Energy Trading 101: The Crack Spread

Good afternoon, monkeys.

Listen: A crude and natural gas midstream firm like MarkWest Energy Partners and an oil refinery in the middle of Alabama will have different price exposures, and thus require different hedges to protect themselves in the event of future uncertainty. While not everyone is interested in the energy markets, I figured I’d do a few pieces of some of the rudimentary energy lingo so you can impress your friends down in Houston.

What is the crack spread?

Nope, sorry PSU alums: that’s not the crack spread I’m talking about. Listen: in the petroleum industry, refinery execs are worried about hedging the difference between their input and output prices. A refinery’s profit is derived from the spread between the price of crude oil and the prices of the refined products it produces. Said products are gasoline and distillates, or, specifically, diesel fuel, jet fuel, and heating oil. This is referred to as the crack spread, as the refiner “cracks” crude oil into its major refined products.

A petroleum refiner, like many industrial sector firms, is caught between two markets: the raw materials (input) and the finished product to sell on the open market (output). As has been more than apparent the past few years, crude prices and its constituent refined product prices are extremely volatile, subject to variables of supply, demand, production economics, operational efficiencies, and even environmental regulations. Thus, refiners and non-integrated marketers can be exposed to significant risk if oil rises while the refined products remain stable, or even worse, decline. Think of it as your COGS rising, while your sales are level or declining. The crack spread represents a profit margin.

Listen: if you’re like me and not an oil refinery, then this spread can still be useful to you. For one, monitoring asset correlations in any market will give you a better, more complete understanding of it. The crack spread is a key indicator of a refiner’s financial exposure, as its fixed costs are assumed to be known by the firm. You may also want to use it as a hedge against a refining company’s equity value, or even take a directional position with it for your energy portfolio. As of the mid 90’s (I believe), it receives a pretty generous spread credit for margining purposes so you don’t get bludgeoned by margin requirements. Together with inventories, utilization rates, and demand metrics, the crack spread can be a key short term indicator of where the markets are headed.

Trading the Crack Spread

There are multiple ways to manage an operating refinery’s associated price risk. Since a refinery’s output varies according to plant configuration, and has to adapt to seasonal supply/demand variables, there are different crack spreads to hedge different ratios of crude : refined product. Entire departments (risk management, at my particular firm) are dedicated to assessing the firm’s position in the markets so that it may implement an effective crack or frac spread (I will write another piece on frac spreads later).

Simple 1:1 Crack Spread

One of the more common crack spreads is the 1:1 crack spread, which is essentially the refinery profit margin between and crude and refined product. This is executed by selling refined product futures (gasoline, heating oil) and buying crude futures, thereby locking in the differential. Thus, if the sum of the refined value exceeds the crude value, your crack spread is positive (quoted in dollars per barrel). Keep in mind that heating oil and gasoline prices are quoted as ‘cents per gallon,’ so they must be converted to barrels before they are equable.

Refiners are naturally long the crack spread, since they’re continually buying crude and selling refined product to sustain their operations. If they expect crude prices to hold steady or increase somewhat and refined products to decrease (crude up, heating oil/gasoline down), they would “sell” the crack; that is, they would sell gasoline and heating oil futures and buy crude futures. Buying the crack spread is typically less common, and as far as I’m aware, is only done in extenuating circumstances (company is unable to produce enough product to meet term supply obligations, thus has to enter the spot markets. I’ve never seen it personally, and am therefore not a reliable source here [unless you’re an investor looking to take a speculative position; then it makes sense]).

3:2:1 and 5:3:2 Crack Spreads

Listen: there are more complex hedging strategies that can be tailored to match a specific refinery’s exposure, which is, in my opinion, the coolest part of the spread. According to the CME’s website, in a typical refinery, gasoline output is double that of distillate fuel oil (the cut of the barrel that contains diesel, heating oil, and jet fuel). Thus, in order to hedge your exposure properly, you’d need a way to capture the ratio in your crack spread.
Like the balance sheet, your crack spread needs to “balance.” So if you’re refinery produces twice the quantity of gasoline as distillate, you might use a 3:2:1 spread, buying three crude futures, selling 2 gasoline futures, and selling one heating oil future (3 = 2 + 1). Or, perhaps your refinery runs crude oil at a lower gas to heating oil yield. Then, a 5:3:2 ratio might suit your exposure better. If you’re at a hedge fund, you’ll use a crack spread to hedge against a firm’s share value; if you’re an energy trader, it will simply be another aspect of your portfolio. If you have the capital and willingness to meet margin, then you can tailor it to fit your every desire.

Trading the Crack with Options

Crack spread options circulating through the exchange are typically a 1:1 ratio, so they might not be perfectly suitable to your exposure, but have many benefits nonetheless.

•A call lets marketers protect themselves during price and spread instability. Think of it as an insurance policy.
•A put gives refiners a method of locking in their costs and margins without preventing them from realizing further market gains.
•Writing options allows refiners and traders to generate further income.
•By nature, options give the “right,” not the obligation, to obtain a margin. A hedge with futures locks you into that margin, curtailing any further gains that the market might offer in an upswing.
•Less margin. Entering 10 futures contracts is a mess.

Crack Dynamics

So what factors have the biggest impact on the crack spread? In actuality, there are nearly infinite things affecting crude and refined product prices: it’s simply up to you to do your homework and determine which ones will be the most impactful.

•Winter. The one thing refineries and Game of Thrones have in common is that they both anxiously await the coming of winter, and the cold, specifically. Distillate demand up, crack spread strengthens.
•Environmental regulation. Be careful here: restrictions will often tighten the product supply due to increased specifications. Tightened supply means a strengthened crack spread.
•Tax increases. This one is increasingly important given the pending fiscal cliff. Increased sales will hypothetically weaken the spread ahead of the deadline, allowing it to normalize or strengthen after the deadline.
•Summer. We Americans love driving during the summer. Gasoline demand increases, spread strengthens.
•Currency weakness. One of the main determinants of crude prices is an inverse relationship between crude and currency strength. Weak currency means crude rises (your input), so naturally, your spread weakens.

That’s all for now, ladies and gentlemen. Hopefully by now you’ve at least gained an elementary understanding of this metric, as well as how it pertains to certain companies and investors. There are a plethora of resources out there that will help you understand the intricacies of the spread and how it’s applied on a firm/investor specific basis; as a newly minted energy finance professional, I figured I would do a few of these articles on occasion to help impart what wisdom I have on the subject, possibly in hopes that you college kids can do that much better on your Trafi or Shell Trading interviews. Feel free to ask questions, and thanks for reading.