Cracking Spread and Investing Strategy

The term "cracking spread" is used in the oil industry and the futures markets. The "spread" is the difference in the price of a barrel of oil and the price of the products made from the oil during the refining process. The spread must remain positive for refineries to be profitable.

"Cracking" is a term used in the oil refining industry, meaning to "crack" crude oil, which is to break down the long-chain hydrocarbons in the crude oil into shorter chains, thus creating usable products that can be sold by the refinery. Therefore, the refinery's profit margins are directly determined by the spread, or the difference in the price of a barrel of crude oil and the wholesale price of the products created from it.

Although there are several ways to define the ratio between one barrel of crude and the products that can be extracted from it, the most popular ratio is the 3:2:1 ratio. That is, three barrels of crude oil (CL) will produce 2 barrels of unleaded gasoline (HU) and one barrel of heating oil (HO) (or fuel oil). So simply put, is the cost of three barrels of crude oil less than the wholesale price of two barrels of gasoline and one barrel of fuel oil?

An independent refinery that does not control its own distribution and end-item selling, but rather sells its petroleum products wholesale, takes on considerable risk when purchasing crude oil. Because the refineries can accurately predict the refining cost, their primary concern and risk comes from the cracking spread.

Refineries mitigate this risk by purchasing crude oil futures and selling product futures or by buying crude oil call options and selling product put options. However, this method becomes undesirable because it forces the hedging company to hold large amounts of funds in their margin accounts. To meet the risk mitigation need, energy exchanges such as the New York Mercantile Exchange (NYMEX) has developed crack spread contracts. With these contracts, refiners can "lock-in" a crude oil price, gasoline and heating oil prices at the same time, giving them a fixed refining/profit margin.

The NYMEX cracking spread contracts are the best way for most independent refineries to mitigate the spread risk. They can lock-in "bundled" prices, for instance 60,000 barrels of crude with a sale contract set in the future for 40,000 barrels of gasoline and 20,000 barrels of heating oil, thus maintaining the typical 3:2:1 ratio.

For the individual investor or trader, you can trade the cracking spread as futures. Cracking spread futures include both sides of the transaction, both the crude oil price and the product price in one transaction. Just like buying and selling stocks, your goal is to buy the undervalued product and sell it.

Understand that you are trading the cracking spread. The formula below is necessary to convert the different products because crude oil is traded in dollars per barrel, the unleaded gasoline and heating oil is traded in dollars per gallon (42 gallons per barrel). The formula generally used to determine the cracking spread is as follows:

=((gasoline + heating oil) X 42 - 2 x crude)/2

Using an example of crude at $47.2, gasoline at $1.43 and heating oil at $1.39. This gives you a cracking spread of 12.02. If the price of crude goes higher and the price of gasoline and heating oil stay the same (flat), the cracking spread will decrease. If the price of gasoline and/or heating oil goes up and the crude price stays the same, the spread will increase.

Crack spread results can be affected by several factors, one being the season of the year. In the winter, heating oil is in more demand than in the summer months. In the summer, the demand is swapped and unleaded gasoline is in higher demand.

When the spread narrows, refineries will slow down production due to lower profits until product demand increases, increasing prices again. When the refineries are slowing production traders will support heating oil and/or unleaded gasoline. When there is a wide cracking spread, refineries will operate wide open, increasing production to sell their products at the highest prices. In this case, traders will support crude oil contracts.

If you are new to futures trading, many of the online brokers have simulated futures trading platforms that allow you to learn to trade before you risk any of your own money. The numbers and formulas may seem difficult to comprehend at first, but with practice you can become proficient at trading the cracking spread.

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