Crack Spread

Crack Spread is the price difference between the raw material and the finished goods. It is commonly used in the Oil & Gas Industry, where the crack spread is defined as the cost difference between a 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.

The significance of the spread between the costs of raw materials and the finished product is huge as it can directly affect the profit margins of the producers. In the oil industry, refiners mitigate the crack spread price risks by using futures and options to hedge the deviations in prices.

• A crack spread represents the cost discrepancy between raw materials and the end products commonly used in the oil and gas industry. In this context, it measures the price difference between a barrel of crude oil (the raw material) and refined petroleum products (like gasoline and fuel oil) – the finished goods. 
• There are two main types of crack spreads: simple and diversified.
• Understanding crack spreads is crucial for investors assessing the profitability of oil and refinery companies, influencing investment decisions in bonds and debentures. Additionally, traders, arbitrageurs, and investors can utilize crack-spread information to inform their strategies and choices.

A crack spread is a difference in the price of raw materials in comparison to its finished products. It is majorly used in the oil industry where the process of converting one barrel of petroleum into finished products such as gasoline, oil, etc,.

A crack spread chart is an important tracker for those who deal with or are 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 of understanding the movement of crude oil prices. When crack spread widens, it indicates that crude oil prices will rise, and when it narrows, it indicates that crude oil prices will fall ceteris paribus.

Buying or selling crack spreads is based on the views and expectations of the market participants.

If market participants expect that the crude oil prices will fall and demand for 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 crude oil prices to rise and demand for refined products, such as gasoline, etc., will fall, they will generally sell the crack spread, i.e., buying crude futures and refining product futures.

Let us understand the different types of crack spread prices through the explanation below.

#1 - Simple

The single product (usually the output such as gasoline and fuel oil) is compared with the input crude oil to find the difference, effectively spreading the spread between the two products. This can be either positive or negative. A positive spread happens when refined output prices are 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). Still, it can vary depending upon the product mix and margin mix.

Let’s understand the concept of crack spread chart with the help of a couple of examples and how a change in the price of any input affects the entire spread.

Example #1

Aries International is an oil refinery company based out of Atlanta. The company procures raw crude oil from one of the major crude oil suppliers Aramco inc. Aries refined the crude oil purchased from Aramco Inc. into main refined products such as gasoline and fuel oil, which is the business's major revenue source. 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:

• Crude Oil: $59 per Barrel
• Gasoline: $1.8 per Gallon
• Fuel Oil: $1.3 per Gallon

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 because of political upheaval in the middle east, which led to Aramco charging higher prices from Aries international. On the contrary, due to the summer in Atlanta, Aries had to sell its gasoline and fuel oil output at a lesser price due to decreased 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 the price of output gasoline and fuel oil impacted the crack spread margin substantially from a positive $28.80 to a negative $3.90.

Example #2

The prices of oil for producers such as Saudi Arabia or Russia of course matter. However, the refining cost would mean that the gasoline, oils, and jet fuel become extremely heavy on the pockets of common citizens.

In the refinery industry, they follow a 3-2-1 spread; which means that for every three barrels of crude oil, two barrels of gasoline and one barrel of distillates such as jet fuel.

In January 2023, the 321 crack spread breached the three-month high of $42 a barrel. The spread in margins during the refining process had breached $60 in 2022 during the peak of the Russia-Ukraine war. Central banks keep a close eye on this margin as these could be indicators of higher diesel and fuel costs and hence, inflation rates.

Let us understand the advantages of incorporating the 321 crack spread in the refining process and how it benefits large refineries, governments, and citizens as well through the points below.

• It helps investors interested in investing in bonds and debentures of oil and refinery companies by providing insights into the company's margin.
• It helps understand the major components affecting companies' refinery business margins.
• It is frequently used by arbitrageurs, traders, and equally by investors.

Despite the various advantages mentioned above, there are a few factors from the other end of the spectrum that prove to be a hassle for citizens and governments alike. Let us understand the disadvantages of crack spread process through the discussion below.

• It is highly volatile and results in excessive speculation by traders.
• The political conditions of the country heavily impact it. The impact of the spread is more visible in countries that mostly import crude oil, and the majority of oil refineries are government-owned.
• This is impacted by seasonal weather conditions as well as the demand for output gasoline and other fuel oil output from crude oil varies based on seasonal weather conditions.

This has been a guide to What is Crack Spread & its definition. Here we explain Crack Spread types along with examples (3-2-1), advantages, & disadvantages. You can learn more about it from the following articles –

• Option Adjusted Spreads
• Credit Spread Option
• Formula of Bid Ask Spread
• How to Trade Options?