What is the Crack Spread?

A crack spread refers to the overall pricing difference between a barrel of crude oil and the petroleum products refined from it.  It is an industry-specific type of gross processing margin.

The “crack” being referred to is an industry term for breaking apart crude oil into the component products, including gases like propane, heating fuel, gasoline, light distillates, like jet fuel, intermediate distillates, like diesel fuel, and heavy distillates, like grease.  – Investopedia

Let’s look at a basic ‘crack spread’ using one of Masters in Trading proprietary trading tools: Energy EDGE

Above is a very basic crack spread using 3 futures contracts:

1. Heating Oil
2. RB Gasoline
3. Crude Oil

When the crack spread trades high, the profit margin for refineries is expanding.

When the crack spread trades low, the profit margin for refineries is contracting.

The chart above takes the same crack spread we charted earlier, but now overlays the price of $PSX – a large cap Oil Refinery.  See the trade set-up?

In our Monday member-only class, we introduced this exact trade to our Options members.  The white line is clearly trading inexpensive relative to the red line.

Using ‘common sense’ it’s clear to see how that white line ($PSX) tracks the crack spread (the red line).  Right?

KEY TAKEAWAYS

• • A crack spread is the overall pricing difference between a barrel of crude oil and the petroleum products refined from it.  Said another way, in October of 2020 the product margin for refineries was considerably lower than October of 2021.
  • The price of a barrel of crude oil and the prices of the different products derived from it are not always in sync, leading to the spread in prices. The role of the trader is to keep markets in sync.  When prices deviate, traders can take advantage of mispricing.
  • The difference in prices is important to oil refiners as it can impact their profit margins.  Following the ‘crack spread’ is like following a ‘cheat sheet’ when trading refineries.
  • To mitigate the pricing risk, refiners use futures to hedge the crack spread. Futures and options can also be used by traders to hedge other investments or speculate in the oil market.  Again, the role of the trader is to keep markets efficient.  The further traders get away from guessing in direction (speculating) the more sustainable success they will achieve.
  • Crack spreads can be used as a market signal for price movements in oil and refined products depending on whether the spread is tightening or widening.  Look at the chart below.  This chart overlaps the price of a major refiner:  $PSX, and the above crack spread.

Once traders determine the strength or weakness in the crack spread, they can move on to finding Refiners that are trading cheap or expensive relative to the behavior of the ‘crack spread.’

In this past Monday’s member-only options class, Jonathan Rose shared $PSX with the community.  Not only has $PSX traded inexpensively relative to the recent behavior of the ‘crack spread’ (above chart)… using our High-Value Target tool (below) notice how $PSX is also getting multiple buy signals?

Learn More About High-Value Target Tool Here