DEFINITION of 'Crack'
A crack spread, or crack, is a term used in the energy markets to represent the differences between crude oil and wholesale petroleum product prices. It is a trading strategy used in energy futures to establish a refining margin. Crack is one primary indicator of oil refining companies' earnings. Crack allows refining companies to hedge against the risks associated with crude oil and those associated with petroleum products. By simultaneously purchasing crude oil futures and selling petroleum product futures, a trader is attempting to establish an artificial position in the refinement of oil created through a spread.
BREAKING DOWN 'Crack'The term "crack" is derived from the fluid catalytic cracking of crude oil, which is used to refine crude oil into petroleum products, such as gasoline and heating oil. Crack is a simple calculation that is often used to estimate refining margins and is based on one or two petroleum products produced in a refinery. However, crack does not take into consideration refineries' revenues and costs, just the cost of the price per barrel of crude oil. The comparison between the prices of crude oil to those of refined products could indicate the market's supply condition.
Single Product Crack
A single product crack reflects the difference between the prices of one barrel of crude oil and one barrel of a specified product. For example, a crude oil refiner believes that gasoline prices will remain strong over the next two months and wishes to lock-in the margins now. In February, the refiner notices that May Western Texas Intermediate (WTI) crude oil futures are trading at $45 per barrel and June New York Harbor RBOB gasoline futures are trading at $2.15 per gallon, or $90.30 per barrel. The refiner believes this is a favorable single product crack spread of $45.30 per barrel, or $90.30 - $45.
Since refiners purchase crude oil to refine the commodity into a petroleum product, the refiner decides to purchase the May WTI crude oil futures, while simultaneously selling the June RBOB gasoline futures. Consequently, the refiner has locked in a crack of $45.30.
Multiple Product Crack
Refiners and investors also implement crack strategies on multiple products. For example, a refiner aims to hedge against the risk of increasing WTI crude oil prices and falling petroleum product prices. The refiner could hedge the risk with the 3, 2, 1 crack spread. Using the same futures prices and expiration dates for WTI crude oil and RBOB gasoline, the refiner could purchase three crude oil futures contracts and selling two RBOB gasoline futures contracts. Assume that June heating oil futures are trading at $1.40 per gallon, or $58.80 per barrel, the refiner would also sell one futures contract on the commodity. Consequently, the refiner locks in a favorable margin of $34.80 per barrel, or ($58.80 + 2 * $90.30 - 3 * $45) / 3.