Crack Spread - Futures Trading

Futures Trading

For integrated oil companies that control their entire supply chain from oil production to retail distribution of refined products, there is a natural economic hedge against adverse price movements. For independent oil refiners which purchase crude oil and sell refined products in the wholesale market, adverse price movements can present a significant economic risk. Given a target optimal product mix, an independent oil refiner can attempt to hedge itself against adverse price movements by buying oil futures and selling futures for its primary refined products according to the proportions of its optimal mix.

For simplicity, most refiners wishing to hedge their price exposures have used a crack ratio usually expressed as X:Y:Z where X represents a number of barrels of crude oil, Y represents a number of barrels of gasoline and Z represents a number of barrels of distillate fuel oil, subject to the constraint that X=Y+Z. This crack ratio is used for hedging purposes by buying X barrels of crude oil and selling Y barrels of gasoline and Z barrels of distillate in the futures market. The crack spread X:Y:Z reflects the spread obtained by trading oil, gasoline and distillate according to this ratio. Widely used crack spreads have included 3:2:1, 5:3:2 and 2:1:1. As the 3:2:1 crack spread is the most popular of these, widely quoted crack spread benchmarks are the "Gulf Coast 3:2:1" and the "Chicago 3:2:1".

Various financial intermediaries in the commodity markets have tailored their products to facilitate trading crack spreads. For example, NYMEX offers virtual crack spread futures contracts by treating a basket of underlying NYMEX futures contracts corresponding to a crack spread as a single transaction. Treating crack spread futures baskets as a single transaction has the advantage of reducing the margin requirements for a crack spread futures position. Other market participants dealing over the counter provide even more customized products.

The following discussion of crack spread contracts comes from the Energy Information Administration publication Derivatives and Risk Management in the Petroleum, Natural Gas, and Electricity Industries:

Refiners’ profits are tied directly to the spread, or difference, between the price of crude oil and the prices of refined products. Because refiners can reliably predict their costs other than crude oil, the spread is their major uncertainty. One way in which a refiner could ensure a given spread would be to buy crude oil futures and sell product futures. Another would be to buy crude oil call options and sell product put options. Both of those strategies are complex, however, and they require the hedger to tie up funds in margin accounts. To ease this burden, NYMEX in 1994 launched the crack spread contract. NYMEX treats crack spread purchases or sales of multiple futures as a single trade for the purposes of establishing margin requirements. The crack spread contract helps refiners to lock-in a crude oil price and heating oil and unleaded gasoline prices simultaneously in order to establish a fixed refining margin. One type of crack spread contract bundles the purchase of three crude oil futures (30,000 barrels) with the sale a month later of two unleaded gasoline futures (20,000 barrels) and one heating oil future (10,000 barrels). The 3-2-1 ratio approximates the real-world ratio of refinery output—2 barrels of unleaded gasoline and 1 barrel of heating oil from 3 barrels of crude oil. Buyers and sellers concern themselves only with the margin requirements for the crack spread contract. They do not deal with individual margins for the underlying trades. An average 3-2-1 ratio based on sweet crude is not appropriate for all refiners, however, and the OTC market provides contracts that better reflect the situation of individual refineries. Some refineries specialize in heavy crude oils, while others specialize in gasoline. One thing OTC traders can attempt is to aggregate individual refineries so that the trader’s portfolio is close to the exchange ratios. Traders can also devise swaps that are based on the differences between their clients’ situations and the exchange standards.