Halloween's approaching, and with it comes the prospect of tricks and treats for oil market traders. For traders plying the "crack spread," one of the market's tricks actually turns out to be more of a treat.

These ghoulish-sounding crack spreads ("crack" refers not to the crushing of bones but the busting of hydrocarbon molecules) simulate the economics of oil refining. For example, a refiner typically buys crude oil and processes it into products, such as gasoline and heating oil, for subsequent sale. Thus, a refiner's profits are highly dependent upon purchasing crude at a sufficient discount to the proceeds of the refined product.

There are two main types of crack spreads to note. The so-called 2-1-1 crack, geared for either winter refining or the use of heavier grades of crude, yields one barrel each of gasoline and heating oil for every two barrels of input crude. Lighter, sweeter inputs such as West Texas Intermediate can supply incrementally more gasoline and may be cracked in a "3-2-1" ratio; that is, every three barrels of crude supply two barrels of gasoline and one barrel of heating oil.

Spread Calculations

The first step in determining the potential profit represented by a crack is rationalizing the spread's components.

Crude oil is priced by the barrel, but gasoline and heating oil prices are denominated in gallons. Both futures contracts, however, call for the delivery of 1,000 barrels, albeit indirectly in the case of distillate futures. (Heating oil and gasoline contracts, priced in cents per gallon, require a 42,000-gallon delivery, but with each barrel holding 42 U.S. gallons, it's really just 1,000 barrels, like crude futures. To determine the gross crack spread implied by futures, a trader simply multiplies distillate prices by 42 to obtain their barrel equivalents.)

Let's walk through an example. Suppose that nearby NYMEX crude futures are offered at $80.00 per barrel. That represents a refiner's input cost.

The processing output is typically represented by gasoline and heating oil contracts deliverable in the month following crude delivery, as this better simulates the actual storage, refining and marketing timeline. So let's suppose gasoline a month forward of the crude delivery is bid at $2.00 a gallon, while heating oil's fetching $2.10.

Converting the distillates to their barrel equivalents makes gasoline worth $84 a barrel ($2.00 a gallon x 42 gallons) and heating oil $88.20 a barrel ($2.10 a gallon x 42 gallons).

The 3-2-1 crack spread can then be calculated using the simple arithmetic:

3-2-1 Crack Spread = [(2 x Gasoline) + (1 x Heating Oil)] - (3 x Crude Oil)

or [(2 x $84.00) + (1 x $88.20)] - (3 x $80.00) = $16.20 per 3 barrels of crude, or $5.40 per barrel.

The math for a 2-1-1 crack is similar:

2-1-1 Crack Spread = [(1 x Gasoline) + (1 x Heating Oil)] - (2 x Crude Oil)

or [(1x $84.00) + (1x $88.20)] - (2 x $80.00) = $12.20 per 2 barrels of crude, or $6.10 per barrel.

The 2-1-1 crack commands a premium over the 3-2-1 spread typically in the fall and winter, as the demand for heating oil increases. Fortunes reverse ahead of the summer driving season, when the gasoline-heavy 3-2-1 crack tends to outperform the 2-1-1 spread.

Interpreting The Crack Spread

Variances in the crack spread reflect the pricing of input crude relative to its output products. Generally speaking, there's a negative correlation between crude oil prices and the crack spread; meaning when oil prices increase, profit margins tend to contract.

Also, in great part, crude oil tends to re-price more quickly than the products, so crack spreads tend to widen or narrow when crude oil prices move precipitously. For example, last year, when crude peaked at $145.29 just before Independence Day, the 3-2-1 crack spread stood at $13.12 a barrel. By the time oil bottomed at $33.98 in mid-February 2009, the spread had widened to $22.98.

Additionally, there's a positive correlation between the crack spread and capacity utilization, reflecting refiners' ability to modulate their product availability. Refinery operators clearly have more maneuvering room on the downside to deal with slackening demand. For example, in September 2008, after the summer driving season ended, utilization dropped below 67 percent as refining margins thinned.

Refinery capacity constraints will likely be felt even in a robust economic recovery, should demand for products overtax existing facilities. After all, it'll take a long time to put new refining capacity online.

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