Crude Oil Crack Spread
From FXPedia
The term crack spread is commonly used in two different contexts within the oil industry. The first instance refers to the difference in the retail earnings of the refined petroleum products and the original cost of the crude oil; in other words, the profit generated by refining crude into retail products. Refining crude oil physically breaks up (i.e. “cracks”) the long-chain hydrocarbons into shorter-chain hydrocarbons found in the finished products such as gasoline and heating oil.
The second instance of crack spread is used in the commodities market when a hedging strategy is used to offset the risk of market price changes. Oil refiners make the most use of crack spread hedges in an attempt to lock-in the cost of crude oil as well as guaranteeing the price they will receive for their refined products.
Oil refiners can manage most of their costs – worker compensation and capital costs for facilities for instance, are generally stable and predictable. What refiners cannot control directly however, are crude oil costs and the prices refined products can be sold for at the wholesale / retail level. Because profits are tied to the crack spread price differential, refineries are particularly vulnerable to changes in the world price of crude oil as well as competition and other factors that can affect retail prices.
To counter this vulnerability, refineries have historically considered strategies enabling them to lock-in both the cost of oil and wholesale prices. One of the most common ways in the past to attempt this was through a series of call and put options agreements whereby refineries would buy a series of crude oil calls providing them with a guaranteed price for crude, thus fixing their costs. The refinery would then offer an off-setting series of gas or heating oil puts enabling them to sell the refined products at a guaranteed price serving to lock-in their revenue streams for the processed crude. Together, the calls and puts would ensure a particular profit margin for the refinery.
One of the most common strategies - referred to as a “3 : 2 : 1” - consists of the refinery purchasing a series of crude oil calls. The refinery then sells two-thirds of the value of the calls as gasoline puts, with the remaining third being sold as heating oil puts as this ratio roughly approximates the breakdown of the oil refining process.
While the theory behind this approach is simple, in actuality, it requires a great deal of effort to maintain. Refineries are dealing with millions of barrels of crude and the whole plan is predicated on the premise that you can find crude sellers and refined products buyers when you need them and at the price point you need to make your strategy profitable.
To simplify the process and open the oil hedging market to a wider group of investors, the New York Mercantile Exchange (NYMEX) created the first publically-traded oil futures in 1994. Other exchanges now offer similar products but the original oil futures available through NYMEX consisted of futures tied to either blended gasoline or heating oil future prices.
These futures were set up with one leg of the contract linked to the price of crude oil, and the second leg linked to the price of finished products. This makes the job of hedging market price changes much easier as both legs of the contract can be locked-in resulting in a guaranteed cost of the crude together with a guaranteed price for the refined product.
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