Crack spreads are a measure of the difference in price between crude oil and the refined petroleum products produced from it, such as gasoline, diesel, and jet fuel. The term “crack” refers to the process of breaking down crude oil into its component parts through refining.
A crack spread is typically calculated as the price of the refined product minus the price of the crude oil used to produce it. For example, if the price of gasoline is $2.50 per gallon and the price of the crude oil used to produce it is $50 per barrel, the crack spread would be $2.50 per gallon minus ($50/barrel divided by 42 gallons/barrel), or about $0.21 per gallon.
Crack spreads are an important tool for refiners and traders, as they can help to measure the profitability of refining operations. A high crack spread indicates that refining margins are strong, as the price of the refined product is higher than the cost of the crude oil used to produce it. Conversely, a low or negative crack spread indicates that refining margins are weak, as the price of the refined product is lower than the cost of the crude oil used to produce it.
Crack spreads can also be used by investors and analysts to track trends in the energy markets and to gauge the overall health of the refining industry. They can be influenced by a range of factors, including changes in the price of crude oil, changes in demand for refined products, and shifts in global refining capacity.
What is the 3-2-1 crack spread?
The 3-2-1 crack spread is a widely used benchmark for refining margins that measures the profitability of refining crude oil into gasoline and diesel fuel. It is called the 3-2-1 crack spread because it represents the profit margin obtained by refining three barrels of crude oil into two barrels of gasoline and one barrel of diesel fuel.
The calculation of the 3-2-1 crack spread involves subtracting the price of crude oil from the combined price of two barrels of gasoline and one barrel of diesel fuel. For example, if crude oil costs $60 per barrel, gasoline costs $2.50 per gallon (which is equivalent to $105 per barrel) and diesel fuel costs $2.75 per gallon (which is equivalent to $115.50 per barrel), the 3-2-1 crack spread would be:
($105 per barrel x 2) + ($115.50 per barrel x 1) – ($60 per barrel x 3) = $260.50
This means that the refiner would earn a profit of $260.50 for every three barrels of crude oil refined into two barrels of gasoline and one barrel of diesel fuel.
The 3-2-1 crack spread is an important benchmark for refiners, as it can help them to determine whether refining operations are profitable. When the crack spread is high, refining margins are strong, as the price of the refined products is higher than the cost of the crude oil used to produce them.
Conversely, when the crack spread is low or negative, refining margins are weak, as the price of the refined products is lower than the cost of the crude oil used to produce them.
How do refiners hedge crack spreads?
Refiners can hedge crack spreads using a variety of financial instruments and strategies to protect against unfavorable changes in refining margins.
Here are a few common ways that refiners may hedge crack spreads:
- Futures Contracts: Refiners can use futures contracts to hedge the price risk of crude oil and refined products. By taking long or short positions in futures contracts, refiners can lock in prices for crude oil and refined products and protect against price fluctuations.
- Options: Options are financial contracts that give the holder the right, but not the obligation, to buy or sell an asset at a specified price and time. Refiners can use options to protect against downside risk in refining margins. For example, a refiner could buy put options on gasoline or diesel futures to protect against a decline in the price of refined products.
- Crack Spread Options: Crack spread options are options contracts that are specifically designed to hedge against changes in refining margins. These options allow refiners to buy or sell a crack spread at a specified price and time.
- Swap Agreements: Refiners can enter into swap agreements with other parties to lock in a specific refining margin. For example, a refiner could enter into a swap agreement with a counterparty to receive payments when the crack spread exceeds a certain level and make payments when the crack spread falls below a certain level.
- Spread Trading: Refiners can also use spread trading strategies to hedge crack spreads. This involves taking long and short positions in different refining products to offset risk and protect against unfavorable changes in refining margins.
Overall, the choice of hedging instrument and strategy depends on the specific needs and risk profile of the refiner.
By hedging against fluctuations in refining margins, refiners can better manage their exposure to price risk and protect against unexpected losses.