What is the crack spread and how do I trade it?

What is the Crack Spread?

The crude oil distillation tower and the corresponding outputs at various temperatures.


Crack spread is a term used in the oil industry and futures trading for the differential between the price of crude oil and petroleum products extracted from it – that is, the profit margin that an oil refinery can expect to make by “cracking” crude oil (breaking its long-chain hydrocarbons into useful shorter-chain petroleum products).

In the futures markets, the “crack spread” is a specific spread trade involving simultaneously buying and selling contracts in crude oil and one or more derivative products, typically gasoline and heating oil. Oil refineries may trade a crack spread to hedge the price risk of their operations, while speculators attempt to profit from a change in the oil/gasoline price differential.

U.S. refineries produce about 19 gallons of motor gasoline from one barrel (42 gallons) of crude oil. The remainder of the barrel yields distillate and residual fuel oils, jet fuel, and many other products. Refinery yields of individual products vary from month to month as refiners focus operations to meet demand for different products and maximize profits.

One useful tool is to use the crack spread chart to uncover hidden strength in the energy complex. If crude oil begins to strengthen relative to the products then the crack spread will become less positive and the trend of the crack spread will weaken. Therefore, refinery profits will decline.

Refiners’ profits are tied directly to the spread, or difference, between the price of crude oil and the prices of refined products. Because refiners can reliably predict their costs other than crude oil, the crack spread is their major uncertainty. One way in which a refiner could ensure a given spread would be to buy crude oil futures and sell product futures.

Traditionally, crack spreads tend to be wider in the spring than in the fall because most refiners perform annual maintenance during late winter, less supply. Refiners tend to operate nearer capacity in the fall to assure heating oil supplies for the coming winter months, spreads are weak due to supply.

Of course, refiners can tweak their outputs to adapt to changing market conditions. When margins are soft, refiners can raise overall profitability either by slowing operations and keeping capacity utilization relatively low, or by closing down less efficient units entirely.

The crack spread does not take into account all product revenues, and excludes operating and feed-stock costs other than the price of crude oil. But, nonetheless, a crack spread can be a useful metric, particularly for directional changes in refiner margins.

Seasonality and Volatility

Crack spreads tend to be wider in late spring into fall due to summer gasoline demand and building heating oil stocks for winter.

For crude oil, relatively weak seasonal variation is depicted in the long-term factor, with volatility slightly higher for all twelve contracts during early fall through winter when demand peaks for heating in the Northern Hemisphere. The same seasonal pattern is observed for the two refined commodities, implying that the long-term shocks to the crude oil market correlate strongly with those of the two refined commodities.

For heating oil, the volatility in the last few months of trading is higher for the contracts maturing in late fall through the end of winter, during which the demand peaks for space heating. It is particularly high for the January   through March contracts due to low inventory at the end of the peak-demand season.   You might think that the southern hemisphere’s “winter” would even out the fluctuations, but the northern hemisphere has 90% of the world’s population – so it’s the northern winter that drives heating oil prices.

For unleaded gasoline, the volatility is high for contracts maturing in late summer through fall when gasoline inventory is low after the summer peak-demand season and before the commodity specification shifts from the summer to winter grade.  July through September can be a volatile time when gasoline stocks are low from summer driving season and refineries are preparing to switch to heating oil production or changing grades of gasoline.

Individual storms in the Gulf of Mexico have been shown to affect crack spread futures prices. As hurricanes strike refiner-dense areas, prices of refined petroleum products rise.  Crack spread prices are even affected by seasonal hurricane forecasts.  For example, a one standard deviation increase in the June forecast of the net tropical cyclone activity in the upcoming season increases 3-2-1 crack spread prices by over 9%.

Another important, but less well known, reason for rising crack spreads and gasoline prices is that May 1 marks the date for most of the country when more costly summer-grade gasoline is required (April 1 in southern California). The maximum allowable vapor pressure, which is measured as Reid vapor pressure (Rvp), is the primary distinction between winter- and summer-grade gasoline.  When the weather turns warm, a high vapor pressure increases the evaporation of the gasoline into the atmosphere. The volatile organic compounds that are released from gasoline into the air not only contribute directly to health problems, but also indirectly through the formation of ground-level ozone and smog. Gasoline vapor pressure is also important for an automobile engine to operate efficiently. Vapor pressure must be high enough to allow an engine to start easily, but it must not be so high as to lead to vapor lock, which stalls the engine when gasoline in the engine’s fuel delivery system prematurely turns from liquid to vapor.

Reducing gasoline vapor pressure to lessen harmful emissions and maintain car drive-ability during the summer adds to refiners’ operating costs in the second and third quarters. Because of these higher costs, the rise in the crack spread during the summer months overstates the actual increase in the profitability of gasoline sales.

Source:  http://www.eia.gov/forecasts/steo/


For instance, a refiner expecting the spread to contract in the future may buy oil futures, and sell the products such as Heating Oil futures, and/or Gasoline futures (RBOB).  This locks in a future price for taking crude and refining into salable components.

The crack spread X:Y:Z reflects the spread obtained by trading oil, gasoline and distillate according to this ratio. Widely used crack spreads have included 3:2:1, 5:3:2 and 2:1:1.  As the 3:2:1 crack spread is the most popular of these, widely quoted crack spread benchmarks are the “Gulf Coast 3:2:1″ and the “Chicago 3:2:1″.

As of May 17th, 2013, 3:2:1 Ratio

Barrel of Crude Oil Price = 96.27

Barrel of Gas = 2.89*42 =  121.38

Barrel of Heating Oil = 2.93*42 = 123.06


The Math

3 Barrels of Crude  = 96.27*3 = 288.81

Produces 2 gas & 1 heating oil = (2*121.38)+(123.06) = 365.82

Crack Spread = Outputs – Inputs = 365.82 – 288.81 = 77.01 profit per 3 barrels of crude = 25.67 per barrel


Profit Margin

profit / cost = 25.67/96.27 = 26.67%

So a refiner is making an estimated 26.67% gross refining margin per barrel of crude into its components.

Cost of Goods

$77.01 / 365.82 = 21.05% profit on 3:2:1 refined.

This is the number stock analysts watch when evaluating a publicly traded refining company. It’s useful to know both numbers because one running significantly ahead of the other often signals windfalls.


Margin Differential:  

26.67% – 21.05% = 5.62%

Long positions in the independents are favored as soon as the differential between the two margins tips over 5%.


Let’s keep this simple.


What futures are involved?

WTI Crude Futures (CL)

Heating Oil Futures (HO)

RBOB Gasoline futures (RB)

What are the ratios?

The simplest ratio is a 1:1 ratio, selling a CL contract and buying an RB or HO contract.  RB is priced in gallons, and CL is priced in barrels, since there are 42 gallons in a barrel of crude, to chart it in ThinkorSwim use (42*/RB)-/CL.


3-2-1 Ratio

Typically one uses the 3-2-1 ratio because it mirrors the refinery output ratio required to produce the bi-products from crude oil. This commonly used formula represents the theoretical refining margin that two barrels of unleaded gasoline and one barrel of heating oil are derived from three barrels of crude oil.

The formula for ThinkorSwim: (2*42*/RB)+(42*/HO)-(3*/CL)


What if I don’t trade futures?

If you can’t trade futures or are uneasy with the leverage, then you can take advantage of the spread in many other ways. Remember that we said refiners profits are directly tied to the crack spread?

Do you know of any refiners that are public companies?


The crack spread can be simulated by selling short the United States Oil Fund (USO) while buying the United States Gasoline Fund (UGA) and the United States Heating Oil Fund (UHN). Without a margin break, however, the ETF version of the trade isn’t as attractive as futures.

Independent Oil & Gas Stocks

Long positions in the independents are favored as soon as the differential between the two margins tips over 5%.

Integrated oil companies such as ExxonMobil (XOM) and Chevron Corp. (CVX) have a natural hedge against adverse price movements of the refining spread components because they control their entire supply chain. It’s the independent oil refiners that are favored to use crack spreads to hedge their operational risks.

The outright purchase of an independent oil refiner such as Valero Energy Corp. (VLO), Tesoro Corp. (TSO) or Holly Corp. (HFC) can be timed with the margin differential at extremes.

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