Struggling Crack Spreads
Among the myriad of factors influencing the price of oil, the most salient one is possibly the 3-2-1 CME Group crack spread. It displays the price differential between three units of crude oil against second units of RBOB and one unit of heating oil. In the arena of Oil futures trading, it is as good a reflection of the physical refining margins in the world’s biggest economy as it gets. Consequently, it is a crucial barometer of the health of the oil market in general.
The chart above exhibits the average annual prices of CME Group’s flagship Crude Oil contract, WTI and the 3-2-1 crack spread over the past 10 years. The high positive correlation between the two (it has been over 90% since 2015) will not come as a surprise. Demand for crude oil, which reflects refiners' thirst for feedstock, is supported by consumer demand for products and is manifested in the strength or weakness of the crack spread. What is intriguing in the chart above is the recent weakness in refinery margins.
A multi-year low of $11.26/bbl in the annual average crack spread value was reached during the COVID-19 pandemic when the world’s economy came to a virtual standstill. It was coupled with WTI averaging below $40/bbl in 2020. The recovery saw refining margins reaching a summit of $38.46/bbl in 2022 also aided by Russia’s invasion of Ukraine. The U.S. crude oil benchmark peaked at $94.33/bbl that year.
The decline in the 3-2-1 crack spread since 2022 was nothing short of spectacular and is due to several factors. Firstly, a correction to the overreaction to the uncertainty precipitated by the Ukrainian war was inevitable. Secondly, Chinese economic headwinds and sub-5% growth have had a profound impact on the country’s product consumption. Thirdly, the transition from fossil fuel to renewable energy, however slow it is, also has a tangible effect on product demand. In the U.S., for example, gasoline and distillate consumption is likely to have peaked in 2018. For these reasons, reverting to the mean of the pre-2022 period of around $17/bbl is very much plausible, unless flare-ups in geopolitical tension will lead to significant and protracted supply shortages.
All examples in this report are hypothetical interpretations of situations and are used for explanation purposes only. The views in this report reflect solely those of the author and not necessarily those of CME Group or its affiliated institutions. This report and the information herein should not be considered investment advice or the results of actual market experience.