Crack Spread: A Real-Time Indicator of the Oil Industry

Crack Spread: A Real-Time Indicator of the Oil Industry

As a result of recent macroeconomic developments and the general atmosphere of the market, crack spreads have skyrocketed this year; Demand for gasoline has exceeded supply. As a result of this increase, numerous industry analysts have revised their projections for the price of gasoline in 2022 – Many are forecasting a significant increase in the price of fuel, with projections reaching an average of $312 per gallon in 2022.

This article will examine the concept of crack spread and evaluate its significance for oil industry stakeholders.

Crack Spread – An Industry-Specific Term

Crack Spread is a petroleum industry term that defines the price differential between crude oil and its byproducts, including kerosene, heating oil, and gasoline. The spread calculates a refinery company's profit margin, which is crucial for determining the effect of the price differential on their profit margins.

Like most petroleum refiners or manufacturers, the corporation is perpetually stuck between two markets: the raw materials it must purchase and the completed products it sells. The price of crude oil relative to its derivatives is frequently affected by supply, demand, production, and environmental issues. When the price of crude oil rises but the prices of its by products remain the same or even decline, the majority of refiners face a substantial risk.

Crack Spread, a real-time indicator of the oil industry
Figure 1: Global Refinery Margin Tracker. Source: Commodity Context, Bloomberg

What is Influencing a Crack Spread

The occurrence of crack spread is influenced by a wide variety of elements. These include issues pertaining to geopolitics, geography, demographics, the economy, and international relations. Because of all of these factors, there is a decrease in the supply of crude oil, which leads to an increase in the price of the latter. In addition, as a result of refineries reducing product production in response to the decreasing availability of crude oil, the crack initially decreases in size but then gradually grows larger over the course of time.

The weather is the second factor to consider. For instance, there is a greater need for particular by-products during the winter months, which leads to a greater spread of crack. This is because of the freezing temperatures.

Last but not least, there is the currency deflation. The crack spread narrows as a result of an increase in the price of crude oil and a proportional fall in the value of the currency used to purchase it. Nevertheless, the profit margin on crude oil will decrease if the price of crude oil continues to grow. Because of the falling value of currencies, investors may feel driven to move their money into crude oil in order to protect their purchasing power. As a direct consequence of this, the price of crude oil will surge, which will bring about a concomitant reduction in crack spreads. It is necessary for the value of crude oil to be significantly less than the price of the byproducts for there to be a favorable crack spread.

Crack Spread for Trading

Some refiners benefit from the existence of this price differential, despite the fact that it has a significant negative impact on the industry as a whole. Traders that wish to improve their position in futures trading utilize a crack spread. If a refiner depends on selling gasoline and the price of gasoline falls under the value of crude oil, the refiner may incur a loss. Traders will attempt to profit on the difference in price between crude oil and gasoline.

Typically, merchants and refiners will either purchase or sell the crack spread. If they choose to purchase it, they assume that the crack spread will widen, indicating that refining margins are expanding due to falling crude oil prices or rising demand for refined products. Selling the crack spread indicates a belief that refined product demand is falling or that the spread itself is tightening owing to fluctuations in oil prices. For refineries to limit loss and reevaluate potential hazards from a crack spread, there are a number of risk management strategies available.

The majority of refineries and manufacturers employ a certain approach to establish a crack spread futures position that is compatible with their current cash market operations. The most prevalent sort of crack spread is the simple 1:1 crack spread ratio, which indicates the profit margin between byproducts and crude oil for a refinery. Theoretically, it is implemented by selling refined goods futures and purchasing crude oil futures, thus securing the price spread between refined products and crude oil.

Crack Spread, a Powerful Indicator

Because crack spreads are utilized both as a method of marketing and for trading, they can also function as a helpful market indication on prospective price movements because of their dual uses. The volatility of crude oil prices and the pricing of its byproducts determine how a crack spread structure is affected. If the crack continues to spread, there is a distinct likelihood that the demand for the byproducts, as well as their pricing, would rise. Which investors regard as a fantastic opportunity to foresee perhaps higher prices for crude oil to match the demand for refined products obtained from primary sources.

In conclusion, all investors, refiners, and manufacturers are aware of the fact that a crack spread does not only present a risk to the company, but it is also a transparent and real-time indicator of the products’ performance and display the overall profitability of the oil industry.

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