Economics of Refinery Octane Part 2 – Today’s High Octane Values Mean Opportunities For Refiners
See other posts in this series, Economics of Refinery Octane:
- Part 1 – U.S. Octane Values 2016-2025
- Part 2 – Today’s High Octane Values Mean Opportunities For Refiners
The last three years have seen historic changes in the U.S. octane market. The wholesale value of octane, the primary yardstick of gasoline quality and price, spiked threefold in July 2022, followed by another year of high and volatile values in 2023. The numbers for 2024 and (so far) 2025 have been more stable, but still historically high. In today’s blog, we address three questions raised in Part 1 of this series:
- Why have retail octane values risen so high?
- Why have refiners been capturing only a small share of the increase in octane margin?
- Why did wholesale octane values increase in a stepwise pattern in July of 2022?
Octane is the primary measure of gasoline quality and price. In Part 1 of this series, we showed how the U.S. retail pump price differential between premium gasoline (typically 93 octane) and regular gasoline (typically 87 octane) has increased steadily the last 10 years, from a long-term historical value below $0.20/gal to $0.90/gal today.
We can think of this $0.90/gal premium-regular pump price differential (also known as the “grade differential”) as the retail value of octane; that is, the current differential of 90 cents/gal is the value the end consumer is willing to pay for the extra six (93-87) octane numbers that come with premium versus regular gasoline.
Part 1 of this series showed the refiner captures only a small portion of this $0.90/gal octane differential. The refiner’s octane margin is taken to be the differential between premium and regular gasoline prices measured at the wholesale level. That data shows that, today, on average, the refining segment is capturing $0.15-0.35/gal of the total $0.90/gal octane differential, with the balance of $0.55-0.75 being captured downstream, at what we will call, for simplicity, the retail level.
Furthermore, before July 2022, the refining segment’s octane margin capture had been only $0.05-0.25/gal, which jumped up by $0.10 in a stepwise pattern in July 2022. The wholesale numbers differ by region. Figure 1 shows the rising U.S. retail octane value in blue, and the stepwise increase in wholesale octane value in green for the U.S. Atlantic region:
Let’s address three questions raised by these observations:
- Why have retail octane values risen so high?
- Why have refiners been capturing only a small share of the corresponding increase in octane profit margin?
- Why did wholesale octane values increase in a stepwise manner in July of 2022 while retail octane values had been rising in a near linear trend for 10 years
Why have retail octane values risen so high?
The near linear increase in retail octane value actually got started in 2012 (see Breaking The Chains for the longer-term history). The causes have been studied, discussed and analyzed by octane market enthusiasts since then. The list of factors includes:
- More owner’s manuals say premium gasoline is recommended or required
- More cars are equipped with fuel-efficient turbocharged engines that require premium
- Engine manufacturers want even more high compression engines which need high octane fuel
- The penetration of ethanol (an effective octane blendstock) into the gasoline pool has caused refiners to quit investing in improved refinery octane production
- Today’s premium fuel buyer is less price-sensitive
- Premium buyers face higher “search and adjustment costs”
The last factor, search and adjustment costs, refers to the fact that premium gasoline buyers must make more effort to price shop for premium gasoline. That’s because, in most states, premium prices are not displayed on station signs. Usually, to price shop on premium, a customer must pull into the station and look at the price posted on the pump itself. Not many premium buyers make that extra effort, meaning there is opportunity for shrewd retailers to capture extra profit margin from less price-aware premium buyers.
This search and adjustment cost theory is supported by data showing the retail octane differential is lower in California, where posting of premium prices is required, than in other states.
Why have refiners been capturing only a small share of the increase in octane margin?
Before starting its steady rise in 2012, the octane grade differential at the retail pump reflected mostly the cost differential for producing the two grades. That was described as a “cost-driven” octane market.
Since then, the retail value of octane has clearly decoupled from octane production cost, growing steadily while refinery octane production cost stayed low and flat. That could be called a “demand-driven” octane market.
And through these changes, most of the resulting increased margin on octane has been captured by the retail segment.
While the steady increase in retail octane margin has gotten much attention and explanation from octane market analysts, the comparatively low level and flat trend in refiner’s octane margin capture has not drawn much attention or explanation. We will propose an explanation here that says refiners tend to focus less on market price dynamics than do retailers, and that, when it comes to capturing the increased value of octane, refiners have been outperformed by retailers on pricing strategy.
We will propose an explanation here that says refiners tend to focus less on market price dynamics than do retailers, and that, when it comes to capturing the increased value of octane, refiners have been outperformed by retailers on pricing strategy.
This conjecture suggests that refiners could capture a larger share of today’s high octane margin through more aggressive octane pricing strategies at the wholesale level.
Historically, refiners have considered themselves “price-takers”, meaning they must accept prevailing market prices due to lack of ability to influence them. In one-on-one polling, when asked about the numbers showing their relatively low percentage of octane margin capture, refiners seem surprised by that data and have told us the prices they can capture are constrained by intense competition at the wholesale level – which is generally true.
But fuel retailing is arguably even more competitive than refining – and when there is a 5-fold increase in the retail value of a commodity, it is not automatic that the manufacturer will capture its due share of that increased market value without deliberate effort to exercise its market power.
Also in one-on-one polling, we’ve been told by some refiners that retail octane values are irrelevant – only wholesale prices make a difference to them. Retail prices are not even on their radar screen.
As manufacturers, refiners’ top priorities, understandably, are safety, reliability, operations excellence, turnaround performance (turnarounds can cost $hundreds of millions), environmental performance, public relations and cost optimization. After that, there’s not much oxygen left in the room to allocate to product pricing and revenue enhancement.
refiners’ top priorities, understandably, are safety, reliability, operations excellence, turnaround performance (turnarounds can cost $hundreds of millions), environmental performance, public relations and cost optimization.
The culture of safe, reliable, low cost fuel manufacturing contrasts sharply with that of fuel retailers who have whole teams of people working full time to optimize pricing and procurement strategies with the goal of optimizing margin capture.
With this sharp contrast in core capabilities and cultural tendencies, it would not be surprising to see the refiner outperforming on operations excellence and cost optimization while the retailer is outperforming on pricing strategy and revenue enhancement.
With this sharp contrast in core capabilities and cultural tendencies, it would not be surprising to see the refiner outperforming on operations excellence and cost optimization while the retailer is outperforming on pricing strategy and revenue enhancement.
An Example Case – Marathon Petroleum Company
For several years, Marathon Petroleum Company (MPC) has consistently emphasized their corporate strategy to improve “commercial performance”.
For example, in their 4th quarter 2022 earnings conference call, Mike Hennigan, then MPC’s President and CEO said:
“Our team’s dynamic responses to volatile product markets delivered strong commercial performance, resulting in a 98% full year capture.” (This use of the term capture refers to MPC’s margin as a percent of a refining industry benchmark margin).
Elaborating on this point, their Executive Vice President and Chief Financial Officer (now President and CEO), Maryann Mannen, said in the same earnings conference call:
“As our strategic pillar indicates, we have been committed to improving our commercial performance and we believe that the capabilities we have built over the last 18 months will provide a sustainable advantage. . . and will produce results that can be seen in our financials.”
Every subsequent MPC earnings report has referred to this strategic pillar as a major factor in MPC’s strong financial and stock price performance, and when asked by financial analysts to elaborate, MPC has referred specifically to product pricing as an aspect of this commercial strategy, for example, from the same earnings conference call:
“we have meaningfully changed the way we go to market from a commercial perspective throughout our entire company”
and
“we had strong light product margins, . . . and favorable pricing of secondaries.”
Marathon’s successful multi-year initiative to develop an improved commercial performance capability is distinctive among refiners and supports our theory on why the refining sector as a whole is not capturing more of the increase in octane value. It shows that a deliberate focus on revenue and margin capture can greatly enhance financial performance of a pure refining company.
Why did wholesale octane values increase in a stepwise pattern in July of 2022?
Our theory is that most refiners were surprised by the billions of dollars of unexpected octane supply destruction caused by full implementation of the Tier 3 10-ppm gasoline sulfur specification in 2020, which caused a large step down in domestic octane supply capacity.
When refiners were first challenged, after the Covid lockdowns, to meet the Tier 3 requirement while running full-speed in summer 2022, they were forced to react in real time to an unanticipated octane shortage. The workaround was to buy expensive octane blend stocks, sulfur credits, and benzene credits (see Welcome To The Future and I Love a Piano for details on this).
Part 3 of this series will provide more hard data on the stepwise increase in octane costs in 2022 and its aftermath. We will also cover some nuances of the octane market, including its seasonality and the competition between gasoline and the petrochemicals market for high-octane gasoline components, and elaborate on the concept of the octane-gallon as an essential concept in quantitative economic analysis of the octane market.
Recommendation
Every refining executive should have a comprehensive understanding of the technical, regulatory, and economic aspects of Tier 3 gasoline, octane, and the sulfur credit program and how they affect your business. Those wanting a quick education on the Tier 3 issue should get the short book, Gasoline Desulfurization for Tier 3 Compliance, which will make you an expert in a day.
Once you have become expertly informed of the problem, you can save your team years of redundant work by buying Hoekstra Research Report 8. We are the ones who saw this situation coming, did the research and field tests, ran the simulations and analyzed the results so you and your team can take immediate steps to increase gasoline margin capture in the Tier 3 world. The report includes detailed pilot plant and commercial field test data, full detail of sulfur credit pricing and credit bank status, spreadsheet models to help improve gasoline optimization, sulfur credit strategy and refining margin capture in the Tier 3 world.
Don’t get caught panic buying after the credits spike.
George Hoekstra
George.hoekstra@hoekstratrading.com
+1 630 330-8159
