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.

RELATED TERMS
  1. Downstream

    The oil and gas operations that take place after the production ...
  2. Oil Refinery

    An industrial plant that refines crude oil into petroleum products ...
  3. Crack Spread

    The spread created in commodity markets by purchasing oil futures ...
  4. Cracking

    Used in the oil and gas industry to refer to a variety of methods ...
  5. Crude Oil

    Crude oil is a naturally occurring, unrefined petroleum product ...
  6. West Texas Intermediate - WTI

    Light, sweet crude oil commonly referred to as "oil" in the Western ...
Related Articles
  1. Investing

    Why Low Oil Prices Don't Always Mean Low Gas Prices

    Find out why gasoline prices do not always decline with oil prices. Learn about the impact of the refining process, taxes and marketing, and distribution.
  2. Investing

    Make a Downstream Bet with Oil Refiners

    Now is a good time to bet on the oil refinery sector. Here's why.
  3. Investing

    Europe's Oil Refineries Get A Second Chance (CS, TOT)

    The European refining sector is benefiting from the drop in oil prices, but it may not last the year. Can high margins beat structural overcapacity?
  4. Investing

    The 2016 Outlook For Oil Refiners

    Many refiners have benefited from wide crack spreads in recent years but profits may suffer when crude oil stabilizes.
  5. Insights

    Tough Times Ahead for U.S. Refiners

    Despite increased motor travel, the summer of 2016 may not be fruitful for U.S. oil refiners. Here’s why
  6. Investing

    The Difference Between Oil Services And Refiners

    Oil service companies and refiners both play an important role in the oil industry, but they tend to profit more in opposite markets.
  7. Investing

    Oil Stocks That Benefit From OPEC Overproduction (TSO, HFC)

    Despite falling oil prices, many oil refinery stocks have had a stellar performance. Here's a list of top performers with strong future potential.
  8. Investing

    The End of US Foreign Oil Dependency

    Learn about how U.S. production of oil is increasing on an annual basis and how oil imports are dropping, and why Congress may lift a ban on the export of oil.
  9. Investing

    Large Cap Energy Companies Benefit From Cheap Oil

    Some pockets of the US oil value chain, such as refining, as well as some high-tax foreign operators tend to benefit when oil prices decline.
  10. Investing

    Ending The Limits On U.S. Crude Oil Exports

    As US storage capacity reaches its limit, industry participants and their lobby groups in Washington are calling for an end to the crude oil exports ban.
RELATED FAQS
  1. What is a heavy oil differential and how does it affect oil producers?

    Learn what the phrase "heavy oil differential" refers to and the significance of heavy oil differentials for oil production ... Read Answer >>
  2. Do all oil companies received the quoted price of West Texas Intermediate for their ...

    Learn about the three benchmark oil prices, the primary factors that determine the quality of crude oil and the price it ... Read Answer >>
  3. What economic indicators are especially important to oil traders?

    Economic indicators are used by traders and investors in an attempt to understand the underlying fundamentals of the market. ... Read Answer >>
  4. What does a barrel of oil equivalent (BOE) refer to in the oil and gas sector?

    Find out about the oil and gas industry, what a barrel of oil equivalent refers to and what it measures in the oil and gas ... Read Answer >>
Hot Definitions
  1. Cash Flow

    The net amount of cash and cash-equivalents moving into and out of a business. Positive cash flow indicates that a company's ...
  2. PLUS Loan

    A low-cost student loan offered to parents of students currently enrolled in post-secondary education. With a PLUS Loan, ...
  3. Graduate Record Examination - GRE

    A standardized exam used to measure one's aptitude for abstract thinking in the areas of analytical writing, mathematics ...
  4. Graduate Management Admission Test - GMAT

    A standardized test intended to measure a test taker's aptitude in mathematics and the English language. The GMAT is most ...
  5. Magna Cum Laude

    An academic level of distinction used by educational institutions to signify an academic degree which was received "with ...
  6. Cover Letter

    A written document submitted with a job application explaining the applicant's credentials and interest in the open position. ...
Trading Center