equal volumes. It therefore converts all the refined product volumes to per barrel equivalents, using conversion factors.

• Residual Low Sulphur Fuel Oil: 1 Tonne to 6.35 barrels
• Diesel: 1 Tonne to 7.45 barrels
• Naphtha: 1 Tonne to 8.9 barrels
• Gasoline: 1 Tonne to 8.33 barrels
• Propane: 1 Tonne to 12.41 barrel

The refinery runs 50,000 barrels of crude oil per month, yielding close to that as refined product. Using the original volume yields, and the volume conversions, it determines it has the following refined products – crude differentials volumes to hedge in 2025:

• Residual Low Sulphur Fuel Oil: 30% x 50,000 = 15,000 barrels per month
• Diesel: 15% x 50,000 = 7,500 barrels per month
• Naphtha: 20% x 50,000 = 10,000 barrels per month
• Gasoline: 30% x 50,000 = 15,000 barrels per month
• Liquid Petroleum Gases: 5% x 50,000 barrels = 2,500 barrels per month

The refinery therefore uses Onyx Markets to get a buy price for each of these refined products versus crude prices, known as “cracks” versus Dated Brent.

For each “crack”, the refinery asks for a buy price to sell for each month for the whole of 2025, for a total volume of 600,000 barrels (600KB). It then sells these “cracks” with the view to holding these oil swap contracts to settlement.

If the “cracks” rise, the refinery margin strengthens, and the refinery will have a negative cash balance with Onyx Markets. However, as the oil swap contracts closely track the physical, it should have a closely matched rise in the refinery margin in the underlying physical market, and therefore makes up for the losses with gains in the open market for the physical goods. If the refinery margins on average fall when it comes to settlement, the refinery will have a positive cash balance with Onyx Markets but will make less than $4 per barrel in the open market, thereby offsetting the gains.

The refinery is then free to concentrate on running the operations as efficiently as it can, without worrying about unexpected refinery margin falls in the open market.