crack spread calculations demystified

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Crack Spread Calculations Demystified15 commentsy: Hard Assets Investor

March 05, 2009 | about stocks: DBO /OIL /SCO /UGA /UHN

By Brad Zigler

Each week, we comment on the U.S. Department of Energy reports of crude oil and fuel inventories (see our last commentary, "GotGas? There's Less Now"). As part of our commentary, we depict potential profit margins that oil refiners can obtain by "cracking" crudil into its major tradable distillates: gasoline and heating oil. This so-called "crack spread" represents the dollars earned, above the cf crude oil inputs, by selling wholesale lots of refined products.

We get lots of questions about our crack spread computations. Traders and market observers wonder, at times, if we've been breathracking tower fumes a bit too long. Allow us to set the record straight.

First of all, we derive our numbers from that most transparent of petroleum marketplaces-futures. As such, the crack spread is generoesn't represent the profit margin earned by all refiners. Or any onerefiner, in fact. The crack spread, and the resulting refining mar

s more a rough topographic map than a GPS tracker of profit. Still, even crudely derived - ahem- margins can point to rough or smooads ahead for refiners and investors.

For example, some refiners use light, sweet grades of crude deliverable against New York Mercantile Exchange [NYMEX] futures. ThNYMEX basis grade is West Texas Intermediate [WTI], a crude that yields more gasoline than more viscous and sour grades. Ourumbers are based upon a classic WTI crude refining model (3-2-1) that yields two barrels of gasoline and one barrel of heating oil fovery three barrels of oil input.

Other crudes, such as OPEC basket grades, yield less gasoline, so a 2-1-1 (two barrels of crude producing one barrel, each, of gasond heating oil) may better describe operations based upon these inputs. Often, news reports referencing crack spreads are based u-1-1 pricing.

Calculating The Spread

Calculating a crack spread requires you to first rationalize crude oil and distillate prices. Crude oil is priced in dollars per barrels, butasoline and heating oil prices are denominated in gallons. Let's suppose the nearby NYMEX crude futures settled at $40.00 per bar

That's the input. The refining output is represented by gasoline and heating oil contracts deliverable in the month followingthe crudeelivery. Hedgers and traders use distillate prices a month out from the crude expiration to simulate a storage, refining and marketingycle. Let's suppose gasoline last settled at $1.28, while heating oil did so at $1.16.

A crude oil futures contract calls for delivery of 1,000 barrels. So too, do the distillate contracts, albeit indirectly. Heating oil and gasoontracts specify delivery of 42,000 gallons, but with a barrel holding 42 U.S. gallons, it's really 1,000 barrels. Just multiply the distillarices by 42 to get the barrel prices. Your gasoline, then, fetches $53.76 a barrel, and a barrel of heating fuel, $48.72.

The 3-2-1 crack spread is found through simple arithmetic as:

GasolineHeating OilCrude Oil

[(2 x $53.76) + (1 x $48.72)] - (3 x $40.00) = $36.24 per 3 barrels, or $12.08 per barrel, of crude

Similar math is employed to derive a 2-1-1 crack:

GasolineHeating OilCrude Oil

[(1x $53.76) + (1x $48.72)] - (2 x $40.00) = $22.48 per 2 barrels, or $11.24 per barrel, of crude

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As you can see, there's a difference in crude yields depending upon the refining model employed. Crack spreads are seasonal. The 3spread, double-weighted in gasoline, tends to outperform the 2-1-1 spread when gasoline prices rise in relation to heating oil.

Seasonally, that's typically in winter and spring ahead of the peak summer driving season. Slackening demand for petrol, on the otheand, can push the 3-2-1 spread to a discount. In the terminal stages of the oil price spiral, for example, gasoline was well-supplied,ressuring the spread under the 2-1-1 crack. Then, at the oil price peak, demand for gasoline dissipated, further deepening the disco

Only since February has the 3-2-1 spread returned to premium and, if history is any guide, points to a May peak.

Crack Spread Models

The ETF Spread

Not everybody, of course, cares to trade in futures. We've mentioned the recent introduction of exchange-traded funds that make amargin-free alternative possible. Think of these collectively as a "good news, bad news" version of the crack spread. The good news hat these ETFs can create a 2-1-1 replicant. The bad news? No 3-2-1 simulant.

Buying equal lots of the ProShares UltraShort DJ-AIG Crude Oil ETF (NYSE Arca: SCO), the United States Gasoline Fund (NYSArca: UGA) and the United States Heating Oil Fund (NYSE Arca: UHN) puts you short two units of oil and long one unit each ofasoline and heating oil- la the 2-1-1 model.

The price of the ProShares SCO fund represents the cost of acquiring two units of oil, while the value of the UGA and UHN funds stan as the proceeds derived from selling the distillates. Since the introduction of the ProShares SCO last November, the ETF proxy'sroduced a 13.8% gain versus the 15.1% return generated by the futures model.

2-1-1 Crack Spread (Futures Vs. ETF)


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You can see the ETF spread doesn't exactly track its futures analogue. There are two reasons for the disparity. First, the futures spres based upon settlement - not last sale - values. The ETF spread, however, reflects the last sale data available to retail investors. Usnd-of-day bids or NAVs narrows the apparent difference significantly. The difference between the ETFS' last reported sale and end-

ay indicative values has been as wide as 77 basis points (0.77%) recently.

There's another source of dissonance that can't be adjusted away through selective quotation, though. Contango or backwardation iseflected in the ETF spread. The product ETFs, by design, are continuously invested in front-month futures, rather than second-montontracts. The current difference between first- and second-month futures runs between a 15 basis point discount for gasoline to an 8asis point premium for heating oil.

Hopefully, this discourse has cleared the air. Or, at least waved away some of those nagging cracking tower fumes.


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