What is Crack Spread?
Crack Spread is the price difference between the raw material and the finished goods and is commonly used in Oil & Gas Industry, where, the crack spread is defined as the cost difference between barrel of crude oil (raw material) and the final petroleum products (finished goods like gasoline, fuel oil, etc). It finds its relevance across investors, traders, and arbitrageurs.
Types of Crack Spread
#1 – Simple
The single product (usually the output such as gasoline, fuel oil) is compared with the input crude oil to find out the difference which is effectively the spread between the two products. This can be either positive or negative. A positive spread happens when the price of refined output is more than crude oil (input) and vice versa.
#2 – Diversified
Under this type, spread involves multiple products (usually the byproducts such as gasoline, fuel oil, etc) in a predefined ratio (mostly 3-2-1), but can vary depending upon the product mix and margin mix.
Examples of Crack Spread (3-2-1)
Let’s understand the concept of crack spread with the help of a practical example and understand how a change in the price of any input affects the entire spread.
Aries International is an oil refinery company based out of Atlanta. The company procures raw material crude oil from one of the major crude oil suppliers Aramco inc. Aries refine the crude oil purchased from Aramco inc into main refined products such as gasoline and fuel oil which is the major source of revenue for the business. The major cost for Aries international contributes to the cost of crude oil. The company operates and hedges its risk using a 3-2-1 crack spread.
3-2-1 crack spread implies Buying 3 barrels of crude oil and selling 2 barrels of gasoline and 1 barrel of fuel oil
Let’s assume the following:
Based on the above information and a 3-2-1 crack spread; at prevailing rates, this is coming out to:
During the next three months, the price of crude oil spiraled to $65 on account of political upheaval in the middle east which led to Aramco charging higher prices from Aries international. On the contrary, due to summer in Atlanta, Aries had to sell its output of gasoline and fuel oil at a lesser price due to decrease demand for these products during this season. Details of the revised price are shown below:
With the new information lets compute this:
Thus we see how a change in the price of crude oil (raw material) and price of output gasoline and fuel oil impacted the crack spread margin substantially from a positive $28.80 to a negative $3.90.
Advantages
- It helps investors interested in investing in bonds and debentures of companies in the oil and refinery industry by providing them insights into the margin of the company.
- It helps in understanding the major components that affect the margins of companies in the refinery business.
- It is frequently used by arbitrageurs, traders and equally by investors.
Disadvantages
- It is highly volatile and results in excessive speculation by traders.
- It is heavily impacted by the political conditions of the country. For countries that mostly import crude oil and the majority of oil refineries are government-owned, the impact on the spread is more visible.
- This is impacted by seasonal weather conditions as well as the demand for output gasoline and other fuel oil output from crude oil varies from based on seasonal weather conditions.
Important Points
- Buying or selling of crack spread is based on the views and expectations of the market participants.
- If market participants expect that the crude oil prices will fall and demand refined products will rise then they will generally buy the crack spread i.e selling crude futures and buying refined product futures.
- Similarly, if market participants expect that crude oil prices will rise and demand refined products such as gasoline etc will fall, they will generally sell the crack spread i.e. buying crude futures and selling refined product futures.
Conclusion
This is an important tracker for those who deal or related to the commodities market especially crude and its constituent products. It is one of the important yardsticks through which refinery companies are evaluated. This also holds important relevance for traders in the commodities market and the widening or narrowing of crack spread is a classic sign to understand the movement of crude oil prices. When crack spread widens it is an indication that crude oil prices will rise and when it narrows, it is an indication that crude oil prices will fall ceteris paribus.
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