Crack Spread

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Definition: Crack Spread

What is the dictionary definition of Crack Spread?

Dictionary Definition

Crack Spread defines the difference between crude oil prices and refined product prices in the oil refining business.

Oil refinery profit margins are driven by the difference between refined product market prices and crude oil costs. This difference is defined as the crack spread. The term is derived from the cracking of crude oil molecules into smaller finished product molecules–like gasoline and diesel.

However, there is not one single crack spread that applies to all refineries. Each refinery produces a different portfolio of finished products refined from different sources of crude oil. Therefore, each refinery or refining company will track the crack spread for their own production.

Because the spread between crude prices and refined products is the main driver of refinery profit margins, futures contracts have been established to allow refining companies to hedge their results. The most common of these is the NYMEX 3:2:1. Trading this contract allows the refining company to account for price swings in the 3 products–crude, unleaded gasoline, and heating oil–in a 3:2:1 ratio.

“3-2-1 crack is an approximation of the profit margin that a refiner earns by turning crude oil into end-use products. Take the price of two barrels of gasoline and one barrel of heating oil, divide by three, subtract this average from the price of a barrel of crude, and there’s your crack spread.”

Full Definition of Crack Spread

The word “spread” is generally used in the financial industry to refer to the difference between two related entities that can be expressed quantitatively while the word “crack” is used in the oil refining industry as a verb describing the process of separating and transforming the various chemical components of crude oil into saleable refined products. Thus the term “crack spread” refers to the spread, or margin, that a refinery can earn by cracking a barrel of oil into refined products.

One of the most important factors affecting this spread is the relative proportions of the products produced by a refinery. There is a wide range of such products which can include gasoline, kerosene, diesel, heating oil, aviation fuel, asphalt and various others. To some degree, the mix of these products can be varied in order to suit the demands of the local market. Regional differences in the demand for each refined product depend upon the relative demand for fuel for heating, cooking or transportation purposes. Within a region, there can also be seasonal differences in demand for heating fuel versus transportation fuel.

The mix of refined products is also affected by the blend of crude oil feedstock processed by a refinery and by the capabilities of the refinery. Heavier crude oils contain a higher proportion of heavy hydrocarbons composed of longer carbon chains. As a result, heavy oil is more difficult to refine into lighter products such as gasoline. A refinery using less sophisticated processes will be constrained in its ability to optimize its mix of refined products when processing heavy oil.

One of the primary goals in managing a refinery is optimizing the mix of refined products given the supply and demand constraints of the local market. These constraints are expressed by relative differences in the local prices of both refined products and available feedstocks. By adjusting its product mix to take advantage of local price differentials, a refinery can optimize its crack spread.

For integrated oil companies that control their entire supply chain from oil production to retail distribution of refined products, there is a natural economic hedge against adverse price movements. For independent oil refiners which purchase crude oil and sell refined products in the wholesale market, adverse price movements can present a significant economic risk. Given a target optimal product mix, an independent oil refiner can attempt to hedge itself against adverse price movements by buying oil futures and selling futures for its primary refined products according to the proportions of its optimal mix.

For simplicity, most refiners wishing to hedge their price exposures have used a crack ratio usually expressed as X:Y:Z where X represents a number of barrels of crude oil, Y represents a number of barrels of gasoline and Z represents a number of barrels of distillate fuel oil, subject to the constraint that X=Y+Z. This crack ratio is used for hedging purposes by buying X barrels of crude oil and selling Y barrels of gasoline and Z barrels of distillate in the futures market. The crack spread X:Y:Z reflects the spread obtaining by trading oil, gasoline and distillate according to this ratio. Widely used crack spreads have included 3:2:1, 5:3:2 and 2:1:1. As the 3:2:1 crack spread is the most popular of these, widely quoted crack spread benchmarks are the “Gulf Coast 3:2:1” and the “Chicago 3:2:1”.

Various financial intermediaries in the commodities markets have tailored their products to facilitate trading crack spreads. For example, NYMEX offers virtual crack spread futures contracts by treating a basket of underlying NYMEX futures contracts corresponding to a crack spread as a single transaction. Treating crack spread futures baskets as a single transaction has the advantage of reducing the margin requirements for a crack spread futures position. Other market participants dealingthe counter provide even more customized products.

The following discussion of crack spread contracts comes from the Energy Information Administration publication Derivatives and Risk Management in the Petroleum, Natural Gas, and Electricity Industries:

Refiners’ profits are tied directly to the spread, or difference, between the price of crude oil and the prices of refined products. Because refiners can reliably predict their costs other than crude oil, the spread is their major uncertainty. One way in which a refiner could ensure a given spread would be to buy crude oil futures and sell product futures. Another would be to buy crude oil call options and sell product put options. Both of those strategies are complex, however, and they require the hedger to tie up funds in margin accounts.
To ease this burden, NYMEX in 1994 launched the crack spread contract. NYMEX treats crack spread purchases or sales of multiple futures as a single trade for the purposes of establishing margin requirements. The crack spread contract helps refiners to lock-in a crude oil price and heating oil and unleaded gasoline prices simultaneously in order to establish a fixed refining margin. One type of crack spread contract bundles the purchase of three crude oil futures (30,000 barrels) with the sale a month later of two unleaded gasoline futures (20,000 barrels) and one heating oil future (10,000 barrels). The 3-2-1 ratio approximates the real-world ratio of refinery output—2 barrels of unleaded gasoline and 1 barrel of heating oil from 3 barrels of crude oil. Buyers and sellers concern themselves only with the margin requirements for the crack spread contract. They do not deal with individual margins for the underlying trades.

An average 3-2-1 ratio based on sweet crude is not appropriate for all refiners, however, and the OTC market provides contracts that better reflect the situation of individual refineries. Some refineries specialize in heavy crude oils, while others specialize in gasoline. One thing OTC traders can attempt is to aggregate individual refineries so that the trader’s portfolio is close to the exchange ratios. Traders can also devise swaps that are based on the differences between their clients’ situations and the exchange standards.

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Crack Spread. Payroll & Accounting Heaven Ltd. September 25, 2021
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Definition Sources

Definitions for Crack Spread are sourced/syndicated and enhanced from:

  • A Dictionary of Economics (Oxford Quick Reference)
  • Oxford Dictionary Of Accounting
  • Oxford Dictionary Of Business & Management

This glossary post was last updated: 4th August, 2021 | 1 Views.