Crack

Crack

A crack, or crack spread, is a term used in the energy markets to represent the differences between crude oil and the prices of the wholesale petroleum products that derive from it, such as jet fuel, kerosene, home heating oil, and gasoline. 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 sell two RBOB gasoline futures contracts. 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. 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. A crack, or crack spread, is a term used in the energy markets to represent the differences between crude oil and the prices of the wholesale petroleum products that derive from it, such as jet fuel, kerosene, home heating oil, and gasoline.

The term crack is derived from the fluid catalytic cracking of crude oil, which is used to refine crude oil into petroleum products

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 the prices of the wholesale petroleum products that derive from it, such as jet fuel, kerosene, home heating oil, and gasoline.

Crack or crack spread 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.

The term crack is derived from the fluid catalytic cracking of crude oil, which is used to refine crude oil into petroleum products
Trading crack spreads allow refiners to hedge their price risk.
A single product crack reflects the difference between the prices of one barrel of crude oil and one barrel of a specified product. Refiners and investors also implement crack strategies on multiple products.
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.

Understanding a 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.

Factors That Affect Cracks

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.

Examples of a Crack

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 sell two RBOB gasoline futures contracts. Assuming 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.

Related terms:

Commodities Exchange

A commodities exchange is a legal entity that determines and enforces rules and procedures for the trading commodities and related investments. read more

Commodity-Product Spread

The commodity-product spread measures the difference between the price of a raw material and the price of a finished good using that raw material. read more

Cracking

Cracking is a technique used in oil refineries whereby large hydrocarbon molecules are broken down into smaller and lighter components. read more

Crack Spread

A crack spread is the spread created in commodity markets by purchasing oil futures and offsetting the position by selling gasoline and heating oil futures. read more

Crude Oil & Investing Examples

Crude oil is a naturally occurring, unrefined petroleum product composed of hydrocarbon deposits and other organic materials. read more

Demand

Demand is an economic principle that describes consumer willingness to pay a price for a good or service.  read more

Downstream

Downstream operations are oil and gas functions that occur after the production phase to the point of sale. Read how downstream companies make money.  read more

Energy Derivatives

Energy derivatives are financial instruments whose underlying asset is based on energy products, including oil, natural gas, and electricity. read more

Futures

Futures are financial contracts obligating the buyer to purchase an asset or the seller to sell an asset at a predetermined future date and price. read more

Hedge

A hedge is a type of investment that is intended to reduce the risk of adverse price movements in an asset. read more