Cracking the Crack Spread
The ‘crack spread’ is a term used in the oil industry that refers to the differential between the price of crude oil and the petroleum products extracted from it, such as gasoline and heating oil. The name comes from the process of 'cracking' crude oil in a refinery to produce these valuable products.
The spread serves as a measure of refining margin, or profitability, for oil refineries. When the prices of petroleum products are high relative to the price of crude oil, the crack spread widens, and refining margins increase, making it profitable for refineries. Conversely, when the price of crude oil is high relative to the products, the crack spread narrows, and refining can become less profitable or even unprofitable.
The crack spread is typically expressed in terms of the ratio between the input (crude oil) and the outputs (refined products). For example, a 3:2:1 crack spread assumes that three barrels of crude oil can produce two barrels of gasoline and one barrel of heating oil.
In the futures market, the crack spread can be traded by buying crude oil futures and selling futures in its products, thus locking in the margin between input and output prices. This can serve as a form of hedging against price risk for those involved in the oil industry.
This week, we will delve into various factors influencing the crack spread and evaluate their potential impact on the current spread;
Geopolitical Concerns
SPR Refill
One of the key points mentioned when we last covered oil was the potential refills of the SPR which are still pending as an attempt to purchase up to 6 million barrels was abandoned at the last minute. As the drawdown in the SPR continues, it seems inevitable that the Biden administration will have to replenish the reserve, likely pushing oil prices higher due to increased demand.
Russia Ukraine escalation
The simmering tensions of the Russia-Ukraine conflict leave us wondering if the price of crude oil might escalate further. The ongoing conflict focuses on a key port in the Black Sea. Consequently, this could potentially impact up to 20% of oil exports from Russia. Although most major nations no longer rely on Russia for oil supply, some countries are still buying from Russia. This leads to the concern that such countries might have to turn to the open market to make up for their supply shortage one day.
Seasonality
Crack falls in the 2nd half of the year
Seasonal trends indicate a pattern where the 3:2:1 crack spread declines in the second half of the year. This trend has persisted for 6 out of the past 10 years, with the average decline of 29%. Three of the remaining four years closed flat, with one year ending approximately 20% higher.
Economic Growth
Current economic growth weak but some soft landing expected
The year-on-year GDPs for major economies are trailing their long-term averages, indicating still fragile economic growth as industries and consumers grapple with sticky inflation and high rates. Weak economic growth generally dampens the crack spread, as industries and consumers cut back on spending, reducing the demand for refined products.
Currency
Interplay Between Dollar, Crude, and Crack Spread
The Inverse Dollar and Crude Oil has as long-standing positive correlation up until the Russian-Ukraine Crisis when both Crude Oil and the dollar move sharply higher. As this relationship now begins to normalize again, any weakness in the dollar could provide the fuel for Crude & the Crack Spread to rally again.
The crack spread is also highly correlated with Crude Oil outright prices, hence any view on crude oil can also be expressed using the Crack Spread.
The crack spread hit an all-time high in June 2022 amidst the Russia-Ukraine tensions. Currently, the spread trades at a higher range relative to the past two decades and seems to face some resistance at the previous all-time high in 2013.
On a shorter timeframe, the crack spread appears to be breaking out of a symmetrical triangle to the upside, typically a signal of bullish continuation. With prices slightly dipping, this could present an enticing opportunity.
On balance the impending risk of the geopolitical event breaking out as well as the structurally weakening dollar seems to outweigh the seasonality and economic weakness effect. To express our view on the 3:2:1 crack spread, we can set up a long position on the crack spread. This can be set up by buying 2 RBOB Gasoline Futures & 1 NY Harbor ULSD Futures and selling 3 Crude Oil Futures at the current level of 114.5, stop loss at 97 and take profit at 140.
The calculation of the 3:2:1 crack spread should also be noted as: (2 * RBOB Gasoline Futures + 1 * NY Harbor ULSD Futures ) * 42 – (3 * Crude Oil Futures). The factor 42 is multiplied to the RBOB Gasoline Futures and NY Harbor ULSD Futures as the two are quoted in USD per gallon, this converts the price quotation in Barrel terms, which is the same as Crude Oil Futures.
The charts above were generated using CME’s Real-Time data available on TradingView. Inspirante Trading Solutions is subscribed to both TradingView Premium and CME Real-time Market Data which allows us to identify trading set-ups in real-time and express our market opinions. If you have futures in your trading portfolio, you can check out on CME Group data plans available that suit your trading needs tradingview.com/cme/
Disclaimer:
The contents in this Idea are intended for information purpose only and do not constitute investment recommendation or advice. Nor are they used to promote any specific products or services. They serve as an integral part of a case study to demonstrate fundamental concepts in risk management under given market scenarios. A full version of the disclaimer is available in our profile description.
Reference:
eia.gov/dnav/pet/hist/LeafHandler.ashx?n=PET&s=WCSSTUS1&f=W
cmegroup.com/markets/energy/refined-products/rbob-gasoline.contractSpecs.html
cmegroup.com/markets/energy/refined-products/heating-oil.contractSpecs.html
cmegroup.com/markets/energy/crude-oil/light-sweet-crude.contractSpecs.html
cmegroup.com/education/articles-and-reports/introduction-to-crack-spreads.html
The spread serves as a measure of refining margin, or profitability, for oil refineries. When the prices of petroleum products are high relative to the price of crude oil, the crack spread widens, and refining margins increase, making it profitable for refineries. Conversely, when the price of crude oil is high relative to the products, the crack spread narrows, and refining can become less profitable or even unprofitable.
The crack spread is typically expressed in terms of the ratio between the input (crude oil) and the outputs (refined products). For example, a 3:2:1 crack spread assumes that three barrels of crude oil can produce two barrels of gasoline and one barrel of heating oil.
In the futures market, the crack spread can be traded by buying crude oil futures and selling futures in its products, thus locking in the margin between input and output prices. This can serve as a form of hedging against price risk for those involved in the oil industry.
This week, we will delve into various factors influencing the crack spread and evaluate their potential impact on the current spread;
Geopolitical Concerns
SPR Refill
One of the key points mentioned when we last covered oil was the potential refills of the SPR which are still pending as an attempt to purchase up to 6 million barrels was abandoned at the last minute. As the drawdown in the SPR continues, it seems inevitable that the Biden administration will have to replenish the reserve, likely pushing oil prices higher due to increased demand.
Russia Ukraine escalation
The simmering tensions of the Russia-Ukraine conflict leave us wondering if the price of crude oil might escalate further. The ongoing conflict focuses on a key port in the Black Sea. Consequently, this could potentially impact up to 20% of oil exports from Russia. Although most major nations no longer rely on Russia for oil supply, some countries are still buying from Russia. This leads to the concern that such countries might have to turn to the open market to make up for their supply shortage one day.
Seasonality
Crack falls in the 2nd half of the year
Seasonal trends indicate a pattern where the 3:2:1 crack spread declines in the second half of the year. This trend has persisted for 6 out of the past 10 years, with the average decline of 29%. Three of the remaining four years closed flat, with one year ending approximately 20% higher.
Economic Growth
Current economic growth weak but some soft landing expected
The year-on-year GDPs for major economies are trailing their long-term averages, indicating still fragile economic growth as industries and consumers grapple with sticky inflation and high rates. Weak economic growth generally dampens the crack spread, as industries and consumers cut back on spending, reducing the demand for refined products.
Currency
Interplay Between Dollar, Crude, and Crack Spread
The Inverse Dollar and Crude Oil has as long-standing positive correlation up until the Russian-Ukraine Crisis when both Crude Oil and the dollar move sharply higher. As this relationship now begins to normalize again, any weakness in the dollar could provide the fuel for Crude & the Crack Spread to rally again.
The crack spread is also highly correlated with Crude Oil outright prices, hence any view on crude oil can also be expressed using the Crack Spread.
The crack spread hit an all-time high in June 2022 amidst the Russia-Ukraine tensions. Currently, the spread trades at a higher range relative to the past two decades and seems to face some resistance at the previous all-time high in 2013.
On a shorter timeframe, the crack spread appears to be breaking out of a symmetrical triangle to the upside, typically a signal of bullish continuation. With prices slightly dipping, this could present an enticing opportunity.
On balance the impending risk of the geopolitical event breaking out as well as the structurally weakening dollar seems to outweigh the seasonality and economic weakness effect. To express our view on the 3:2:1 crack spread, we can set up a long position on the crack spread. This can be set up by buying 2 RBOB Gasoline Futures & 1 NY Harbor ULSD Futures and selling 3 Crude Oil Futures at the current level of 114.5, stop loss at 97 and take profit at 140.
The calculation of the 3:2:1 crack spread should also be noted as: (2 * RBOB Gasoline Futures + 1 * NY Harbor ULSD Futures ) * 42 – (3 * Crude Oil Futures). The factor 42 is multiplied to the RBOB Gasoline Futures and NY Harbor ULSD Futures as the two are quoted in USD per gallon, this converts the price quotation in Barrel terms, which is the same as Crude Oil Futures.
The charts above were generated using CME’s Real-Time data available on TradingView. Inspirante Trading Solutions is subscribed to both TradingView Premium and CME Real-time Market Data which allows us to identify trading set-ups in real-time and express our market opinions. If you have futures in your trading portfolio, you can check out on CME Group data plans available that suit your trading needs tradingview.com/cme/
Disclaimer:
The contents in this Idea are intended for information purpose only and do not constitute investment recommendation or advice. Nor are they used to promote any specific products or services. They serve as an integral part of a case study to demonstrate fundamental concepts in risk management under given market scenarios. A full version of the disclaimer is available in our profile description.
Reference:
eia.gov/dnav/pet/hist/LeafHandler.ashx?n=PET&s=WCSSTUS1&f=W
cmegroup.com/markets/energy/refined-products/rbob-gasoline.contractSpecs.html
cmegroup.com/markets/energy/refined-products/heating-oil.contractSpecs.html
cmegroup.com/markets/energy/crude-oil/light-sweet-crude.contractSpecs.html
cmegroup.com/education/articles-and-reports/introduction-to-crack-spreads.html
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