Expect Oil's 'Crack Spread' to Widen

Watch out for an uptick in crack spread trades over the next few weeks: economic and market conditions are in the perfect place for such bets to yield huge profits.

The crack spread is the price difference between crude oil its derivative products, such as gas. When those prices go in separate directions, traders can make big money by buying one and selling the other, while limiting the amount of risk they take on because of the inherent hedge in the trade.

For a great crack spread trade, you need to have weird economic conditions - which is exactly what we have right now. While banks are still having to write down the amount of debt they have on their balance sheets, confidence is returning to the lending market, and hence to the share prices of banks themselves. Even as the U.S. sheds 663,000 jobs in March, bringing unemployment closer to double-digits, equity valuations are holding up well. Those who were proclaiming we had another 2 years of chaos to contend with only weeks ago are now conceding that the end might be rather nearer in sight.

As a result of bullish sentiment in March, oil prices are showing some new-found resistance to selling. At $52.15 a barrel, oil has risen 9% in the past week, and shows signs of having stabilized above the $50-mark. As CNBC noted Friday morning, oil is likely to track equity prices far more than any typical petro-fundamental for the time being.

But that doesn’t mean to say that rising unemployment and continued weakness on the economic front don’t matter: they do. For products such as gasoline, these factors matter a lot. With gas prices surpassing the $2 a gallon mark for the first time since November 2008 earlier this week, this presents traders with a great time to get short gas, while hedging some of that with crude oil contracts. The hedge becomes a double-bagger of course, if oil prices continue to rise (along with the equity market), and gas prices come off their highs (along with consumer spending on gas products).

Essentially, it’s a market vs. economic fundamentals trade. In the aftermath of the massive comeback in March, it may end up being one of the most profitable trades around.

Stock position: None.

Comments

[ernmor:]

My 'Day Chart ' says we have a good chance that CL #F, front futures crude oil, has a chance to move over $55.00 a barrel soon. It would help my position (HOU) and USO (I don't have) somewhat I think. I like my 'Down Trap' of 3 days ago for this idea... Would like to see a close
over $55.00 Next Friday. This market is rolling around the '90 Day Moving average, just now over, as we speak.

Apr 05 08:13 PM

[xsellside:]

Take a look at the 3 or 6 month chart on USO and UGA. They have been drifting apart since January, with UGA outperforming USO by 25%+. Short UGA, Long USO? As squirrely as these ETFs can be (contango issues), is there a better way to trade this?

Apr 06 10:36 AM

[econjunkie:]

You can buy a pure refiner, like valero or tesoro. I realize that other factors affect equity prices, but energy commodities etf performance has not been perfect. If you've got money/balls, you can work with the futures.

Apr 06 11:34 AM

[Rohan C. Pease:]

I your worried about contango you could use a third variable and that is a shipper such as EXM, drys, or FRO. I use EXM and PBR to set up a long crude trade, and when PBR sells off with front month crude, the back of the board falls less which widens the contango and makes the shippers rise in value.

Apr 06 11:35 AM

[econjunkie:]

To the author:

I don't think I understand your headline. Are you buying the crack spread? If so, why are you suggesting bullish crude and bearish products. I think you mean, expect crack spread to narrow.

A widening crack spread must be the other way around, unless it's negative (not as common, because you can't crack below variable cost over the long term). If you are buying the crack, you are the next of (short oil/long products).

Apr 06 11:39 AM

[Drew Arnold:]

Re: econjunkie

You're right, the title is off. If he's long oil and short gas, then isn't that implying that he thinks the crack spread will narrow? If he thinks that crack spreads will narrow, his trade should be the opposite and he should look at getting long the refiners.

Apr 06 12:44 PM

[DavidHumeTower:]

I think the title's right, but his thesis and strategy are long. Per the charts, UGA is trending up and USL/USO sideways/down.

Apr 06 01:02 PM

[CPST1:]

Crack spread analysis calls for new equations on an old twist. Some alternative fuels like that of ethanol have lost its yield to the spread guidance as the refineries that have been built have declared bankruptcy (Verasun) even though government regulation demands that reformulated gasoline be used.

Therefore, the spread could more aptly be measured to that of alternative fuel conversion. Where the conversion to alternative energy means (e.g. wind, solar, geo-thermal...energy storage (GE)) is creating demand for traditional means of energy in order to build the new alternative fuel dependent system.

It is the gainful yield from which the spread should be measured that an alternative energy can in fact replace legacy (GM) oil dedicated systems.

Apr 06 01:09 PM

[econjunkie:]

I agree that the crack spread is widening, but it's because crude inventories are building and refiners are cutting back on their throughput. Sorrry to say the same thing several ways.

Apr 07 11:57 AM

[Larry Livin...:]

Reason why the crack is widening today, in my opinion ($2 up to $12.35 for the front month) is that front month WTI is undervalued...you can infer it from the WTI-Brent spread hitting a low of -$2.35 (versus a normal average of positive $0.7) and the contangon widening again to around $3.00...every time this has happened in the ast few months it switched back with WTI increasing (look at WTI at $35 on 1/15 as a perfect example...the crack hit $13.9 then)

Apr 07 03:08 PM