Crack Spread: What it is, How to Trade It

What Is a Crack Spread?

A crack spread refers to the overall pricing difference between a barrel of crude oil and the petroleum products refined from it. It is an industry-specific type of gross processing margin. The “crack” being referred to is an industry term for breaking apart crude oil into the component products, including gases like propane, heating fuel, gasoline, light distillates, like jet fuel, intermediate distillates, like diesel fuel, and heavy distillates, like grease.

Understanding a Crack Spread

The price of a barrel of crude oil and the various prices of the products refined from it are not always in perfect synchronization. Depending on the time of year, the weather, global supplies, and many other factors, the supply and demand for particular distillates results in pricing changes that can impact the profit margins on a barrel of crude oil for the refiner.

To mitigate pricing risks, refiners use futures to hedge the crack spread. Futures and options traders can also use the crack spread to hedge other investments or speculate on potential price changes in oil and refined petroleum products.

Using a Crack Spread to Hedge Price Risk

The traditional crack spread strategies used to hedge against these risks involve the refiner purchasing oil futures and offsetting the position by selling gasoline, heating oil, or other distillate futures that they will be producing from those barrels.

Refiners can use this hedge to lock in a profit. Essentially, refiners want a strong positive spread between the price of a barrel of oil and the price of its refined products; meaning a barrel of oil is significantly cheaper than the refined products.

To find out if there is a positive crack spread, you take the price of a barrel of crude oil—in this case, WTI at $51.02/barrel, for example—and compare it to your chosen refined product. Let's say RBOB gasoline futures at $1.5860 per gallon. There are 42 gallons per barrel, so a refiner gets $66.61 for every barrel of gasoline for a crack spread of $15.59 that can be locked in with futures contracts. This is the most common crack spread play, and it is called the 1:1 crack spread.

Of course, it is a bit of an oversimplification of the refining process as one barrel of oil doesn't make exactly one barrel of gasoline and, again, different product mixes are dependent on the refinery. So there are other crack spread plays where you buy three oil futures and then match the distillates mix more closely, as two barrels worth of gasoline contracts and one worth of heating oil, for example.

This is known as a 3:2:1 crack spread and there are even 5:3:2 crack spreads, and they can also be used as a form of hedging. For most traders, however, the 1:1 crack spread captures the basic market dynamic they are attempting to trade on.

Trading a Crack Spread

Generally, you are either buying or selling the crack spread. If you are buying it, you expect that the crack spread will strengthen, meaning the refining margins are growing because crude oil prices are falling or demand for the refined products is growing. Selling the crack spread means you expect that the demand for refined products is weakening or the spread itself is tightening due to changes in oil pricing, so you sell the refined product futures and buy crude futures.

Reading a Crack Spread as a Market Signal

Even if you aren't looking to trade the crack spread itself, it can act as a useful market signal on potential price moves in both the oil and refined product market. If the crack spread widens significantly, meaning the price of refined products is outpacing the price of oil, many investors see that as a sign that crude oil will eventually rise in price to tighten the spread back up to historical norms.

Similarly, if the spread is too tight, investors see that as a sign that refiners will slow production to tighten supply to a level where the demand will restore their margins. This, of course, has a dampening effect on the price of crude oil. So, whether you intend to trade it or not, the crack spread is worth keeping an eye on as a market signal.