What is a Crack Spread?
Crack spread is a term used in the energy market. It’s a kind of spread that shows the difference in price between crude oil and something made from oil, usually gasoline or heating oil. You can trade crack spreads on some exchanges using a single future or option.
What Are Crack Spreads Used For?
Hedgers and speculators use crack spreads in a couple main ways:
Taking Advantage of Positive Refining Margins
One way is to “buy the crack spread”. This means you buy crude oil futures and at the same time sell futures for heating oil or gasoline. You’d do this when you think refining margins will be good.
See, “refining margin” means the difference between how much a refinery pays for crude oil vs how much they can sell the products they make from that oil for. If the products are selling for a lot more than what the crude cost, refining margins are positive. Buying crude and selling product futures is a way to try to make money from that.
Profiting From Negative Refining Margins
The other main way to use crack spreads is to “sell the crack spread”. This is the opposite of buying it. You sell crude futures and buy product futures. This play makes sense when refining margins are bad – when crude prices are high compared to gasoline and heating oil prices.
If products are selling for less than what refineries paid for crude, they’re losing money on each barrel. Selling crude and buying products is a way to profit off this by being on the other side of the refineries’ trades.
How Crack Spreads Are Quoted
There’s a few different ways exchanges might list crack spreads, but a common one shows the number of barrels of product you’d buy or sell for each barrel of crude.
For example, a “3-2-1” crack spread means:
- Buying 3 crude oil futures
- Selling 2 gasoline futures
- Selling 1 heating oil future
All 3 of those contracts together are 1 unit of the 3-2-1 crack spread. The prices reflect a typical refinery yield – generally you get about 2 barrels of gasoline and 1 barrel of distillate fuel like diesel or heating oil from refining 3 barrels of crude.
Managing Exposure With Crack Spreads
Refineries can use crack spreads to hedge and lock in their refining margins. For example, if a refinery thinks margins might fall in the future, they could sell the crack spread. Then if margins do get worse, the gains on their spread position help offset their refining losses.
Airlines are another big user of crack spreads. Airlines are basically always “long” jet fuel – they need to buy a lot of it to operate. They can hedge that exposure by buying crude oil futures and selling heating oil futures. Heating oil is chemically very similar to jet fuel. So this creates a synthetic hedge for them.
Risks of Trading Crack Spreads
Of course, trading crack spreads is risky, like all futures trading. Margin requirements mean you only have to put up a small percent of the contract value to control a large position. That leverage means even small price moves can cause big gains or losses.
Prices can also move in unexpected ways. Buying a crack spread makes money if the price of crude falls or product prices rise – but sometimes they all move together. Geopolitical events, economic shifts, natural disasters, and all kinds of other factors can make energy prices and crack spreads volatile.
Physical traders have to worry about operational risks too. Refineries break down sometimes. If you’re running a refinery and you hedged by selling a crack spread, that’s great – as long as your refinery is running. If it has to shut down unexpectedly, you’re suddenly just short a bunch of futures with no physical barrels to offset them if prices move against you.
Frequently Asked Questions
How do you trade a crack spread?
To trade a crack spread, you have to simultaneously buy or sell crude oil futures and futures for products like gasoline and heating oil. Exchanges offer crack spread contracts that let you do this in a single trade.
What exchanges offer crack spread trading?
CME Group (NYMEX and CBOT), the Intercontinental Exchange (ICE), Multi Commodity Exchange (MCX) and several other commodity exchanges around the world list crack spread futures and options.
What is a crack spread option?
A crack spread option give the buyer the right to buy or sell a crack spread at a certain price on or before some expiration date. Call options give you the right to buy the spread, while puts give you the right to sell it.
Why do traders trade crack spreads?
Traders trade crack spreads to speculate on or hedge refining margins. Refineries can lock in margins by selling crack spreads, while other traders buy or sell the spreads if they think refining economics will improve or worsen.
