Cracking

What Is Cracking?

Cracking is a technique used in oil refineries whereby large and complex hydrocarbon molecules are broken down into smaller and lighter components that are more useful for commercial or consumer use. Cracking is a critical stage in the process of refining crude oil.

Other petroleum products, such as heating oil, diesel fuel, and gasoline, rely on cracking.

How Cracking Works

Following its extraction from a well, crude oil in its raw form contains a blend of large and complex hydrocarbon molecules. Although the crude oil is valuable even in its raw form, its economic usefulness is relatively limited until it has been subject to additional refining processes.

In order to help render the crude oil into a form that can be more widely utilized, the first and foremost stage in the refining process is to break up, or "crack," the unprocessed hydrocarbon molecules into smaller components. This stage — commonly referred to as "cracking" — makes it possible to turn crude oil into a variety of marketable fuels, lubricants, and other products.

Although the basic concept is the same in all cases, the process of cracking can be implemented in a variety of ways. A common application is what is known as fluid catalytic cracking (FCC), which is used in the production of gasoline as well as various distillate fuels.

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, from crude oil into gasoline. Refiners and investors also implement crack strategies against multiple products. For example, a barrel of oil into gasoline, kerosene, jet fuel, and heating oil.

Real World Example of Cracking

Although cracking is a common stage in the oil refinery process, some types of oil — such as light sweet crude oil — requires relatively limited treatment in order to be sold. Because of the limited amount of investment they require before being sold, such types of oil are highly sought after and command high prices on international commodities markets.

Although dozens of products can be produced by refining crude oil, the ones most commonly traded on commodities markets are heating oil and gasoline. Although their relative prices vary over time based on supply and demand, a common heuristic used by traders is that the ratio between them should typically fluctuate around 3 to 2 to 1. In other words, this ratio assumes that three barrels of oil should typically yield two barrels of gasoline and one barrel of heating oil.

When prices diverge substantially from these ratios, traders might seek to speculate on a reversion to the mean by buying the commodity that seems undervalued relative to this ratio, or selling the one that seems overvalued. Traders may also use this ratio as a guideline when seeking to hedge against their exposure to these commodities.

The Crack Spread

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. This is known in the commodities market as the crack spread.

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.

Traders can either buy or sell the crack spread. If you are buying it, you expect the crack spread will strengthen, meaning the refining margins are growing because crude oil prices are falling and/or demand for refined products is growing. Selling the crack spread means you expect 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.