What is Cracking
Cracking is a chemical process used in oil refineries. Cracking separates large hydrocarbon molecules in raw crude oil to create byproducts such as heating oil, gasoline, liquefied petroleum gas, diesel fuel, jet fuel and other petroleum distillates.
Oil refineries essentially serve as the second stage in the production process following the actual extraction of crude oil by rigs.
BREAKING DOWN Cracking
Cracking is just one of a few techniques used to turn crude oil into a wide variety of fuels, lubricants and other products. While crude oil itself is a valuable commodity, in its raw form, it offers little economic utility until separated into marketable products.
Crude oil contains a blend of large and complex hydrocarbon molecules. Oil refineries use cracking in various ways to split these molecules into smaller ones so specific products such as gasoline or heating oil can be separated and sold to other companies.
Cracking the Crude
Several forms of cracking exist, however, fluid catalytic cracking is the most often method used. Separation of hydrocarbons into molecules produce many products. The cracking process may vary depending upon the type of crude oil a refinery processes.
Sweet crude oil requires less processing but is more expensive to mine than other forms of crude oil. The less expensive, heavier, and sour crude oil is also cracked, but may be more costly to refine.
When crude oil reaches a refinery, a variety of processes are used to separate it into lighter and heavier substances. First, the oil is distilled into three main categories that are classified by molecular weight as light, medium and heavy. The lighter products are gaseous ones, such as butane and propane, while heavier products include tars and resins.
What remains is a group of molecules of medium weight, distillates which usually generate the highest value from a barrel of oil. These medium weight products include heating oil and gasoline. The cracked molecules can be further processed and sold.
Hedging Oil Cracking
Although dozens of products can be refined from crude oil, the ones of most importance in the commodities markets are heating oil and gasoline. The crack spread is often used by traders as a way of hedging contracts in all three commodities. There are several different spreads for various forms of crude oil.
One common crack spread is the 3:2:1 spread. This is a ratio that assumes that three barrels of oil yields two barrels of gasoline and one barrel of heating oil. If the profit margin is high enough a trader could lock in that profit by selling heating oil and gasoline futures contracts and buying crude oil contracts following that ratio.