What is Crack Spread?

What is Crack Spread?

A crack spread refers to the overall pricing difference between a barrel of crude oil and the petroleum products refined from it. It is an industry-specific type of gross processing margin. 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.

A crack spread is the overall pricing difference between a barrel of crude oil and the petroleum products refined from it.

The price of a barrel of crude oil and the prices of the different products derived from it are not always in sync, leading to the spread in prices.

The difference in prices is important to oil refiners as it can impact their profit margins.

Factors Affecting Crack Spread

One of the factors that affect the spread is geopolitical issues. Generally, during periods of political uncertainty and instability, there will be a reduction in oil supply. The result is a rise in crude oil prices relative to refined products.

This weakens, or narrows, the crack spread initially. However, as refineries respond to the reduced crude oil supply and byproduct output reduction, the crack spread widens. Foreign policy changes also affect crude oil producers and the prices of crude byproducts.

Prevailing weather conditions, mainly summer and winter seasonality, affect the spreads as well. During the summer season, there is a higher demand for specific byproducts such as gasoline and diesel, which significantly strengthens the crack spread. The winter season increases the demand for distillates like diesel fuel and motor gasoline and also results in a wider crack spread.

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There exists an inverse relationship between crude oil and currency strength, and any changes in the strength of a currency may affect crude oil prices and ultimately the crack spread. When the value of a currency declines, crude oil prices increase, and this weakens the crack spread.

An increase in the value of crude oil means that the profit margins from crude oil components are reduced. For refiners to get a strong positive crack spread, the price of crude oil must be significantly lower than the price of refined products.

How to Trade Crack Spreads?

Crack spreads are commonly traded using the following two methods:

1. Single product crack spreads

The single product crack spread is the most common type of crack spread, and it reflects the refinery margin difference between crude oil and refined products such as diesel or gasoline. It is executed by selling refined products futures and buying crude oil futures.

If the refined product price is higher than the price of crude oil, the cracking margin is positive. If the refined product price is less than that of crude oil, the cracking margin is negative.

2. Multiple product crack spreads

The multiple product spreads are designed to reflect a refiner’s yield of refined products. According to the CME Group, gasoline output is double that of distillate fuel oil. This ratio has prompted hedgers to focus on 3:2:1 crack spreads.

The 3:2:1 ratio crack spread is traded by buying three barrels of crude oil futures and selling two barrels of gasoline futures and one barrel of fuel oil futures. A refiner with lower yields of gasoline relative to other distillates might use other combinations such as a 5:3:2 spread. The 5:3:2 ratio is traded by buying five barrels of crude oil futures and selling three gasoline futures and two distillate fuel oil futures.

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Reading a 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 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.