Commodity Traders are Wicked Smart.

Take a behind-the-scenes look into what drives billions on energy trading desks.

In just 1 century, the commodities trading market has transformed into a nearly $100 billion industry, delivering record profits on an annual basis. But more interesting than the size of the market is the sophisticated techniques deployed by some of the largest and smartest commodity trading shops.

There’s no better example of this ingenuity than: The “Crack” Spread.

Background — Crack? That sounds weird.

The name of this may be a bit off-putting (if you’re from the U.S.) and maybe laughable, but I assure you, this is something else.

The crack spread refers to the pricing difference between a barrel of crude oil and the petroleum products refined from it. The “crack” being referred to is an industry term for breaking apart crude oil into the component products, including gases like propane, heating fuel, gasoline, light distillates, like jet fuel, intermediate distillates, like diesel fuel, and heavy distillates, like grease.

The reason for tracking this spread between crude oil and crude-derived products, is that it is a major factor in the profitability of the refining companies.

The job of a petroleum refining company is to buy the raw crude oil, process it, then sell the processed products (diesel, jet fuel, etc.) for a profit. However, despite the products being derived from crude oil, the prices of the products don’t always move in tandem with the price of the underlying crude oil.

This leads to an extremely precarious position where if crude prices rose, but say, the price of diesel didn’t; the refiner has to pay higher prices for the raw crude oil, but they would have to sell the diesel for a loss since it didn’t also rise.

The continuous nature of this risk validates the existence of commodity trading desks. By structuring trades around the crack spread, traders can hedge this risk for the refining companies and ensure survival and sustained profitability.

Let’s see what that might look like:

Trading The Spread

There is a wide degree of variability in the strategies used to trade the spread, but we’ll focus on the most common, the 3:2:1 spread.

This spread assumes that for every three barrels of crude oil, two barrels of gasoline and one barrel of distillate fuel oil (such as diesel or heating oil) are produced. By comparing the combined value of the refined products to the cost of the crude oil, traders can estimate the profitability of refining operations and make decisions based on that information.

Let’s assume the following market prices:

• Crude Oil: $60 per barrel
• Gasoline: $2 per gallon
• Distillate Fuel Oil (e.g., diesel or heating oil): $2.2 per gallon

First, we need to convert the gasoline and distillate fuel oil prices from gallons to barrels. There are 42 gallons in a barrel, so:

• Gasoline: $2 per gallon * 42 gallons = $84 per barrel
• Distillate Fuel Oil: $2.2 per gallon * 42 gallons = $92.4 per barrel

Next, we’ll calculate the total value of the refined products:

• Value of refined products = (2 barrels of gasoline * $84 per barrel) + (1 barrel of distillate fuel oil * $92.4 per barrel) = $168 + $92.4 = $260.4

Now, we’ll find the total cost of the crude oil:

• Cost of crude oil = 3 barrels * $60 per barrel = $180

Finally, we’ll calculate the 3:2:1 spread:

• Crack spread = Value of refined products — Cost of crude oil = $260.4 — $180 = $80.4 per 3 barrels of crude oil

To find the crack spread per barrel, we can divide the result by 3:

• Crack spread per barrel = $80.4 / 3 = $26.8

In this example, the 3:2:1 crack spread is $26.8 per barrel. This means that, under these market conditions, a refiner can earn a gross margin of $26.8 for each barrel of crude oil processed into gasoline and distillate fuel oil.

As market conditions change, so will this spread value. When this value becomes negative or close to zero (combined value of the refined products lower than cost of crude), it means that under current market conditions, the refinery firm cannot profit.

At that point, the trading desk will most likely hedge buy selling futures on the refined products to lock-in the prices. They may also simultaneously buy crude oil futures to secure the price and hedge against potential further price increases.

Pretty smart, right?

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Happy trading! :)