Crack spread: To hedge or to speculate?

In contrast, independent oil refiners that buy crude oil on the market and sell refined products may face adverse price movements. These companies face a significant economic risk if oil prices suddenly spike while the prices of the products to be sold do not rise in tandem. The good news is that an independent oil refiner is able to hedge itself depending of the optimal product mix. The refiner can buy oil futures and sell futures of its refined products.

At the commodity (futures) market, a crack spread can be created by trading oil futures and offsetting this position by trading gasoline and heating oil futures. The crack spread is usually expressed as X:Y:Z. X represents a number of barrels of crude oil (for instance light sweet crude WTI), Y is a number of barrels of gasoline and Z represents a number of barrels of distillate heating oil; subject to the constraint that X=Y+Z. A 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. Crack spreads may have the ratio 3:2:1, 5:3:2 or even 2:1:1.

The ratio 3:2:1 crack spread is the most popular traded by refiners and speculators. Widely quoted crack spread benchmarks are the Gulf Coast 3:2:1's and the Chicago 3:2:1's. These ratios are based upon a classic WTI crude refining model which yields two barrels of gasoline and one barrel of heating oil for every three barrels of oil input.

Trading unit differentiation

It is important to consider that the contracts of WTI (CL), gasoline (HU) and heating oil (HO) have different trading units. For instance, while CL is quoted in dollars per barrel, but HO and HU are both quoted in dollars per gallon, so HO and HU must be converted into gallons. This is done by multiplying their prices by 42, because 1 barrel contains 42 gallons. Beware that (WTI) crude oil futures contracts call for delivery of 1,000 barrels, so do distillate contracts (albeit indirectly).

Subsequently, each leg of the spread has to be multiplied by the number of contracts per leg, depending of the ratio of the crack spread.

Given the following prices at March 3 2010: CL $80.73; HU $2.2335 (*42); HO $2.085(*42). The different crack spread prices can be calculated

3:2:1: - $80.73 *3 + $2.2335 *42 *2 + $2.085 *42 * 1 = $32.994 per 3 barrels CL. Thus this spread per 1 barrel CL = $10.9980.
5:3:2: $52.991 per 5 barrels CL. Thus this spread per 1 barrel = $10.5822.
2:1:1: $19.917 per 2 barrels CL. Thus this spread per 1 barrel = $9.9558.

Market participants anticipating an expansion in refiner profits (increasing crack spreads) typically sell crude oil futures and simultaneously purchase heating oil and gasoline contracts. Thus "buying the crack" produces money, as crude oil costs lag increases in the prices of refined products. On the contrary, shrinking refiner margins (in the case of an expected rise of crude oil prices] can be traded profitably by "selling the crack", buying crude oil while shorting gasoline and heating oil.

The crack spreads may be affected by seasonal factors. For instance, during the summer months, unleaded gasoline (HU) is in greater demand than heating oil (HO) because of the driver's season. During the winter period in the northern hemisphere, demand will likely shift to heating oil.

The 3:2:1 crack spread is double weighted in gasoline, thus it tends to outperform the 2:1:1 spread when gasoline prices rise more than heating oil. The other way around is also possible: diminishing demand for petrol, can push the 3:2:1 spread into a discount.

Finally, to put everything in perspective, two charts give an indication of how crack spreads behave. The following charts show a lot of volatility, which can be traded in a profitable way. The only thing market participants have to do, is to take a good position, whether it will be a hedge or a speculative trade.

If you are interested in oil trading and crack spreads, please contact Mercurious. The oil trading course covers also the crack spread.