What is 'Crack Spread'

Crack spread refers to the overall pricing difference between a barrel of crude oil and the petroleum products refined from it. The “crack” being referred to is an industry term for breaking apart crude oil into the component products, including gases like propane, heating fuel, gasoline, light distillates like jet fuel, intermediate distillates like diesel fuel and heavy distillates like grease. The price of a barrel of crude oil and the various prices of the products refined from it are not always in perfect synchronization. Depending on the time of year, the weather, global supplies and many other factors, the supply and demand for particular distillates results in pricing changes that can impact the profit margins on a barrel of crude oil for the refiner. To mitigate pricing risks, refiners use futures to hedge the crack spread. Futures and options traders can also use the crack spread to hedge other investments or speculate on potential price changes in oil and refined petroleum products.

BREAKING DOWN 'Crack Spread'

The traditional crack spread play used to hedge against these risks involves the refiner purchasing oil futures and offsetting the position by selling gasoline, heating oil or other distillate futures that they will be producing from those barrels. Refiners can use this hedge to lock in profit. Essentially, refiners want a strong positive spread between the price of barrel of oil and the price of the refined products, meaning a barrel of oil is significantly cheaper than the refined products. To find out if there is a positive crack spread, you simply take the price of a barrel of crude oil - in this case WTI at $51.02/barrel, for example - and compare it to your chosen refined product - let's say RBOB gasoline futures at $1.5860 per gallon. There are 42 gallons per barrel, so a refiner gets $66.61 for every barrel of gasoline for a crack spread of $15.59 which can be locked in with future contracts. This is the most common crack spread play, and it is called the 1:1 crack spread.

Of course, it is a bit of an oversimplification of the refining process as one barrel of oil doesn't make exactly one barrel of gasoline and, again, their are different product mixes depending on the refinery. So there are other crack spread plays where you buy three oil futures and then match the distillates mix more closely as two barrels worth of gasoline contracts and one worth of heating oil for example. These are known as 3:2:1 crack spreads and even 5:3:2 crack spreads, and they can also be used as a form of hedging for an investment in refiners themselves. For most traders, however, the 1:1 crack spread captures the basic market dynamic they are attempting to trade on.

Trading the Crack Spread

Generally you are either buying or selling the crack spread. If you are buying it, you expect that the crack spread will strengthen, meaning the refining margins are growing because crude oil prices are falling and/or demand for the refined products are growing. Selling the crack spread means you expect that the demand for refined products is weakening or the spread itself is tightening due to changes in oil pricing, so you sell the refined product futures and buy crude futures.

Reading the Crack Spread as a Market Signal

Even if you aren't looking to trade the crack spread itself, it can act as a useful market signal on potential price moves in both the oil and refined product market. If the crack spread widens significantly, meaning the price of refined products is outpacing the price of oil, many investors see that as a sign that crude oil will eventually rise in price to tighten the spread back up to historical norms. Similarly, if the spread is too tight, investors see that as a sign that refiners will slow production in order to tighten supply to a level where the demand will restore their margins. This, of course, has a dampening effect on the price of crude oil. So, whether you intend to trade it or not, the crack spread is worth keeping an eye on as a market signal.

 

RELATED TERMS
  1. Spread Option

    A spread option is a derivative based on the value of the difference, ...
  2. Ask

    The ask is the price a seller is willing to accept for a security. ...
  3. Spread Indicator

    The difference between the bid and ask price is known as the ...
  4. Forward Spread

    A forward spread is the price difference between the spot price ...
  5. Futures Spread

    A futures spread is an arbitrage technique in which a trader ...
  6. Spread Betting

    Spread betting is a type of speculation that involves taking ...
Related Articles
  1. Investing

    Make a Downstream Bet with Oil Refiners

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

    Trading Calendar Spreads in Grain Markets

    Futures investors flock to spreads because they hold true to fundamental market factors.
  3. Investing

    8 Energy Stocks For The New Oil Boom

    Glowing Profits: These stocks are only in "the second or third inning"
  4. Investing

    How To Calculate The Bid-Ask Spread

    It's very important for every investor to learn how to calculate the bid-ask spread and factor this figure when making investment decisions.
  5. 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.
  6. Trading

    Vertical Bull and Bear Credit Spreads

    This trading strategy is an excellent limited-risk strategy that can be widely used.
  7. Investing

    Why Is Spread Betting Illegal In The US?

    Spread betting is a speculative practice that began in the 1940s as a way for gamblers to win money on changes in the line of sporting events. But by 1970, the phenomenon trickled into the financial ...
RELATED FAQS
  1. What's the difference between a credit spread and a debt spread?

    Learn about debit and credit option spread strategies, how these strategies are used, and the differences between debit spreads ... Read Answer >>
  2. What is spread hedging?

    Learn about one of the most common risk-management strategies options traders use, called spread hedging, to limit exposure ... Read Answer >>
  3. In what types of financial situations would credit spread risk be applied instead ...

    Find out when credit risk is realized as spread risk and when it is realized as default risk, and learn why market participants ... Read Answer >>
  4. What causes oil prices to fluctuate?

    Discover how OPEC, demand and supply, natural disasters, production costs and political instability are some of the major ... Read Answer >>
Hot Definitions
  1. Diversification

    Diversification is the strategy of investing in a variety of securities in order to lower the risk involved with putting ...
  2. Intrinsic Value

    Intrinsic value is the perceived or calculated value of a company, including tangible and intangible factors, and may differ ...
  3. Current Assets

    Current assets is a balance sheet account that represents the value of all assets that can reasonably expected to be converted ...
  4. Volatility

    Volatility measures how much the price of a security, derivative, or index fluctuates.
  5. Money Market

    The money market is a segment of the financial market in which financial instruments with high liquidity and very short maturities ...
  6. Cost of Debt

    Cost of debt is the effective rate that a company pays on its current debt as part of its capital structure.
Trading Center