Tracking Crack Spreads

by: Hard Assets Investor posted on: June 18, 2008 | about stocks: CVX / HOC / TSO / UGA / UHN / USO / VLO / XOM    

By Brad Zigler

Each week, we comment on the U.S. Department of Energy reports of crude oil and fuel inventories (see our last commentary, "Oil Report Stumps Analysts"), and each week, we're asked why we include the "crack spread" in our remarks.

Why bother depicting some obscure trading strategy, the queries usually run, when all we really want to know is whether oil's headed up or down?

The crack spread, in case you haven't encountered it before, depicts the potential profit that an oil refiner can obtain by "cracking" crude oil into its major tradable distillates, namely gasoline and heating oil. It doesn't represent the profit margin earned by all refiners, or any one refiner, in fact, but it is important as an indicator of refiners' intentions. Together with other indicators, such as crude oil inventories and refinery utilization rates, shifts in crack spreads or refining margins can help investors get a better sense of where some companies - and the oil market - may be headed in the near term.

To get at the margin, you first have to rationalize crude oil and distillate prices. Crude oil is priced in dollars per barrel, but gasoline and heating oil prices are denominated in gallons. Then, you've got to find prices. The most transparent marketplace is a futures bourse where trades are made publicly. You could have, for example, seen a nearby futures contract for NYMEX crude recently trading at $134.86 per barrel, while unleaded gasoline changed hands at $3.4516 per gallon and a heating oil for $3.8633. To better simulate real-world conditions, use the distillate prices a month out from the crude delivery to allow for a storage, refining and marketing cycle.

A crude oil futures contract calls for delivery of 1,000 barrels. So too, do the distillate contracts, albeit indirectly. Heating oil and gasoline contracts specify delivery of 42,000 gallons, but with a barrel holding 42 U.S. gallons, it's really 1,000 barrels. Just multiply the distillate prices by 42 to get the barrel prices. Your gasoline, then, fetches $144.97 a barrel, and a barrel of heating fuel, $162.26.

A classic refining model yields two barrels of gasoline, and one barrel of heating oil for every three barrels of crude input. The "3-2-1" crack spread would be found through simple arithmetic as:

OUTPUT INPUT

Gasoline Heating Oil Crude Oil

[(2 x $144.97) + (1 x $162.26)] - (3 x $134.86) = $47.62 per 3 barrels = $15.87/barrel of crude

$452.20 - $404.58

If $15.87 represents the gross profit on a barrel of oil that nominally costs $134.86, the gross refining margin appears to be 11.8% ($15.87/$134.86). From a "cost of goods sold" basis, however, the refiner's potential profit is $47.62 on every $452.20 of product sales, or 10.5%. This is the number stock analysts watch when evaluating a publicly traded refining company. It's useful to know both numbers because one running significantly ahead of the other often signals windfalls. We'll come back to this later.

Because the prices of the crack spread components vary, crack spreads and refining margins themselves ebb and flow, sometimes dramatically. Last summer, for example, the nearby one-month NYMEX crack spread collapsed from $27.71 to just $4.92.

NYMEX Crack Spread

There is, in fact, a seasonality to these crack spreads and refining margins. Switchovers in refinery configurations - stepping up gasoline production for the summer, then resetting to produce more heating oil for winter - accounts for much of the seasonal variance, while the inherent scarcity of U.S. refining capacity also acts as a lever.

Traditionally, crack spreads tend to be wider in the spring than in the fall because most refiners perform annual maintenance during late winter. That reduces output. Refiners tend to operate nearer capacity in the fall to assure heating oil supplies for the coming winter months. That's when spreads will typically be weakest. Of course, refiners can tweak their outputs to adapt to changing market conditions. When margins are soft, refiners can raise overall profitability either by slowing operations and keeping capacity utilization relatively low, or by closing down less efficient units entirely. The resulting price spikes for refined products then push crack spreads higher.

Refining Margins vs. Capacity Utilization

At this time of year, experienced futures traders might "sell the spread" in expectation of the seasonal narrowing in refining margins. This "reverse" crack spread entails selling short three futures contracts while simultaneously holding two gasoline contracts and one heating oil contract long.

More commonly, though, futures-savvy investors wait for the fall, when spreads have contracted, to "buy the spread." Holding three crude oil futures long against the sale of two gasoline contracts and one heating oil futures through the winter is a more reliable, and generally more profitable, trade.

Either way, traders buying or selling 3:2:1 NYMEX spreads take advantage of 75% margin credits which make the trades particularly attractive. Alternative ratios - 5:3:2 and 2:1:1 - are also recognized for spread margin treatment.

Investors without a futures account can utilize exchange-traded funds in their securities accounts to trade seasonal margin variances. The crack spread can be simulated by buying the United States Oil Fund (AMEX: USO) while selling short the United States Gasoline Fund (AMEX: UGA) and the United States Heating Oil Fund (AMEX: UHN). Without a margin break, however, the ETF version of the trade isn't as attractive as futures.

There's a margin-timing trade, however, that entails only the outright purchase of an independent oil refiner such as Valero Energy Corp. (NYSE: VLO), Tesoro Corp. (NYSE: TSO) or Holly Corp. (NYSE: HOC).

Integrated oil companies such as ExxonMobil (NYSE: XOM) and Chevron Corp. (NYSE: CVX) have a natural hedge against adverse price movements of the refining spread components because they control their entire supply chain. It's really the independent oil refiners that are obliged to use crack spreads to hedge their operational risks.

We noted previously a distinction between apparent refining margins and profit spreads measured by the "cost of goods sold" method. Long positions in the independents are favored as soon as the differential between the two margins tips over 5%.

Independent Refiner Stock Price vs. Refining Margins

A picture speaks louder than words. Profits speak even louder. Does tracking the crack spread make more sense now?

This article has 13 comments! Add yours below...
Hard Assets Investor

Hard Assets Investor

From HAI:
Become a Contributor Submit an Article

This article has 13 comments:

  •  
    User 206076
    Jun 18 11:30 AM
    Good article, but I don't see anything on the chart that suggests you can buy the refiners when the two margins tip over 5%. Is there any logical explaination for this?
  •  
    Managing
    Editor
    Jun 18 11:51 AM
    My Website
    User -

    Not the TWO margins. The DIFFERENCE between the two margins.

    One tracks the spread between the input price and the prices of the outputs (the apprarent refining margin), the other (gross profit margin, basis the cost of goods sold) the profit represented by the per-barrel crack against the sale prices of the outputs. Gross and grosser, you might say.
  •  
    ihl2003
    Jun 18 07:08 PM
    Great article, I've been trading for a few years but still consider myself somwehat of a novice. This is one of the most informative articles I've seen on this site in quite a while, good work.
  •  
    maximax
    Jun 19 05:21 AM
    the crack spread does not work with coking refineries, of which there are quite a few in the US.
  •  
    Managing
    Editor
    Jun 19 11:29 AM
    My Website
    ihl - Thanks for your comments.

    maximax - Thanks for yours as well.

    Your point's well-taken. Coking spreads take into account more than just two products on the output side, namely WTS, dated Brent and No. 6 fuel oil.

    Coking operations, too, are multiplying.

    The point of the article, however, was to offer a basic model for those unfamiliar with refinery operations in terms that they've likely encountered in investment articles.

    Crack spreads are discussed in investment terms more often than coking spreads.

    Investors, too, are much more likely to grab the two crack spread output prices from retail sources than the less transparent coking components.

    There are a limited set of products, too, for retail investors to use (ETFs) to capture refining margins.

    In a nutshell, this article wasn't destined for professional hedgers or industry insiders. Rather, it's an overview of a concept often encountered by, but seldom adequately explained to, retail investors.
  •  
    User 212797
    Jun 19 11:41 AM
    thanks for the article. How does this impact companies like VLO and FTO in the short term.
  •  
    Managing
    Editor
    Jun 19 12:13 PM
    My Website
    User -

    It depends on how "short" the "short" in your term is.

    And whether or not you can go "short." Seasonally, margins are softening now. If you're especially aggressive--and some might say, foolish--you could sell the independents now.

    Or you could wait for heating oil season when retooling and maintenance operations curb production (look for that 5% margin differential ) to buy the stocks.
  •  
    DCReader
    Jul 21 09:49 AM
    Thanks for the interesting article. You mention that the crack is more important for oil companies not relying (primarily) on their upstream crude extraction operations. How important are the un-integrated players in the distillate production market? Aren't the exxons and chevrons producing most of the nation's gasoline? Are you aware of a source providing data on the percent reliance on foreign crude by the major refiners? Thanks!
  •  
    Larry
    Livingstone
    Jul 21 11:22 AM
    Hi,

    Great article. With the crack spread on gasoline for Oct trading at around $0.33...wouldn't you say this is a good time to buy the spread? P.S. you said that buying the spread entails buying crude and selling gasoline but in essence you want to sell crude and buy gas to bet that either crude price will fall or gas price will rise or both right? or am i missing something here?
  •  
    Managing
    Editor
    Jul 22 09:46 AM
    My Website
    DC Reader -

    Valero actually refines more oil in the United States than ExxonMobil does in its company-owned facilities. Valero cranks out 2,112,000 barrels a day from 13 sites while ExxonMobil churns 1,880,500 barrels out of a half-dozen refineries. Of course, Valero's production is strictly domestic. ExxonMobal operates globally.

    The Oil & Gas Journal keeps tracks of such things.

    Larry -

    The spread seasonally cheapens through the fall. Last October, in fact, it contracted to 12 cents a barrel before rebounding.

    Trading the reverse crack spread (selling crude short and buying the products) is an option if you think crude's headed lower, but it's a much riskier proposition. It's better for most traders to await the bottoming.
  •  
    Scrapster
    Jul 26 10:15 AM
    Whats your current view on VLO (Valero) - Oil prices are falling. Do you see the stock under pressure until the fall? or with the falling price of oil that we are now seeing - does that make the stock attractive now?

    thanks for your comments
  •  
    bobbo
    Jul 28 07:37 AM
    Thanks for the article. What you didn't point out was that since the crack spread variance is almost entirely seasonal (high spread moving into the summer driving months peak demand, and low spread in the early fall) the crack seasonal variances are priced into the contangos so the trade is far from as obvious as your chart might otherwise suggest.

    Indeed the 3:2:1 crack spread norm in the 1990's was in the 2 to 6 area and it is only the higher price of oil and capacity utilization problems that have more recently widened these margins.

    For a more accurate picture of refining margins look to the crack spread crude current contract against one month forward on the products and remove the seasonal variances. Also consider the price differences in OK and NY crude as well as pipeline/transportatio... costs.

    It is easy to buy the front months at tight crack spread coming into the fall but difficult to buy the seasonal demand forward months.

    Whilst the crack can offer nice short term trading plays on shortages in the supply pipeline: crude to refineries, refining capacity, unexpected shutdowns, hurricanes and so on trading without considering the standard seasonal variances is at your peril!

    Managing Editor -
    Selling crude and buying the products is the less risky trade not the more risky as you suggest. Look at the convexity! Refiners slow down throughput approaching a zero spread by slowing down less efficient plants; thus your bottom on the trade is effectively limited approaching zero on the crack if you are long products and short crude on a 3:2:1 at a tight spread. Indeed looking at the history the crack has risen to the 30's at times of refinery shutdown or capacity threat such as Katrina - whereas the spread is rarely much below 5 these days. Since refinery utilization runs almost at full capacity in the US there is significantly more risk of a shutdown than of surplus even if gasoline demand is starting to level off. Of course that means that running the crack by shorting products is certainly the more profitable - but that is akin to selling hurricane insurance through the season: not something I am sure most want to do!
  •  
    anachronist
    Jul 29 07:13 PM
    Why is the crack spread calculated using only crude oil, heating oil, and unleaded gasoline? Unleaded gasoline and heating oil account for only 68% of the refined products obtained from a barrel of oil. There's also propane, natural gas, and diesel, and minor stuff not having futures contracts that make up the remainder.
Loading...
Symbols:
Authors:
Quick Links:

ETFs In Focus

  • Long Ideas

  • Short Ideas

  • Cramer's Picks