What is Crack Spread?

Types of Crack Spread

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#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.

Examples of Crack Spread (3-2-1)

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

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 BarrelGasoline: $1.8 per GallonFuel 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.

Advantages

  • It helps investors interested in investing in bondsBondsBonds refer to the debt instruments issued by governments or corporations to acquire investors’ funds for a certain period.read more and debenturesDebenturesDebentures refer to long-term debt instruments issued by a government or corporation to meet its financial requirements. In return, investors are compensated with an interest income for being a creditor to the issuer.read more 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.

Disadvantages

  • 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.

Important Points

  • 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.

Conclusion

This 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 marketCommodities MarketThe commodity market is a place where people buy and sell positions in commodities such as oil, gold, copper, silver, barley, wheat, and so on. Started with agricultural commodities, there are now fifty main commodity markets throughout the world, dealing with over a hundred commodities.read more, 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.

This has been a guide to What crack spread is & its Definition. Here we discuss the crack spread types, examples (3-2-1), advantages, and disadvantages. You can learn more about it from the following articles –

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