Crack Spread

What Is a Crack Spread?

A crack spread alludes to the overall pricing difference between a barrel of crude oil and the petroleum products refined from it. It is an industry-explicit type of gross processing margin. The "crack" being alluded to is an industry term for breaking separated crude oil into the part products, including gases like propane, heating fuel, gas, light distillates, similar to fly fuel, intermediate distillates, similar to diesel fuel, and heavy distillates, similar to lube.

Grasping a Crack Spread

The price of a barrel of crude oil and the different prices of the products refined from it are not generally in perfect synchronization. Contingent upon the season, the climate, global supplies, and numerous different factors, the supply and demand for specific distillates brings about pricing changes that can impact the profit margins on a barrel of crude oil for the purifier.

To moderate pricing risks, purifiers use futures to hedge the crack spread. Futures and options traders can likewise utilize the crack spread to hedge different investments or estimate on potential price changes in oil and refined petroleum products.

Utilizing a Crack Spread to Hedge Price Risk

The traditional crack spread strategies used to hedge against these risks imply the purifier purchasing oil futures and offsetting the position by selling fuel, heating oil, or other distillate futures that they will create from those barrels.

Purifiers can utilize this hedge to lock in a profit. Basically, purifiers need a strong positive spread between the price of a barrel of oil and the price of its refined products; meaning a barrel of oil is fundamentally less expensive than the refined products.

To see whether there is a positive crack spread, you take the price of a barrel of crude oil — in this case, WTI at $51.02/barrel, for instance — and compare it to your picked refined product. Suppose RBOB fuel futures at $1.5860 per gallon. There are 42 gallons for each barrel, so a purifier gets $66.61 for each barrel of fuel for a crack spread of $15.59 that can be locked in with futures contracts. This is the most common crack spread play, and it is called the 1:1 crack spread.

Of course, it is a bit of a distortion of the refining system as one barrel of oil doesn't make exactly one barrel of gas and, once more, unique product mixes are dependent on the refinery. So there are other crack spread plays where you buy three oil futures and afterward match the distillates mix all the more closely, as two barrels worth of gas contracts and one worth of heating oil, for instance.

This is known as a 3:2:1 crack spread and there are even 5:3:2 crack spreads, and they can likewise be utilized as a form of hedging. For most traders, in any case, the 1:1 crack spread catches the essential market dynamic they are endeavoring to trade on.

Trading a Crack Spread

By and large, you are either buying or selling the crack spread. Assuming you are buying it, you expect that the crack spread will reinforce, meaning the refining margins are developing since crude oil prices are falling or demand for the refined products is developing. Selling the crack spread means you expect that the demand for refined products is debilitating or the spread itself is tightening due to changes in oil pricing, so you sell the refined product futures and buy crude futures.

Perusing a Crack Spread as a Market Signal

Even on the off chance that you're not hoping to trade the crack spread itself, it can act as a valuable market signal on potential price moves in both the oil and refined product market. On the off chance that the crack spread enlarges essentially, meaning the price of refined products is dominating the price of oil, numerous investors see that as a sign that crude oil will eventually rise in price to tighten the spread back up to historical standards.

Essentially, if the spread is too tight, investors see that as a sign that purifiers will ease back production to tighten supply to a level where the demand will reestablish their margins. This, of course, affects the price of crude oil. Thus, regardless of whether you mean to trade it, the crack spread is worth keeping an eye on as a market signal.

Features

• A crack spread is the overall pricing difference between a barrel of crude oil and the petroleum products refined from it.
• The price of a barrel of crude oil and the prices of the various products derived from it are not generally in that frame of mind, to the spread in prices.
• Crack spreads can be utilized as a market signal for price developments in oil and refined products relying upon whether the spread is tightening or broadening.
• To relieve the pricing risk, purifiers use futures to hedge the crack spread. Futures and options can likewise be utilized by traders to hedge different investments or hypothesize in the oil market.
• The difference in prices is important to oil purifiers as it can impact their profit margins.