Primer on Crude Oil Crack SpreadEver dreamt of being an oil refiner? Fret not. You can operate a virtual refinery using a combination of energy derivatives that replicates oil refiner returns.
Crude oil is the world’s most traded commodity. Oil consumption fuels the global economy. Crude is refined into gasoline and distillates.
Refining is the process of cracking crude into its usable by-products. Gross Processing Margin (GPM) guides refineries to modulate their output. Crack spread defines GPM in oil refining.
This primer provides an overview of factors affecting the crack spread. It delves into the mechanics of harnessing refining spread gains using CME suite of energy products.
UNPACKING THE CRACK SPREAD
Crack spread is the difference between price of outputs (gasoline & distillate prices) and the inputs (crude oil price). Cracking is an industry term pointing to breaking apart crude oil into its component products.
Portfolio managers can use CME energy futures to gain exposure to the GPM for US refiners. CME offers contracts that provide exposure to WTI Crude Oil ( CL ) as well as the most liquid refined product contracts namely NY Harbor ULSD ( HO ) and RBOB Gasoline ( RB ).
Crude Prices
Crude oil prices play a significant role in determining the crack spread. Refining profitability is directly impacted by crude oil price volatility which is influenced by geopolitics, supply-demand dynamics, and macroeconomic conditions.
Higher oil prices lead to a narrowing crack spread. Lower crude prices result in wider margins.
Expectedly, one leg of the crack spread comprises of crude oil.
Gasoline Prices
Gasoline is arguably the most important refined product of crude oil. Gasoline is not a direct byproduct of the distillation process. It is a blend of distilled products that provides the most consistent motor fuel.
Gasoline prices at the pump in the US vary by region. Price differs due to differences in state taxes, distance from supply sources, competition among gasoline retailers, operating costs in the region, and state-specific regulations.
CME’s RBOB Gasoline contract provides exposure to Reformulated Blendstock for Oxygenate Blending (RBOB). It is procured by local retailers, who blend in their own additives and sell the final product at pumps.
RBOB is blended with ethanol to create reformulated gasoline. It produces less smog than other blends. Consequently, it is mandated by about 30% of the US market. RBOB price is thus representative of US gasoline demand.
Each CME RBOB Gasoline contract provides exposure to 42,000 gallons. It is quoted in gallons instead of barrels. The contract size is equivalent to one thousand barrels like the crude oil contract.
Distillate Prices
Distillate or Heating Oil is another important refined product of crude oil. Distillate is used to make jet fuel and diesel. Demand for distillate products is distinct from gasoline demand.
A substantial portion of the North-East US lack adequate connection to natural gas. Hence, the region depends on HO for energy during winters making HO sensitive to weather.
CME NY Harbor ULSD contract ("ULSD”) provides exposure to 42,000 gallons of Ultra-low sulphur diesel which is a type of HO. ULSD contract is also equivalent to one thousand barrels.
Chart: ULSD Price Performance Over the Last Twenty Years.
TRADING THE CRACK SPREAD
The crack spread can be expressed using the above contracts in three distinct ways:
1) 1:1 SPREAD
This spread consists of a single contract of CL on one leg and a single contract of one of the refined products on the other. This spread helps traders to express their view on the relationship between single type of refined product against crude oil. It is useful when price of one of the refined products diverges from crude oil prices.
1:1 spread is also useful when there are distinct conditions affecting each of the refined products.
2) 3:2:1 SPREAD
This spread consists of (3 contracts of CL) on one leg and (2 contracts RBOB + 1 contract of ULSD) on the other leg. The entire position thus consists of six contracts. It assumes that three barrels of crude can be used to create two barrels of RBOB and one barrel of HO.
This trade is better at capturing the actual refining margin. It is commonly used by refiners to hedge their market exposure to crude and refined products.
3:2:1 spread is used by investors to express views on conditions affecting refineries.
3) 5:3:2 SPREAD
Spread consists of (5 contracts of CL) on one leg and (3 contracts of RBOB + 2 contracts of heating oil) on the other leg. This spread captures the actual proportions from the refining process. However, it is much more capital-intensive.
FACTORS IMPACTING CRACK SPREAD
Seasonality, supply-demand dynamics, and inventory levels collectively impact crack spreads.
Seasonality
Mint Finance covered seasonal factors affecting crude oil prices in a previous paper . In that paper, we described that crude seasonality is influenced by variation in refined products demand.
In summer, gasoline demand is higher, and, in the winter, distillate demand is higher.
Seasonal price performance of the three contracts is distinct leading to a unique seasonal variation in various crack spreads. Summary performance of the three spreads is provided below.
Chart: Seasonal price performance of Crude, its refined products, and their spread (excluding years 2008, 2009 and 2020 in which extreme price moves were observed)
Refiners strategically time their operations based on seasonal trends, ramping up refinery capacity ahead of peak demand in summer and winter. This involves building up inventories to meet anticipated high demand.
However, this preparation often results in a narrowed spread just before peak utilization. As the spread reaches its lowest point, refiners take capacity offline for maintenance.
Subsequently, crack margins begin to expand as refined product supplies dwindle, aligning with decreased crude oil consumption. This results in a gradually increasing spread through high consumption periods.
Supply/Inventories
Supply and inventories of crude oil and refined products influence crack spreads. When inventories of refined products remain elevated, their prices decline narrowing the spread.
When the production and inventory of crude oil is elevated, its price declines leading to a widening spread.
On the contrary, low inventories of refined products can lead to a wider crack spread and low inventories of crude oil leads to a narrower crack spread.
Demand
Refinery demand has a self-balancing effect as higher refining requires higher consumption of crude which acts to increase crude oil prices.
Demand for crude oil and refined products is broadly correlated. However, there are often periods when demand diverges on a short-term scale.
Economic activity and available supplies drive demand for refined products. During periods of high economic growth, refined product consumption is robust pushing their price higher.
Demand for refined products can precede or lag demand for crude oil from seasonal as well as trend-based factors. This lag can be identified using the crack spread. Sharp moves in crack spread pre-empt moves in the underlying which act to normalize the spread.
CURRENT CONDITIONS
There are two trends defining the crack spread currently:
1) Divergence in demand & inventories of gasoline and distillates: Low demand for gasoline is evident due to expectations of an economic slowdown while gasoline inventories remain elevated. Though, distillate consumption remains high as inventories are declining and lower than the 5-year average range.
Chart: Divergence in inventories of distillate and gasoline (Source – EIA 1 , 2 ).
Moreover, inventories of gasoline and distillates are higher than usual. Both factors together have led to a gloomy outlook for refined product demand. Gasoline stocks have started to increase while distillate stocks are still declining.
When refined product inventories are elevated investors can position short on the crack spread in anticipation of ample supply. Conversely, if refined product inventories are low, investors can position long on the crack spread.
Chart: Divergence in refined product inventories in US (gasoline rising and distillate declining).
2) Declining crude price and tight supplies: In September, Saudi Arabia and Russia announced supply cuts extending into January. Globally, this led to a supply deficit of crude oil. Supplies of crude in the US was particularly stressed as refiners increased utilization to build up inventories while margins were high and exacerbated by a pipeline outage.
Chart: Crude Oil inventories in US have stabilized in September and October.
Following increase in oil prices, refining activity has slowed, and supplies have become more stable.
When inventories of crude are stable or elevated, it indicates less demand from refiners. Investors can opt to position long on the crack spread anticipating ample crude supply.
Chart: US Refinery Utilization and Crude Inputs have slowed in October.
Although, crude oil supply cuts from Saudi are going to continue until January 2024, there is no longer a deficit as consumption has slowed down.
Together, both trends have caused a sharp collapse in the crack spread. Value of the 3:2:1 crack spread has declined by 50% over the past month.
Prices of refined products have been affected more negatively by low demand than crude oil. Inventories and supply situation for refined products is more secure than crude oil. Still, seasonal trends suggest an expansion in crack spread once refined product inventories start to be depleted.
HARNESSING GAINS FROM CHANGES IN CRACK SPREAD
Two hypothetical trade setups are described below which can be used to take positions on the crack spread based on assessment of current conditions.
LONG 3:2:1 SPREAD
Based on (a) sharp decline in crack spread which is likely to revert, and (b) seasonal trend pointing to increase in the crack spread, investors can take a long position in the crack spread. This consists of:
• Long position in 2 x RBF2024 and 1 x HOF2024
• Short position in 3 x CLF2024
The position profits when:
1) Price of RBOB and ULSD rise faster than Crude.
2) Price of Crude declines faster than RBOB and ULSD.
The position looses when:
1) Price of Crude rises faster than RBOB and ULSD.
2) Price of RBOB and ULSD declines faster than Crude.
• Entry: 63.81
• Target: 79.12
• Stop Loss: 55.73
• Profit at Target: USD 45,930 ((Target-Entry) x 1000 x 3)
• Loss at Stop: USD 24,240 ((Stop-Entry) x 1000 x 3)
• Reward/Risk: 1.89x
LONG 1:1 HEATING OIL SPREAD
Based on relative bullishness in distillate inventories plus stronger seasonal demand for distillates during winter, margins for refining heating oil will likely rise faster than gasoline refining margins. Focusing the expanding crack margin on a 1:1 heating oil margin spread can lead to a stronger payoff.
This position consists of Long 1 x HOF2024 and Short 1 x CLF2024 .
The position profits when:
1) Price of ULSD rises faster than Crude.
2) Price of Crude declines faster than ULSD.
The position will endure losses when:
1) Price of Crude rises faster than ULSD.
2) Price of ULSD declines faster than Crude.
• Entry: 36.15
• Target: 42.79
• Stop Loss: 32.3
• Profit at Target: USD 6,640 ((Target-Entry) x 1000)
• Loss at Stop: USD 3,850 ((Stop-Entry) x 1000)
• Reward/Risk: 1.72x
KEY TAKEAWAYS
Crack spread refers to the gross processing margin of refining (“cracking”) crude oil into its by-products.
Refined products RBOB and ULSD can be traded on the CME as separate commodities. Both are representative of demand for crude oil from distinct sources.
There are three types of crack spread: 1:1, 3:2:1, and 5:3:2.
a. 1:1 can be used to express views on the relationship between one of the refined products and crude.
b. 3:2:1 can be used to express views on the refining margin of refineries.
c. 5:4:3 can give a more granular view of proportions of refined products produced at refineries but is far more capital-intensive.
Crack spreads are affected by seasonality, supply, and inventory levels of crude and refined products, as well as demand for each refined product.
A low-demand outlook for refined products of crude is prevalent due to expectations of an economic slowdown.
MARKET DATA
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