What is a 'Crack'

A crack, or crack spread, 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. A crack spread is typically a hedge created by going long in oil futures while shorting gasoline and heating oil futures.

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 West 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.

Factors that Affect Crack Spreads

The proportions of petroleum products a refinery produces from crude oil can also affect crack spreads. Some of these products include asphalt, aviation fuel, diesel, gasoline and kerosene. In some cases, the proportion produced varies based on demand from the local market. 

The mix of products also depends on the kind of crude oil processed. Heavier crude oils are more difficult to refine into lighter products like gasoline. Refineries that use simpler refining processes may be restricted in their ability to produce products from heavy crude oil.

RELATED TERMS
  1. Cracking

    Cracking is a process to convert large hydrocarbon molecules ...
  2. Downstream

    Downstream operations are oil and gas operations that take place ...
  3. North Sea Brent Crude

    North Sea Brent Crude is a light sweet blend of crude oil whose ...
  4. Peak Oil

    Peak oil is the hypothetical point at which global oil production ...
  5. Petroleum

    Petroleum is a fluid found in the earth that can be refined into ...
  6. Futures Contract

    A contractual agreement, generally made on the trading floor ...
Related Articles
  1. 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?
  2. 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.
  3. Investing

    4 Factors You Didn't Know About RBOB

    Learn the basics of how RBOB is traded, including the specifications for the RBOB futures contract. Discover what impacts the price of RBOB.
  4. Investing

    The Reasons for the Mexican-U.S. Oil Swap

    The U.S. government is getting close to a historic deal to allow U.S. producers to swap the light, sweet crude oil that is in too much supply with Mexico, in return for heavy crude.
  5. Investing

    How To Lock In Low Oil & Gas Prices

    We provide a quick overview of how companies can manage the risk of adverse moves in commodity prices by hedging in the futures market.
  6. Investing

    Top 3 ETFs With Exposure to Gasoline and Refineries (CRAK, PXE)

    Learn why refinery stocks are outperforming in the energy sector. Discover three ETFs with strong exposure to refineries and gasoline production.
  7. Investing

    Uncovering Oil And Gas Futures

    Find out how to stay on top of data reports that could cause volatility in oil and gas markets.
  8. Investing

    US EIA Oil Inventory Preview

    U.S. Department of Energy crude oil inventory data released later today should provide an indication of what is next for oil prices.
  9. Investing

    Investing in Crude Oil Futures: The Risks and Rewards

    Learn about the risks and rewards of trading oil futures contracts. Read about a few strategies to limit the risk in trading oil futures contracts.
  10. Financial Advisor

    Learn how to trade crude oil in 5 steps

    Crude oil and energy markets are specialized venues. Here are five steps to take to build consistent profits.
RELATED FAQS
  1. What economic indicators are especially important to oil traders?

    Economic indicators such as crude inventories and production levels are used by oil traders and investors to understand the ... Read Answer >>
  2. What economic indicators do oil and gas investors need to watch?

    Leading indicators for oil and gas investments are centered around the levels of production, consumer demand and inventory ... Read Answer >>
  3. Why are stocks and oil so correlated right now?

    Learn whether the stock market and oil prices will continue their highly correlated price relationship or decouple again ... Read Answer >>
  4. Why do companies enter into futures contracts?

    Learn how companies use futures contracts for the purposes of hedging their exposure to price fluctuations as well as for ... Read Answer >>
Hot Definitions
  1. Net Present Value - NPV

    Net Present Value (NPV) is the difference between the present value of cash inflows and the present value of cash outflows ...
  2. Price-Earnings Ratio - P/E Ratio

    The Price-to-Earnings Ratio or P/E ratio is a ratio for valuing a company that measures its current share price relative ...
  3. Internal Rate of Return - IRR

    Internal Rate of Return (IRR) is a metric used in capital budgeting to estimate the profitability of potential investments.
  4. Limit Order

    An order placed with a brokerage to buy or sell a set number of shares at a specified price or better.
  5. Current Ratio

    The current ratio is a liquidity ratio that measures a company's ability to pay short-term and long-term obligations.
  6. Return on Investment (ROI)

    Return on Investment (ROI) is a performance measure used to evaluate the efficiency of an investment or compare the efficiency ...
Trading Center