Crack spread is the difference between input costs and output costs associated with the petroleum industry. Refinery executives are hedge this difference because profits are tied between the price of crude oil and the price of the refined products such as gasoline or diesel. It is called a “crack” spread because refiners use a process to “crack” crude oil into refined products. Refiners have substantial value exposure when the value of crude oil rises while the value of refined products such as gasoline go lower or remain stagnant. They limit this risk by hedging it through various of strategies. The crack spread is the differential obtained from the profit margin a refiner receives from obtaining crude oil and selling refined products all together. Because the refiners are on both sides of the petroleum market, there is an added risk presented unlike firms who specialize in either obtaining the crude oil or in the process of creating the end product.

Investors use crack spreads as a hedge against a refining corporation enterprise value. The uncertainty of a crack spread can cause doubts for investors because the refiner’s financial exposure is not fully understood or certain. There are situations where investors use crack spreads as a parallel trade part of their energy portfolio because of the benefits they obtain through spread credit from margining. The shift in crack spread can be used by investors as an indicator for where a company or even the whole petroleum market may shift in the short term.

When the crack spread is hedged, there are different ways to manage the price risk. Every refining company develops a strategy based upon the cash market operations and risks presented.

Crack Spread Strategies –

1. Simple 1:1 Crack Spread

The most widely used type of crack spread is the 1:1 crack spread.  The refining margin (crack spread) works by going short or sell refined product futures and going long crude oil futures. This strategy locks in the differential between the refined products and crude oil. Since crude is quoted in dollar per barrel and refined products as cents per gallon, the crack spread is quoted in dollar per barrel. For example, gasoline prices must be converted by multiplying the cents per gallon by 42 because there are 42 gallons in a barrel. If the value of the product, such as gasoline, is less than that of crude, the net cracking margin is negative.  Refiners are typically long crack spread risk because they are constantly buying crude and selling refined products. If the refiner expects the price of crude to be stagnant while product prices fall (declining crack), the refiners would hedge their positions by selling the crack. This means they would sell the refined product they are producing while buying the crude oil future. The method mentioned previously is known as going short the “crack”.

There are instances where refiners buy the crack spread i.e buy refined products while selling crude oil. In this case, the refiner would short crude oil futures and go long refined products futures. The reason for this shift is likely due seasonal nature of the petroleum market causing refiners to either be close or go through maintenance. During this time, refiners enter the markets to supply contracts until they cannot complete existing demand. The refiners then focus on buying products at the current spot price in order to supply their customers. Another issue is the storage space required for incoming crude oil therefore the refiner must sell any excess oil in the spot market. There is a likelihood that due to this chain of events, product prices will increase, and crude oil prices will decrease due to a surplus. In order to hedge against this risk, the refinery use a short hedge against crude while using a long hedge against refined products.

2. Diversified 3:2:1 and 5:3:2 Crack Spread

Crack spreads can have very complex hedging strategies as some are designed solely to mimic the refiner’s return of refined products.  Gasoline output is typically twice the fuel oil in most refineries. This ratio of refinement is a reason why refineries seek 3:2:1 spreads. According to EIA, “The 3:2:1 crack spread approximates the product yield at a typical U.S. refinery: for every three barrels of crude oil the refinery processes, it makes two barrels of gasoline and one barrel of distillate fuel.” In order to calculate this crack spread, you must add the spot price for two barrels of gasoline to the spot price for one barrel of diesel. It is important to remember to convert the price of petroleum products because they are quoted in dollars per gallon. After adding and converting, the result is subtracted by the spot price for three barrels of crude oil. This total is divided by 3, producing a crack spread in dollars per barrel. Since the 3:2:1 crack spread contains 3 different commodities, each commodity is subject to a different supply and demand curve. There can be large spike in this spread due to product supply shortages caused by natural events.

5:3:2 crack spread’s ratio is made by shorting five refined products futures in a 3:2 ratio i.e three diesel futures and two gasoline futures while going long five crude oil futures. This method locks in the 5:3:2 differential that almost matches the refiner’s cracking margin.

Factors that affect a crack spread’s value

1. Geopolitical issues such as politics, geography, economics, etc. –

During times of political uncertainty and instability, there is typically a lower supply for oil. This causes a rise in the price of crude oil against refined products. This makes the differential, or crack spread, narrower. Eventually, refiners respond by tightening crude oil supply and reduce the product outputs causing the crack to widen/strengthen.

2. Seasonality

Products in the petroleum industry are subject to seasonality. For example, around June and until August, the underlying commodity of the contracts are required to meet a certain pressure and obtaining such a pressure cost more for refiners. This increase in cost causes the futures to increase and widens the crack spread. There is a higher demand for driving late spring and summer therefore the spread remains high through these 4-5 months. During the winter, the opposite occurs. Domestic gasoline consumption declines while distillate consumption increases for heating reasons. In this case the gas crack spread lowers while the distillate crack spread goes higher.

3. Slower economic growth

This factor is obvious for majority of financial instrument. As the economy slows down, the crack begins to shrink because of lower expectations in demand.

Other factors include: currency weakness causes an increase in crude oil prices as investors seek safer investment opportunities, this causes a decrease in the spread; expiration of trading month, the crack spread varies based on the closing of the positions; environmental regulations cause a restriction on the product supply and strengths the crack; tax increase causes the crack to shrink and expand after the tax deadline.

The reason for trading crack spreads can be broken into speculation or hedging. Refiners seek to maximize their profits and limit risks therefore they “hedge margins, shutdown time, capital asset purchase, or current market opportunity”.  Speculators always look for inefficiencies in the market and desire to capture the market value at the given moment. The crack ratio is chosen based on the refinery’s set up i.e the type of crude, refinery product etc.

Example – 3:2:1 Spread

A refiner has acknowledged the risk of increasing crude oil costs and falling product prices. This refining margin will be less than expected therefore the refinery would lock in cracking margins using the 3:2:1 strategy.

On August 12, the refiner decides to sell the spread by selling two November RBOB gasoline futures and one ULSD future while buying three crude oil futures. This method locks in the 3:2:1 spread of 18.60 per barrel. The refiner sells two November ULSD futures at 1.70 per gallon (dividing 71.40 per barrel by 42) and buying three October crude oil futures at 50 per barrel.

In a month, around September 14, the refiner purchases the crude oil at 60 per barrel in the spot market and uses it to make refined products. Simultaneously, gasoline is being sold in the spot market for 1.70 per gallon and diesel fuel for 1.80 per gallon. The 3:2:1 crack spread value in the spot market has declined to 12.80 per barrel.

The October crude oil futures are being sold at 60 per barrel, the November RBOB gasoline futures at 1.70, and the ULSD futures at 1.80. Each of these derivatives is trading higher and the refiner will now look to liquidate the position. The refiner must buy back the spread by repurchasing the gas future and the ULSD future while selling the three crude oil fuutres. This strategy locks in a profit of 5.80 per barrel.

If the refiner had not hedged, the cracking margin would have been limited to 12.80 per barrel, which was gained through the spot market.  With the strategy, the crack spread profit is 18.60 per barrel.  The P/L calculation is:

On August 12^th , the 3:2:1 crack spread future is sold at 18.60:

RBOB gas future = 67.2 , ULSD future = 71.4 , CL future = 50 , plugging in these values we get the crack spread future contract at 18.60.

3:2:1 crack spread value=((2*(RBOB gas futures)+(ULSD futures)-3*(CL futures)))/3

On September 14^th, in the cash market, the refiner sells the spread at 12.80:

Using the same formula, the cracking margin is obtained and is 12.80, here the refiner also buys back the futures contract at 12.80 per barrel in order to lock in the gain of 5.80 per barrel. This is done by reversing the initial trade i.e buying 2 gas futures, 1 diesel futures, and selling 3 crude oil futures.

References :

“Introduction to Crack Spreads – CME Group.” CME Group, www.cmegroup.com/education/articles-and-reports/introduction-to-crack-spreads.html.

“Crack Spread – Learn About the Factors Affecting Crack Spreads.” Corporate Finance Institute, www.corporatefinanceinstitute.com/resources/knowledge/trading-investing/crack-spread/.

“U.S. Energy Information Administration – EIA – Independent Statistics and Analysis.” Energy & Financial Markets – Petprod – U.S. Energy Information Administration (EIA), www.eia.gov/finance/markets/products/prices.php.