HardAssetsInvestor

Written by Brad Zigler  |

June 17, 2008

Time For Crack Spreads?

Details

Managing editor of HardAssetsInvestor.com
Brad Zigler demystifies the obscure trading
strategy.

• The simple arithmetic
• The ebb and flow of refining margins
• Capacity utilizationf

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.