Trading Energy Refining Spreads - "Crack Spreads"
By: Kyle McEwan
Date: August 31, 2011
Traders are able to capitalize on movements in the energy markets by trading refining margins commonly known as "Crack Spreads", a term derived in recognition of the process by which raw crude oil is "cracked" (breaking down large molecules into smaller molecules) to produce lighter useable fuels such as gasoline and heating oil. The difference between the price of the raw material (crude oil) and the price of the products (gasoline, heating oil, etc.) is the profit margin that a refiner receives for converting a barrel of oil into various petroleum products. The volatility in the energy markets can cause very unpredictable and unstable profit margins for refiners. Energy companies use these futures spreads to hedge their margins and the investment community is able to use these spreads to speculate on the direction of the relationship. Trading refining spreads or the crack spread isolates the pricing relationship between the raw crude oil and the markets for the refined products. When these spreads reach historically extreme levels traders can often find opportunities as normal market forces bring the pricing relationship back into line. Refineries are currently making large profits due to the record high margin spreads. Marathon Oil Corporation recently said in its quarterly report, "refining & marketing segment income from operations was $1,260 million in the second quarter of 2011, compared with $590 million in the second quarter of 2010. The increase was primarily the result of a higher refining and marketing gross margin, which increased to 25.66 cents per gallon in the second quarter of 2011 from 13.06 cents per gallon in the second quarter of 2010." [1]
The energy markets are highly sensitive to a number of macroeconomic, geopolitical and seasonality factors. When there are indications of slower economic growth it is inferred that there will be a decline in demand for the refined products causing the crack spread to narrow. Crack spreads will often come to exceptionally low levels during slow economic growth periods. Geopolitical events such as the current unrest in the Middle East and Northern Africa, interrupts supply causing oil to react much more drastically than the products.
Despite driving season starting on Memorial Day and peaking on Independence Day most buying comes into the market long before May. Traders anticipate the pick up in driving and the rising gasoline price through the spring. Historically the most consistent returns come from entering this trade is around the beginning of March. The outperformance of gasoline causes the crack spreads to widen. Heavy driving disappears after Labor Day, as drivers in the 16-25 year old age bracket tend to drive less as they head back to school and family vacations are done by that point. December is another strong season for travel but after New Years people park their cars and get back to work, which is why we usually see gasoline at its lowest in January. Refiners generally shut down or reduce product output during the late winter months and early spring for maintenance which tends to widen the spread. Gasoline inventories are drawn down during this period and snags in the process or delays in restart can cause unexpected disruptions in supply coming into the driving season when gasoline demand is higher. Events such as these can keep crack spreads elevated.
During the winter months there is an increase in middle distillate demand which can support crack spread strength. Refiners start ramping up production of heating oil in early fall to build inventories and the market will often find a peak in mid October in anticipation of the heating required for the winter months. Just as the gasoline is highly sensitive to refinery snags during the winter maintenance period, heating oil becomes more sensitive demand-supply shocks during the fall as the market is concerned about building an adequate inventory supply for the winter.
The computation of the crack spread requires some simple mathematics because crude oil and the products are priced in different units. The most common crack spread involves trading three crude oil contracts against two gasoline contracts and one heating oil contract. This is known as the 321 Crack Spread which approximates the ratio in the actual refining process. Crude is priced in dollars per barrel and the products are priced in cents per gallon. Therefore, you must convert the dollars per gallon price into dollars per barrel price by multiplying the product prices by 42, as there are 42 gallons in a barrel. The calculations are as follows:
1 barrel = 42 Gallons per barrel
Gas Price per gallon $3.1200 X 42 gallons = 131.04 x 2 262.08 per barrel
Heating Oil per gallon $3.1200 X 42 gallons = 131.04 131.04 per barrel
Crude Price per barrel $100.00 x 3 300.00 per barrel
321 Crack Spread Price $93.12
$93.12 (the price of the 321) / 3 = $31.04 (the margin on each barrel of crude oil)
The Current Market
Crack spreads have recently been trading at triple that of a year ago and could remain elevated relative to historical averages for the near future due to a number of factors. WTI crude prices have recently been depressed relative to world prices largely because of increasing oil production in the northern US and the Alberta oils sands. Oil is able to flow easily via pipelines into the Cushing, Oklahoma where the WTI crude is priced. The problem however is a lack of capacity to transport both crude and refined products from the middle of the country to the Gulf of Mexico, Atlantic and Pacific coasts where higher world market prices prevail. US refiners purchase their crude at WTI prices, which is relatively low-cost, and are selling gas, heating oil at these higher world prices resulting in very lucrative refining margins. Some analysts have called for a prolonged period of large spreads between the two crude benchmarks, Brent and WTI. Until there is a deflating of that spread and some solutions put into place to solve the logistical troubles, crack spreads are likely to remain high.
If you would like to learn more about trading crude oil or energy refining spreads please feel free to give us a call at 416-862-3946 or send an email to kyle_mcewan@scotiamcleod.com or visit www.fennellthompson.ca.
[1] From http://www.marathonpetroleum.com/News/Press_Releases/Press_Release/?id=1591783
Disclaimer: Opinions expressed are subject to change without notice. This report should not be construed as a request to engage in any transaction involving the purchase and sale of a futures contract and/or commodity options thereon. The risk of loss in trading futures contracts or commodity options can be substantial, and investors should carefully consider the inherent risks of such an investment in light of their financial condition.
