Petroleum Trading Strategies

Crack Spread

The word "spread" is generally used in the financial industry to refer to the difference between two related entities that can be expressed quantitatively while the word "crack" is used in the oil refining industry as a verb describing the process of separating and transforming the various chemical components of crude oil into saleable refined products.
Thus the term "crack spread" refers to the spread, or margin, that a refinery can earn by cracking a barrel of oil into refined products. One of the most important factors affecting this spread is the relative proportions of the products produced by a refinery. There is a wide range of such products which can include gasoline, kerosene, diesel, heating oil, aviation fuel, asphalt and various others. The mix of refined products is also affected by the blend of crude oil feedstock processed by a refinery and by the capabilities of the refinery. Heavier crude oils contain a higher proportion of heavy hydrocarbons composed of longer carbon chains.

Given a target optimal product mix, an independent oil refiner can attempt to hedge itself against adverse price movements by buying oil futures and selling futures for its primary refined products according to the proportions of its optimal mix.
For simplicity, most refiners wishing to hedge their price exposures have used a crack ratio usually expressed as X:Y:Z where X represents a number of barrels of crude oil, Y represents a number of barrels of gasoline and Z represents a number of barrels of distillate fuel oil, subject to the constraint that X=Y+Z. This crack ratio is used for hedging purposes by buying X barrels of crude oil and selling Y barrels of gasoline and Z barrels of distillate in the futures market. The crack spread X:Y:Z reflects the spread obtaining by trading oil, gasoline and distillate according to this ratio. Widely used crack spreads have included 3:2:1, 5:3:2 and 2:1:1.
As the 3:2:1 crack spread is the most popular of these, widely quoted crack spread benchmarks are the "Gulf Coast 3:2:1" and the "Chicago 3:2:1". Various financial intermediaries in the commodities markets have tailored their products to facilitate trading crack spreads. For example, NYMEX offers virtual crack spread futures contracts by treating a basket of underlying NYMEX futures contracts corresponding to a crack spread as a single transaction.

Treating crack spread futures baskets as a single transaction has the advantage of reducing the margin requirements for a crack spread futures position. Other market participants dealing over the counter provide even more customized products.

Spread trades

Spread positions offer another way of using futures.There are many types of spreads, but they all have two things in common. First, a spread always involves at least two futures positions, which are maintained simultaneously. For example, a trader may be long 10 June NYMEX contracts and short 10 September NYMEX contracts.


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