Crack Spread Calculations Demystified

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, "Got Gas? There's Less Now"). As part of our commentary, we depict potential profit margins that oil refiners can obtain by "cracking" crude oil into its major tradable distillates: gasoline and heating oil. This so-called "crack spread" represents the dollars earned, above the cost of crude oil inputs, by selling wholesale lots of refined products.

We get lots of questions about our crack spread computations. Traders and market observers wonder, at times, if we've been breathing cracking tower fumes a bit too long. Allow us to set the record straight.

First of all, we derive our numbers from that most transparent of petroleum marketplaces-futures. As such, the crack spread is generic. It doesn't represent the profit margin earned by all refiners. Or any one refiner, in fact. The crack spread, and the resulting refining margin, is more a rough topographic map than a GPS tracker of profit. Still, even crudely derived - ahem - margins can point to rough or smooth roads ahead for refiners and investors.

For example, some refiners use light, sweet grades of crude deliverable against New York Mercantile Exchange [NYMEX] futures. The NYMEX basis grade is West Texas Intermediate [WTI], a crude that yields more gasoline than more viscous and sour grades. Our numbers are based upon a classic WTI crude refining model (3-2-1) that yields two barrels of gasoline and one barrel of heating oil for every three barrels of oil input.

Other crudes, such as OPEC basket grades, yield less gasoline, so a 2-1-1 (two barrels of crude producing one barrel, each, of gasoline and heating oil) may better describe operations based upon these inputs. Often, news reports referencing crack spreads are based upon 2-1-1 pricing.

Calculating The Spread

Calculating a crack spread requires you to first rationalize crude oil and distillate prices. Crude oil is priced in dollars per barrels, but gasoline and heating oil prices are denominated in gallons. Let's suppose the nearby NYMEX crude futures settled at $40.00 per barrel. That's the input. The refining output is represented by gasoline and heating oil contracts deliverable in the month following the crude delivery. Hedgers and traders use distillate prices a month out from the crude expiration to simulate a storage, refining and marketing cycle. Let's suppose gasoline last settled at $1.28, while heating oil did so at $1.16.

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 $53.76 a barrel, and a barrel of heating fuel, $48.72.

The 3-2-1 crack spread is found through simple arithmetic as:

Gasoline Heating Oil Crude Oil

[(2 x $53.76) + (1 x $48.72)] - (3 x $40.00) = $36.24 per 3 barrels, or $12.08 per barrel, of crude

Similar math is employed to derive a 2-1-1 crack:

Gasoline Heating Oil Crude Oil

[(1x $53.76) + (1x $48.72)] - (2 x $40.00) = $22.48 per 2 barrels, or $11.24 per barrel, of crude

As you can see, there's a difference in crude yields depending upon the refining model employed. Crack spreads are seasonal. The 3-2-1 spread, double-weighted in gasoline, tends to outperform the 2-1-1 spread when gasoline prices rise in relation to heating oil. Seasonally, that's typically in winter and spring ahead of the peak summer driving season. Slackening demand for petrol, on the other hand, can push the 3-2-1 spread to a discount. In the terminal stages of the oil price spiral, for example, gasoline was well-supplied, pressuring the spread under the 2-1-1 crack. Then, at the oil price peak, demand for gasoline dissipated, further deepening the discount. Only since February has the 3-2-1 spread returned to premium and, if history is any guide, points to a May peak.

Crack Spread Models

The ETF Spread

Not everybody, of course, cares to trade in futures. We've mentioned the recent introduction of exchange-traded funds that make a margin-free alternative possible. Think of these collectively as a "good news, bad news" version of the crack spread. The good news is that these ETFs can create a 2-1-1 replicant. The bad news? No 3-2-1 simulant.

Buying equal lots of the ProShares UltraShort DJ-AIG Crude Oil ETF (NYSE Arca: SCO), the United States Gasoline Fund (NYSE Arca: UGA) and the United States Heating Oil Fund (NYSE Arca: UHN) puts you short two units of oil and long one unit each of gasoline and heating oil-à la the 2-1-1 model.

The price of the ProShares SCO fund represents the cost of acquiring two units of oil, while the value of the UGA and UHN funds stand in as the proceeds derived from selling the distillates. Since the introduction of the ProShares SCO last November, the ETF proxy's produced a 13.8% gain versus the 15.1% return generated by the futures model.

2-1-1 Crack Spread (Futures Vs. ETF)

You can see the ETF spread doesn't exactly track its futures analogue. There are two reasons for the disparity. First, the futures spread is based upon settlement - not last sale - values. The ETF spread, however, reflects the last sale data available to retail investors. Using end-of-day bids or NAVs narrows the apparent difference significantly. The difference between the ETFS' last reported sale and end-of-day indicative values has been as wide as 77 basis points (0.77%) recently.

There's another source of dissonance that can't be adjusted away through selective quotation, though. Contango or backwardation isn't reflected in the ETF spread. The product ETFs, by design, are continuously invested in front-month futures, rather than second-month contracts. The current difference between first- and second-month futures runs between a 15 basis point discount for gasoline to an 89 basis point premium for heating oil.

Hopefully, this discourse has cleared the air. Or, at least waved away some of those nagging cracking tower fumes.

Comments

[fatcat:]

Very best,simple explanation I've seen to date....This will be very educational to a lot of readers.

Good job!

Mar 05 08:08 AM

[john s. gordon:]

thank you for explaining this topic.
> jack

Mar 05 08:19 AM

[ekofisk:]

if you didnt already understand this, you have no business trading petroleum futures.

Mar 05 09:48 AM

[WayneS:]

I don't understand this.
I don't trade petroleum futures.
Would someone explain what service futures-traders
perform. How do they facilitate getting products to
the consumers?

Mar 05 02:07 PM

[Brad Zigler:]

Speculative futures traders provide the liquidity needed by commercial hedgers. Without speculators willing to assume price risk, commercials-- and ultimately consumers--wouldn't be able to budget effectively.

The economic purpose served by hedging is to contain price risk which ultimately means consumers pay less for goods.


On Mar 05 02:07 PM WayneS wrote:

> I don't understand this.
> I don't trade petroleum futures.
> Would someone explain what service futures-traders
> perform. How do they facilitate getting products to
> the consumers?

Mar 05 02:37 PM

[john s. gordon:]

in the case of agricultural commodity futures, a farmer in the spring can pre-sell his crop and lock in a price. if the harvest proves to be bountiful and spot prices fall below his contract price, the risk is on the buyer of the futures contract. this process assists the farmer in his budgeting process. if on the other hand his crop turns out to be a disaster (bad weather etc.), he has to hustle around & spend some money to fulfill his contract.

the operation of oil & metals contracts is somewhat different, these contracts are often purchased by entities (speculative type) that have no intention of ever taking delivery of the actual commodity.
> jack

Mar 05 03:01 PM

[Brad Zigler:]

In actuality, the operation of metals and oil futures doesn't differ appreciably from ag futures.

Very few futures contracts (on average, only 2%-3%)--ags included--are settled by delivery. Most often, commercials offset futures in the exchange market to close their hedges and make/take delivery in the local cash market.


On Mar 05 03:01 PM john s. gordon wrote:

> in the case of agricultural commodity futures, a farmer in the spring
> can pre-sell his crop and lock in a price. if the harvest proves
> to be bountiful and spot prices fall below his contract price, the
> risk is on the buyer of the futures contract. this process assists
> the farmer in his budgeting process. if on the other hand his crop
> turns out to be a disaster (bad weather etc.), he has to hustle around
> & spend some money to fulfill his contract.
>
> the operation of oil & metals contracts is somewhat different,
> these contracts are often purchased by entities (speculative type)
> that have no intention of ever taking delivery of the actual commodity.

Mar 05 03:27 PM

[cannedpawn8:]

I learn something everyday and I don't do futures...just own XOM

Mar 05 03:30 PM

[john s. gordon:]

brad z -

thanks for clarification, i'm not a futures trader.
one year a friend of mine made some money in wheat futures.
the next year he got mashed in potatoes.
> jack

Mar 05 03:46 PM

[Brad Zigler:]

Keeping an eye on the crack spread -- and its seasonality -- can help you understand the vagaries in XOM's downstream revenue stream.


On Mar 05 03:30 PM cannedpawn8 wrote:

> I learn something everyday and I don't do futures...just own XOM

Mar 05 03:48 PM

[Brad Zigler:]

Mashed in potatoes? That's funny, Jack.

But that must have been a long time ago. Potato futures were banned following allegations of maket manipulation.


On Mar 05 03:46 PM john s. gordon wrote:

> brad z -
>
> thanks for clarification, i'm not a futures trader.
> one year a friend of mine made some money in wheat futures.
> the next year he got mashed in potatoes.

Mar 05 03:52 PM

[john s. gordon:]

brad - i think it might have been 1961.

market manipulation - i seem to remember that some years back the hunt brothers tried to corner the silver market, but they got mashed too.
> jack

Mar 05 07:39 PM

[jstratt:]

I have been looking for a good explanation for a while. Thanks much!

The farmers near me should have learned this last year. The crash in prices last year must have been devastating.

Mar 05 07:46 PM

[WayneS:]

So the commercial hedgers and the speculative futures traders cause the "vagaries" in XOM's revenue stream? I remember in the eighties when Exxon sold crude to their own refineries, bypassing the middlemen, and sold gasoline at their retail stores at a cheaper rate. The state of Texas fined them a couple of billion dollars for selling under market.


On Mar 05 03:48 PM Brad Zigler wrote:

> Keeping an eye on the crack spread -- and its seasonality -- can
> help you understand the vagaries in XOM's downstream revenue stream.
>

Mar 06 10:04 AM

[Brad Zigler:]

To the degree futures track the cash market, no, the vagaries are not "caused" by hedgers and traders.Their interaction, however, INFLUENCE XOM's downstream revenues. As well they should.

It is because of the inherent fluctuations in cash market supply and demand that the futures market exists as a risk transference mechanism..



On Mar 06 10:04 AM WayneS wrote:

> So the commercial hedgers and the speculative futures traders cause
> the "vagaries" in XOM's revenue stream? I remember in the eighties
> when Exxon sold crude to their own refineries, bypassing the middlemen,
> and sold gasoline at their retail stores at a cheaper rate. The state
> of Texas fined them a couple of billion dollars for selling under
> market.

Mar 06 10:31 AM

[Fighting Yoda:]

Brad:
Thanks for a wonderful and very informative article. So I will take the liberty to ask a couple of questions:
1. What is the price differential between sour crude and WTI, and can the refiners use the two crudes interchangeably to get the desired mix – 3-2-1 or 2-1-1.

2. Are crack spreads published or they need to be computed.

Thx

Mar 07 06:04 AM

[Fighting Yoda:]

Brad:
A couple more:

Are refinery profit margins and crack spreads the same things. What is considered an optimum or profitable or historical crack spread?

Thanks much.

Mar 07 06:17 AM

[Brad Zigler:]

"Sour" refers to sulfur content. WTI's is comparatively low compared to Brent or the OPEC basket grades. That's why WTI is described as "light, sweet" crude.

The "light" descriptor refers to the oil's specific gravity. Lighter, sweeter crudes are easier to refine into gasoline meeting U.S. standards.

WTI is typically priced at a premium to more viscous, sulfur-rich grades. Over the past few years, for example, the WTI premium over dated Brent ran $1.50/bbl, though daily fluctuations--especial... now--often skew mightily. The premium over OPEC basket grades can run as high as $5/bbl.

The terms "refinery margins" and "crack spreads" are sometimes used interchangeably in media reports, but they're really different numbers.

A gross refining margin represents top line operating profit, so it's expressed as a percentage of the input oil cost. You need a crack spread to derive the margin. Once you calculate the spread, simply divide the per-barrel crack by the cost of the crude.

As mentioned before, crack spreads--and the resulting refining margins--are seasonal (an explanation of this can be found in the Hard Assets Investor article, "Time For Crack Spreads" at www.hardassetsinvestor...). Over the past 3 1/2 years, the median gross margin derived from the nearby 3-2-1 crack has been 15.6%. There's a fair amount of volatility in the margin, though. Lately, it's spiked as high as 64.8% and there was a one-day excursion into negative territory associated with a short squeeze in the expiring October 2008 crude contract.

There's a visual representation of refining margins in the recent Hard Assets Investor article, "Crude Oil Takes A Back Seat To Gasoline" at www.hardassetsinvestor....

The article is part of a continuing weekly update on the petroleum complex published every Wednesday in Hard Assets Investors' (HardAssetsInvestor.com) "Brad's Desktop" column.

An optimum margin? One large enough to create a spread between the gross refining margin and the cost of goods sold of 5% or more. Read the "Time For Crack Spreads" (www.hardassetsinvestor...) article for an explanation.


On Mar 07 06:04 AM SB-tiger wrote:

> Brad:
> Thanks for a wonderful and very informative article. So I will take
> the liberty to ask a couple of questions:
> 1. What is the price differential between sour crude and WTI, and
> can the refiners use the two crudes interchangeably to get the desired
> mix – 3-2-1 or 2-1-1.
>
> 2. Are crack spreads published or they need to be computed.
>
> Thx

Mar 07 12:41 PM