The crack spread is a common term in the crude oil industry as well as crude oil futures markets that refers to the difference in price between crude oil and products refined from crude oil. When crude oil is “cracked” it is separated as gasoline and heating oil. For crude oil futures markets, the crack spread typically involves the simultaneous purchase and sale of contracts on crude oil futures and gasoline or heating oil. The crack spread involves crude oil, heating oil and gasoline futures and is popular with oil refineries and speculators.

When placing a crack spread a hedger’s focus is on trying to reduce the risk of adverse price movements in crude oil price or distillate price. There are different ratios used to express the quantity of crude oil futures contracts vs. heating oil or RBOB (gasoline) futures.  The NYMEX Exchange offers crack spread futures in one to one ratios as well as two-one-one, three-one-one, or five-three-two. These contract bundles offer the benefit of lower margin requirements but should never be considered less risky than crude oil futures markets as they carry the same substantial level of risk and exposure to loss.

The crack spread is expressed as a ratio since X barrels of crude oil can be refined into Y barrels of heating oil and Z barrels of gasoline. X=Y+Z in volume for establishing the crack spread and not necessarily the price. 3000 barrels of crude oil may be refined into 2000 barrels of gasoline and 1000 barrels of heating oil or 3=2+1 in terms of contract size. This would reflect a high output of gasoline and may not work for every refiner as some may produce a lower yield of gasoline relative to distillate.

Past performance is not indicative of future results. Futures trading is not suitable for all investors.  The risk associated with futures trading is substantial.  Only risk capital should be used for this investment because you can lose all or more than your original investment. Seasonal trading has many inherent limitations.  The market has often already allowed for seasonal changes. Even if a seasonal tendency occurs, it may not result in a profitable transaction as fees and the timing of the entry and liquidation may impact on the results. No representation is being made that any account has in the past, or will in the future, achieve profits using seasonal recommendations.

Since crude oil futures, heating oil and gasoline markets each have unique fundamentals, the crack spread can be important for refiners to try to reduce the risk associated with their industry. A potential rise in crude oil prices while gasoline or heating oil prices stay static or decline is an example. Price changes, seasonal demands for heating oil, or weather conditions, and depressed margins have all created scenarios that squeezed producers and lead to widespread interest in crack spread trading.

Refiners are long the crack spread in their cash position and normally sell the crack spread, buy crude oil futures and sell products, to establish a hedge. Purchasing or selling a crack spread depends on which side the premium falls on which is determined by the net price difference between crude oil futures  and the sum of the products.

Disclaimer: Trading in futures and options involves a substantial degree of a risk of loss and is not suitable for all investors. Past performance is not indicative of future results.