This crack spread explanation is continued from http://stockguy22.com/crack-spread-trade-it/.
Presented here are some of the factors the affect crude oil prices and the prices of the well known refined products.
Crude oil prices
Oil demand: Broadly affected by the state of the global economy, as more economic activity generally requires more energy. Recently, non-OECD (Organization for Economic Co-operation and Development) nations have been consuming more and more oil as their economies grow and develop. Meanwhile, oil demand from OECD nations has been flat or falling because their economies are more mature and they’re further using other fuel sources such as renewables, nuclear, and natural gas.
Oil supply: Affected by worldwide oil production. In recent years, oil production in the United States and Canada has increased greatly, which has added stability to global oil supply because production from other sources such as the North Sea has begun to decline. Additionally, OPEC (Organization of Petroleum Exporting Countries) plays a major role in setting global oil supply, as the member countries produce a significant portion of the world’s global oil. OPEC members also periodically convene to discuss optimal pricing and supply.
Speculation: Speculation by market participants through instruments such as crude oil futures also plays a role in setting oil prices. For instance, regarding the extreme oil price volatility seen in 2008, when prices hit almost $150 per barrel at points, economist Thomas Palley stated, “The actual behavior of oil prices is consistent with speculation. In June, oil prices leapt by $11 in one day, and in July they fell back by $15 in three days. Such volatility does not fit a fundamentals-driven market.”
Finished product prices
Gasoline: One of the major drivers of gasoline prices is gasoline demand, driven primarily by miles driven by cars. More cars on the road and more driving create more demand for gasoline. Demand can be seasonal, as more driving occurs in the summer. Higher oil prices also push gasoline prices higher because crude oil is the primary input for gasoline.
Distillates: Includes a group of similar products used for jet fuel, gas turbine fuel, kerosene for heaters and lamps, diesel fuel, home heating fuel oil, and industrial fuel. All have their own unique demand drivers. For example, jet fuel is in higher demand in the summer when more flying occurs. Kerosene burns in portable space heaters, stoves, and water heaters and is in higher demand in the winter. Diesel is another common fuel used for vehicles, and like gasoline it’s in higher demand in the summer driving season. Home heating oil (light fuel oil) is in higher demand during the winter.
Refinery capacity and operations
More refining capacity online can depress crack spreads because that essentially results in more competition to supply the marketplace with finished fuels. During extended periods of low crack spreads, the least profitable refineries may be forced to shut down, which helps to rationalize refining capacity and rebalance the market.
Events that affect refinery operations, such as hurricanes, can take some refineries temporarily offline, thereby causing crack spreads to spike for short periods.
Turnarounds are planned shutdowns of a refinery in order to perform maintenance, repairs, and testing. When a refinery undergoes a turnaround, it’s offline, and this also increases crack spreads.
Crack spreads and earnings
Crack spreads are a major determinant of refinery earnings. Due to the volatile nature of crack spreads, earnings of refining companies can also vary widely from period to period. Because refiners’ earnings can be volatile, refiner valuations can be too. Additionally, refining stocks tend be higher beta than other energy stocks.
Refiners can use different strategies to hedge out the volatility of the spreads using futures, options, or a combination of the derivatives.
Here are some of the more popular stocks and ETFs to trade using the crack spread.
|ALJ||AMLP (etf)||XLE (etf)|
The effect of crack spreads on refiner margins
A typical refinery company’s financial statement would read like this:
- Revenues (finished products times selling prices times volume equals revenues)
- Less the cost of products sold (generally the cost of the crude oil purchased)
- Less direct operating expenses (such as natural gas used for fuel, chemicals and catalysts, utilities)
- Less selling, general, and administrative expenses
- Less depreciation and amortization
- Equals operating income