Oil refineries refine crude oil to produce oil products like heating oil and gasoline. Further processing by distillation or other techniques produces kerosene, diesel or plastics and asphalt.
'Cracking' crude oil refers to the process of separating and transforming the various chemical components of crude oil into saleable refined products.
Complex organic molecules (especially heavy crude) are broken down into simpler molecules. Temperature and the presence of catalysts heavily influence this process.
Each product has its own demand and supply, therefore each product has its own pricing, and thus its own price. However, a refinery's core business is to produce products, not to cope with risks, which in fact they want to avoid. They need to focus on their strengths and not on forecasting price developments.
Now, when the price of crude oil rises while the prices of the oil products appear to be flat liners, the refinery loses money (or at least makes less profit). The solution to this risk is to set up a crack spread. The difference between crude oil and oil products is called a crack spread.
Energy exchanges offer crack spreads as futures. Both legs of the combination (crude oil and an oil product) can be traded in one single transaction.
These derivatives help refineries to offset or manage their risks. But investors can also use these instruments. Form an opinion about the overpricing or undervaluation of one specific product compared to another.
Buying and selling
Buy the underpriced product and sell the overpriced product. If your analysis is correct, the spread will tend toward your calculated mean and you can close your position in profit.
Calculations based on correlation coefficients can support your research. Even technical analysis can help you analyze the differences and the development of the differences between prices over time.
Besides futures, options are also listed on these so-called crack spreads. Remember, however, that a single options position will result in two offsetting futures positions when the option expires.