Crack spread
Encyclopedia
Crack spread is a term used in the oil industry and futures trading
for the differential between the price of crude oil and petroleum product
s extracted from it - that is, the profit margin that an oil refinery
can expect to make by "cracking
" crude oil (breaking its long-chain hydrocarbons into useful shorter-chain petroleum product
s).
In the futures markets, the "crack spread" is a specific spread trade
involving simultaneously buying and selling contracts in crude oil and one or more derivative products, typically gasoline
and heating oil
. Oil refineries may trade a crack spread to hedge
the price risk of their operations, while speculators attempt to profit from a change in the oil/gasoline price differential.
, kerosene
, diesel, heating oil
, aviation fuel
, asphalt
and others. To some degree, the proportion of each product produced can be varied in order to suit the demands of the local market. Regional differences in the demand for each refined product depend upon the relative demand for fuel for heating, cooking or transportation purposes. Within a region, there can also be seasonal differences in demand for heating fuel versus transportation fuel.
The mix of refined products is also affected by the particular blend of crude oil feedstock processed by a refinery, and by the capabilities of the refinery. Heavier crude oils contain a higher proportion of heavy hydrocarbon
s composed of longer carbon chains. As a result, heavy oil
is more difficult to refine into lighter products such as gasoline. A refinery using less sophisticated processes will be constrained in its ability to optimize its mix of refined products when processing heavy oil.
from oil production to retail distribution of refined products, there is a natural economic hedge against adverse price movements. For independent oil refiners which purchase crude oil and sell refined products in the wholesale market, adverse price movements can present a significant economic risk. Given a target optimal product mix, an independent oil refiner can attempt to hedge itself against adverse price movements by buying oil futures
and selling futures for its primary refined products according to the proportions of its optimal mix.
For simplicity, most refiners wishing to hedge their price exposures have used a crack ratio usually expressed as X:Y:Z where X represents a number of barrels of crude oil, Y represents a number of barrels of gasoline and Z represents a number of barrels of distillate fuel oil
, subject to the constraint that X=Y+Z. This crack ratio is used for hedging purposes by buying X barrels of crude oil and selling Y barrels of gasoline and Z barrels of distillate in the futures market
. The crack spread X:Y:Z reflects the spread obtained by trading oil, gasoline and distillate according to this ratio. Widely used crack spreads have included 3:2:1, 5:3:2 and 2:1:1. As the 3:2:1 crack spread is the most popular of these, widely quoted crack spread benchmarks are the "Gulf Coast 3:2:1" and the "Chicago 3:2:1".
Various financial intermediaries
in the commodity markets have tailored their products to facilitate trading crack spreads. For example, NYMEX
offers virtual crack spread futures contracts by treating a basket of underlying NYMEX futures contracts corresponding to a crack spread as a single transaction. Treating crack spread futures baskets as a single transaction has the advantage of reducing the margin requirements for a crack spread futures position. Other market participants dealing over the counter
provide even more customized products.
The following discussion of crack spread contracts comes from the Energy Information Administration
publication Derivatives and Risk Management in the Petroleum, Natural Gas, and Electricity Industries:
Futures contract
In finance, a futures contract is a standardized contract between two parties to exchange a specified asset of standardized quantity and quality for a price agreed today with delivery occurring at a specified future date, the delivery date. The contracts are traded on a futures exchange...
for the differential between the price of crude oil and petroleum product
Petroleum product
Petroleum products are useful materials derived from crude oil as it is processed in oil refineries.According to crude oil composition and demand, refineries can produce different shares of petroleum products. The largest share of oil products is used as energy carriers: various grades of fuel...
s extracted from it - that is, the profit margin that an oil refinery
Oil refinery
An oil refinery or petroleum refinery is an industrial process plant where crude oil is processed and refined into more useful petroleum products, such as gasoline, diesel fuel, asphalt base, heating oil, kerosene, and liquefied petroleum gas...
can expect to make by "cracking
Cracking (chemistry)
In petroleum geology and chemistry, cracking is the process whereby complex organic molecules such as kerogens or heavy hydrocarbons are broken down into simpler molecules such as light hydrocarbons, by the breaking of carbon-carbon bonds in the precursors. The rate of cracking and the end products...
" crude oil (breaking its long-chain hydrocarbons into useful shorter-chain petroleum product
Petroleum product
Petroleum products are useful materials derived from crude oil as it is processed in oil refineries.According to crude oil composition and demand, refineries can produce different shares of petroleum products. The largest share of oil products is used as energy carriers: various grades of fuel...
s).
In the futures markets, the "crack spread" is a specific spread trade
Spread trade
In finance, a spread trade is the simultaneous purchase of one security and sale of a related security, called legs, as a unit. Spread trades are usually executed with options or futures contracts as the legs, but other securities are sometimes used...
involving simultaneously buying and selling contracts in crude oil and one or more derivative products, typically gasoline
Gasoline
Gasoline , or petrol , is a toxic, translucent, petroleum-derived liquid that is primarily used as a fuel in internal combustion engines. It consists mostly of organic compounds obtained by the fractional distillation of petroleum, enhanced with a variety of additives. Some gasolines also contain...
and heating oil
Heating oil
Heating oil, or oil heat, is a low viscosity, flammable liquid petroleum product used as a fuel for furnaces or boilers in buildings. Home heating oil is often abbreviated as HHO...
. Oil refineries may trade a crack spread to hedge
Hedge (finance)
A hedge is an investment position intended to offset potential losses that may be incurred by a companion investment.A hedge can be constructed from many types of financial instruments, including stocks, exchange-traded funds, insurance, forward contracts, swaps, options, many types of...
the price risk of their operations, while speculators attempt to profit from a change in the oil/gasoline price differential.
Factors affecting the crack spread
One of the most important factors affecting the crack spread is the relative proportion of various petroleum products produced by a refinery. Refineries produce many products from crude oil, including gasolineGasoline
Gasoline , or petrol , is a toxic, translucent, petroleum-derived liquid that is primarily used as a fuel in internal combustion engines. It consists mostly of organic compounds obtained by the fractional distillation of petroleum, enhanced with a variety of additives. Some gasolines also contain...
, kerosene
Kerosene
Kerosene, sometimes spelled kerosine in scientific and industrial usage, also known as paraffin or paraffin oil in the United Kingdom, Hong Kong, Ireland and South Africa, is a combustible hydrocarbon liquid. The name is derived from Greek keros...
, diesel, heating oil
Heating oil
Heating oil, or oil heat, is a low viscosity, flammable liquid petroleum product used as a fuel for furnaces or boilers in buildings. Home heating oil is often abbreviated as HHO...
, aviation fuel
Aviation fuel
Aviation fuel is a specialized type of petroleum-based fuel used to power aircraft. It is generally of a higher quality than fuels used in less critical applications, such as heating or road transport, and often contains additives to reduce the risk of icing or explosion due to high temperatures,...
, asphalt
Asphalt
Asphalt or , also known as bitumen, is a sticky, black and highly viscous liquid or semi-solid that is present in most crude petroleums and in some natural deposits, it is a substance classed as a pitch...
and others. To some degree, the proportion of each product produced can be varied in order to suit the demands of the local market. Regional differences in the demand for each refined product depend upon the relative demand for fuel for heating, cooking or transportation purposes. Within a region, there can also be seasonal differences in demand for heating fuel versus transportation fuel.
The mix of refined products is also affected by the particular blend of crude oil feedstock processed by a refinery, and by the capabilities of the refinery. Heavier crude oils contain a higher proportion of heavy hydrocarbon
Hydrocarbon
In organic chemistry, a hydrocarbon is an organic compound consisting entirely of hydrogen and carbon. Hydrocarbons from which one hydrogen atom has been removed are functional groups, called hydrocarbyls....
s composed of longer carbon chains. As a result, heavy oil
Heavy oil
Heavy oil may refer to:*Fuel oil that contains residual oil left over from distillation.*Heavy crude oil, viscous crude oil.*Coal tar creosote, a wood preservative and waterproofing agent....
is more difficult to refine into lighter products such as gasoline. A refinery using less sophisticated processes will be constrained in its ability to optimize its mix of refined products when processing heavy oil.
Futures trading
For integrated oil companies that control their entire supply chainSupply chain
A supply chain is a system of organizations, people, technology, activities, information and resources involved in moving a product or service from supplier to customer. Supply chain activities transform natural resources, raw materials and components into a finished product that is delivered to...
from oil production to retail distribution of refined products, there is a natural economic hedge against adverse price movements. For independent oil refiners which purchase crude oil and sell refined products in the wholesale market, adverse price movements can present a significant economic risk. Given a target optimal product mix, an independent oil refiner can attempt to hedge itself against adverse price movements by buying oil futures
Futures contract
In finance, a futures contract is a standardized contract between two parties to exchange a specified asset of standardized quantity and quality for a price agreed today with delivery occurring at a specified future date, the delivery date. The contracts are traded on a futures exchange...
and selling futures for its primary refined products according to the proportions of its optimal mix.
For simplicity, most refiners wishing to hedge their price exposures have used a crack ratio usually expressed as X:Y:Z where X represents a number of barrels of crude oil, Y represents a number of barrels of gasoline and Z represents a number of barrels of distillate fuel oil
Fuel oil
Fuel oil is a fraction obtained from petroleum distillation, either as a distillate or a residue. Broadly speaking, fuel oil is any liquid petroleum product that is burned in a furnace or boiler for the generation of heat or used in an engine for the generation of power, except oils having a flash...
, subject to the constraint that X=Y+Z. This crack ratio is used for hedging purposes by buying X barrels of crude oil and selling Y barrels of gasoline and Z barrels of distillate in the futures market
Futures exchange
A futures exchange or futures market is a central financial exchange where people can trade standardized futures contracts; that is, a contract to buy specific quantities of a commodity or financial instrument at a specified price with delivery set at a specified time in the future. These types of...
. The crack spread X:Y:Z reflects the spread obtained by trading oil, gasoline and distillate according to this ratio. Widely used crack spreads have included 3:2:1, 5:3:2 and 2:1:1. As the 3:2:1 crack spread is the most popular of these, widely quoted crack spread benchmarks are the "Gulf Coast 3:2:1" and the "Chicago 3:2:1".
Various financial intermediaries
Financial intermediary
Financial intermediation consists of “channeling funds between surplus and deficit agents”. A financial intermediary is a financial institution that connects surplus and deficit agents...
in the commodity markets have tailored their products to facilitate trading crack spreads. For example, NYMEX
New York Mercantile Exchange
The New York Mercantile Exchange is the world's largest physical commodity futures exchange. It is located at One North End Avenue in the World Financial Center in the Battery Park City section of Manhattan, New York City...
offers virtual crack spread futures contracts by treating a basket of underlying NYMEX futures contracts corresponding to a crack spread as a single transaction. Treating crack spread futures baskets as a single transaction has the advantage of reducing the margin requirements for a crack spread futures position. Other market participants dealing over the counter
Over-the-counter (finance)
Within the derivatives markets, many products are traded through exchanges. An exchange has the benefit of facilitating liquidity and also mitigates all credit risk concerning the default of a member of the exchange. Products traded on the exchange must be well standardised to transparent trading....
provide even more customized products.
The following discussion of crack spread contracts comes from the Energy Information Administration
Energy Information Administration
The U.S. Energy Information Administration is the statistical and analytical agency within the U.S. Department of Energy. EIA collects, analyzes, and disseminates independent and impartial energy information to promote sound policymaking, efficient markets, and public understanding of energy and...
publication Derivatives and Risk Management in the Petroleum, Natural Gas, and Electricity Industries:
Refiners’ profits are tied directly to the spread, or difference, between the price of crude oil and the prices of refined products. Because refiners can reliably predict their costs other than crude oil, the spread is their major uncertainty. One way in which a refiner could ensure a given spread would be to buy crude oil futures and sell product futures. Another would be to buy crude oil call optionCall optionA call option, often simply labeled a "call", is a financial contract between two parties, the buyer and the seller of this type of option. The buyer of the call option has the right, but not the obligation to buy an agreed quantity of a particular commodity or financial instrument from the seller...
s and sell product put optionPut optionA put or put option is a contract between two parties to exchange an asset, the underlying, at a specified price, the strike, by a predetermined date, the expiry or maturity...
s. Both of those strategies are complex, however, and they require the hedger to tie up funds in margin accounts.
To ease this burden, NYMEX in 1994 launched the crack spread contract. NYMEX treats crack spread purchases or sales of multiple futures as a single trade for the purposes of establishing margin requirements. The crack spread contract helps refiners to lock-inVendor lock-inIn economics, vendor lock-in, also known as proprietary lock-in or customer lock-in, makes a customer dependent on a vendor for products and services, unable to use another vendor without substantial switching costs...
a crude oil price and heating oil and unleaded gasoline prices simultaneously in order to establish a fixed refining margin. One type of crack spread contract bundles the purchase of three crude oil futures (30,000 barrels) with the sale a month later of two unleaded gasoline futures (20,000 barrels) and one heating oil future (10,000 barrels). The 3-2-1 ratio approximates the real-world ratio of refinery output—2 barrels of unleaded gasoline and 1 barrel of heating oil from 3 barrels of crude oil. Buyers and sellers concern themselves only with the margin requirements for the crack spread contract. They do not deal with individual margins for the underlying trades.
An average 3-2-1 ratio based on sweet crude is not appropriate for all refiners, however, and the OTC market provides contracts that better reflect the situation of individual refineries. Some refineries specialize in heavy crude oils, while others specialize in gasoline. One thing OTC traders can attempt is to aggregate individual refineries so that the trader’s portfolio is close to the exchange ratios. Traders can also devise swaps that are based on the differences between their clients’ situations and the exchange standards.