Crack Spreads explained by professional Forex trading experts the “ForexSQ” FX trading team.
Crack Spreads
Crack spreads are processing spreads in crude oil. A processing spread is one in which one tradable commodity is the product of another tradable commodity. Crack spreads represent the economics of refining a barrel of crude oil into the various components, the oil products. Some examples of oil products are gasoline, heating oil, fuel oil, jet fuel, diesel fuel, asphalt base, kerosene and there are others.
Refining crude oil into products has always been a volatile business from a revenue generating perspective. The higher a crack spread, the more profits a refinery generates. When crack spreads move lower profit margins decline. When crack spreads move too low oil refining can become a losing proposition. Refineries require huge sums of capital to cover operating costs. When a crack spread drops to a level that is below a refinery’s breakeven point the business loses money.
Cracking is the process of refining the raw crude into products. This is because the process involves treating the raw oil often passing it through a catalytic cracker. Different grades of crude oil have different properties thus requiring different treatment when it comes to refining. This creates different economics for varying grades of crude oil. Cracking crude oil breaks down large hydrocarbon molecules into smaller ones.
Processing raw crude oil into useful products is an imperative- the raw crude has few industrial applications. Oil refineries are huge plants that usually process over one hundred thousand barrels of crude oil each day. Refineries tend to be seasonal. They produce products in order to meet demand. Therefore, many refineries prepare for driving season by processing more gasoline and prepare for heating season by processing more heating oil.
The United States is the world’s largest consumer of oil. Gasoline tends to rally towards summer months, or driving season. Heating oil tends to appreciate in price during winter months, or heating season. Sometimes refineries need to shut down between seasons to retool and update their facilities.
The first oil refinery opened in Ploiesti, Romania in 1857. In the 19th Century, refineries in the United States processed crude oil mainly to recover kerosene. Today there are oil refineries all over the world to meet the energy demands of a growing global population. The largest crude oil refinery in the world as of September 2013 is the Reliance Jamnagar Refinery in India, which has a capacity of 1.24 million barrels of crude per day. The second largest is the Paraguana Refining Centre in Venezuela with a capacity of 995,000 barrels per day. The third, fourth and fifth largest are all in South Korea and sixth is the Port Arthur Refinery in Texas which has a 600,000 barrel per day capacity. The United States has the biggest aggregate refining capacity in the world followed by China, Russia, Japan, India, South Korea, Italy, Saudi Arabia, Germany and Canada. Refining crude oil into products involves distinct price risks.
In order to manage those risks traders and companies involved in refining often hedge the differentials between crude oil and oil products.
Futures exchanges offer contracts on cracks spreads. These spreads are often more volatile than the underlying price of crude oil itself. The NYMEX division of the CME offers contracts on Reformulated Blendstock for Oxygenate Blending (commonly called RBOB) gasoline. The exchange also offers contracts on heating oil crack spreads. Since heating oil is similar to diesel fuel, sometimes hedgers employ the heating oil contracts and heating oil crack spreads to lock in prices for diesel requirements. Crack spreads also attract speculators and investors. Monitoring crack spreads is an imperative when it comes to understanding the oil markets. In many ways, the level of crack spreads provides a real-time indicator of refinery profitability.
Understanding and watching the level of crack spreads can also help gauge demand for oil products that are one of the key determinates of the ultimate direction of the price of crude oil.
When it comes to the world of crude oil, crack spreads serve as a benchmark price for refining and are a major factor in understanding global oil markets.
Crack Spreads Conclusion
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