In the petroleum industry, refinery executives are primarily focused on hedging the difference between their input costs and output prices. Refiners’ profits are tied directly to the spread, or price difference, between crude oil and refined products — gasoline and distillates (diesel and jet fuel). The term originates from the refining process that “cracks” crude oil into its major refined products.

A petroleum refiner, like most manufacturers, straddles two markets: the raw materials it needs to purchase and the finished products it sells. The price of crude oil and its principal refined products are often independently subject to the variables of supply, demand, production economics, environmental regulations and other factors. As such, refiners and non-integrated marketers, or independent traders, can be vulnerable to risk when the price of crude oil rises while the prices of the refined products remain stable, or even decline.

Such a situation can severely narrow the crack spread, which represents  a refiner’s profit margin  relative to the cost of the crude oil it purchases and the price of the refined products it sells. Because refiners are on both sides of the market at once, their exposure to market risk can be greater than that incurred by companies that simply sell crude oil, or sell products to the wholesale and retail markets.

Beyond covering operational and fixed costs of operating the refinery, refiners seek to achieve a rate of return on their invested assets. While most refiners can estimate  their costs, other than for crude oil, an uncertain crack spread can considerably cloud their true financial exposure.

The investor community may use crack spread trades as a hedge against a refining company’s equity value, whereas other traders may consider incorporating crack spreads as a directional trade as part of their energy portfolio, benefitting from low margins due to the substantial spread credit received for margining purposes. 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.

A crack spread is quoted in dollars per barrel. Since crude oil is quoted in dollars per barrel and refined products are quoted in cents per gallon, the diesel and gasoline price must be converted to dollars per barrel by multiplying the cents per gallon price by 42 (42 gallons = 1 barrel). If the refined product value is higher than the price of the crude oil, the cracking margin is positive. Conversely, if the refined product value is less than that of crude oil, then the gross cracking margin is negative.

The table below outlines the contract specifications for the three primary futures contracts used to construct crack spreads: Light Sweet Crude Oil futures, RBOB Gasoline futures, and NY ULSD futures.

There are several ways to manage the price risk associated with operating a refinery. Given that a refinery’s output varies according to plant configuration, crude slate, and seasonal product demands, various types of crack spreads are available to help refiners hedge different ratios of crude and refined products.

The most common type of crack spread is one RBOB Gasoline or NY ULSD versus one WTI futures contract, which represents the refinery profit margin between the refined products (gasoline or diesel) and crude oil. The crack spread approximates the theoretical refining margin and is executed by selling the refined products futures and buying Crude Oil futures, thereby locking in the differential between the refined products and crude oil.

If refiners expect crude oil prices to hold steady, or rise somewhat, while products prices fall (a declining crack spread), the refiners would “sell” the crack, i.e. they would sell gasoline or diesel futures and buy crude oil futures. Whether a hedger is “selling” the crack or “buying” the crack, reflects what is done on the product side of the spread, traditionally, the premium side of the spread.

There are more complex hedging strategies for crack spreads that are designed to replicate a refiner’s yield of refined products. A typical refinery adopts a 3:2:1 ratio as gasoline output is approximately double that of distillate fuel oil (the cut of the barrel that contains diesel and jet fuel). This refining ratio has prompted market participants to concentrate on 3:2:1 crack spreads — three Crude Oil futures contracts versus two Gasoline futures contracts and one ULSD futures contract.

A refiner running crude oil with a lower yield of gasoline relative to distillate might be interested in trading other crack spread combinations, such as a 5:3:2 crack spread. This crack spread ratio is executed by selling the five refined products futures (i.e., three RBOB gasoline futures and two ULSD futures) and buying five crude oil futures contracts, thereby locking in the 5:3:2 differential that more closely replicates the refiner’s cracking margins.

Traders may consider using diversified crack spreads as a directional trade as part of their overall portfolio. Also, the hedge fund community may use a diversified 3:2:1 or 5:3:2 crack spread trade as a hedge against a refining company’s equity value.

When evaluating crack spreads, there are several factors that can affect their value. Generally, crack spreads strengthen when product supply tightens due to refinery maintenance or strict environmental regulations or during periods of strong, sustained economic demand. Seasonality also plays a role with gasoline cracks strengthening in the summer and ULSD cracks in the winter. Crack spreads typically weaken during economic slowdowns or when input costs are higher relative to refined products during geopolitical issues. In addition, the U.S. dollar weakens the crack while strengthening crude oil.

In January, a refiner reviews their crude oil acquisition strategy and potential gasoline margins for the spring. Seeing that gasoline prices are strong, the refiner plans a two-month crude-to-gasoline spread strategy that will allow them to lock in their  margins. Similarly, a trader can analyze the technical charts and decide to “sell” the crack spread as a directional play, if the trader takes a view that current crack spread levels are relatively high and will probably decline in the future.

In January, the spread between April Crude Oil futures ($65.50 per barrel) and May RBOB Gasoline futures ($2.10 per gallon or $88.20 per barrel) presents what the refiner believes to be a favorable 1:1 crack spread of $22.70 per barrel. Typically, refiners purchase crude oil for processing in a particular month, and sell the refined products one month later.

The refiner decides to “sell” the crack spread by selling RBOB Gasoline futures and buying Crude Oil futures, thereby locking in the $22.70 per barrel crack spread value. He executes this by selling May RBOB Gasoline futures at $2.10 per gallon (or $88.20 per barrel) and buying April Crude Oil futures at $65.50 per barrel.

Two months later, in March, the refiner purchases the crude oil at $86.25 per barrel in the cash market for refining into products. At the same time, the refiner sells gasoline from their  existing stock in the cash market for $2.50 per gallon, or $105.00 per barrel. The refiner’s crack spread value in the cash market has declined since January and is now $18.75 per barrel ($105 per barrel gasoline less $86.25 per barrel for crude oil).

Because the futures market reflects the cash market, April Crude Oil futures are also selling at $86.25 per barrel in March — $20.75 more than when the refiner purchased them. May RBOB Gasoline futures are also trading higher at $2.50 per gallon ($105.00 per barrel). To complete the crack spread transaction, the refiner buys back the crack spread by first repurchasing the Gasoline futures they sold in January, and the refiner also sells back the Crude Oil futures. The refiner locks in a $3.95 per barrel profit on their  crack spread futures trade.

The refiner has successfully locked in a crack spread of $22.70 (the futures gain of $3.95 is added to the cash market cracking margin of $18.75). Had the refiner been unhedged, their cracking margin would have been limited to the $18.75 gain the refiner had in the cash market. Instead, combined with the futures gain, the refiner’s final net cracking margin with the hedge is $22.70 — the favorable margin he originally sought in January.

An independent refiner who is exposed to the risk of increasing crude oil costs and falling refined product prices runs the risk that their refining margin will be less than anticipated. The refiner decides to lock-in the current favorable cracking margins using the 3:2:1 crack spread strategy, which closely matches the cracking margin at the refinery.

On September 15, the refiner decides to “sell” the 3:2:1 crack spread by selling two RBOB Gasoline futures and one ULSD futures and buying three Crude Oil futures, thereby locking in the 3:2:1 crack spread of $30.40 per barrel. He executes this by selling two December RBOB Gasoline futures at $1.90 per gallon ($79.80 per barrel) and one December ULSD futures at $2.30 per gallon ($96.60 per barrel), and buying three November Crude Oil futures at $55.00 per barrel.

One month later, on October 15, the refiner purchases the crude oil at $65.00 per barrel in the cash market for refining into products. At the same time, he also sells gasoline from his existing stock in the cash market for $2.00 per gallon ($84.00 per barrel) and diesel fuel for $2.40 per gallon ($100.80 per barrel). The 3:2:1 crack spread value in the cash market has declined since September, and is now $24.60 per barrel.

Since the futures market closely reflects the cash market, November Crude Oil futures are also selling at $65 per barrel — $10 more than when he purchased them. December RBOB Gasoline futures are also trading higher at $2.00 per gallon ($84.00 per barrel) and December ULSD futures are trading at $2.40 per gallon ($100.80 per barrel). To liquidate the 3:2:1 crack spread transaction, the refiner buys back the crack spread by first repurchasing the two Gasoline futures and one ULSD futures he sold in January, and he also sells back the three Crude Oil futures. The refiner locks in a $5.80 per barrel profit on this crack spread futures trade.

The refiner has successfully locked in a 3:2:1 crack spread of $30.40 (the futures gain of $5.80 is added to the cash market cracking margin of $24.60). Had the refiner been un-hedged, his cracking margin would have been limited to the $24.60 gain he had in the cash market. Instead, combined with the futures gain, his final 3:2:1 cracking margin with the hedge is $30.40 — securing the favorable margin he originally sought in September.

The “purchase” of a crack spread is the opposite of the crack-spread hedge or “selling” the crack spread. It entails selling crude oil and buying refined products. In this example, the refiner is planning for upcoming maintenance, and decides to “buy” the simple 1:1 crack spread in January by buying RBOB gasoline futures and selling Crude Oil futures, thereby locking in the current $22.80 per barrel crack spread value. He executes this by buying May RBOB Gasoline futures at $2.15 per gallon (or $90.30 per barrel), and selling April Crude Oil futures at $67.50 per barrel.

Two months later, in March, when the refiner begins the refinery maintenance, he sells the crude oil at a lower price of $57.50 per barrel in the cash market because of the refinery closure. At the same time, he also buys gasoline in the spot market for $2.50 per gallon, or $105.00 per barrel. The crack spread value in the cash market has increased since January, and is now $47.50 per barrel ($105.00 per barrel gasoline less $57.50 per barrel for crude oil).

Because the futures market reflects the cash market, April crude oil futures are also selling at $57.50 per barrel in March — $10.00 less than when he purchased them in January. May RBOB Gasoline futures are trading higher at $2.50 per gallon ($105.00 per barrel). To complete the crack spread transaction, the refiner liquidates the crack spread by first selling the Gasoline futures he bought in January, and he buys back the Crude Oil futures at a current level of $47.50 per barrel. The refiner locks in a $24.70 per barrel profit on this crack spread futures trade ($47.50 per barrel less the $22.80 per barrel crack spread in January).

The refiner has successfully hedged for the rising crack spread (the futures gain of $24.70 is added to the cash market cracking margin of $22.80). Had the refiner been unhedged, his margin would have been limited to the $22.80 gain he had in the cash market. Instead, combined with the futures gain, his final net cracking margin with the hedge is $47.50.