Crude oil is one of the most traded commodities in the world, as the fossil fuel is a key energy source for every economy. Traders and hedgers have a number of strategies for playing crude in the futures markets, but one of the most popular is known as a “crack spread.”
What Are Crack Spreads?
A crack spread is a trade where a long position is taken in oil futures while simultaneous short positions are taken in petroleum products that are derived from crude: most often gasoline and heating oil. The term “crack” comes from the fact that gasoline and heating oil are “cracked” off of crude oil; that is to say, they are by-products of crude.
The spread represents a theoretical refining margin. If the crack spread is positive, that means that the spread between crude and its byproducts has widened, making the trade profitable. An example would be if the price of crude oil rose faster than that of gasoline and heating oil, ultimately widening the spread. On the flip side, if the crack spread is negative, it means that the spread has narrowed and is not profitable [see also 25 Ways To Invest In Crude Oil.]
Who Uses Crack Spreads?
To put it simply, hedgers and speculators use crack spreads. From a hedging perspective, refiners use these trades to hedge against any adverse movements in the price of crude’s by-products. For example, if the price of gasoline drops below that of crude oil, that hurts a refiner that relies on selling gasoline. The crack spread can help offset those losses as gasoline prices below that of crude result in a profitable trade (assuming the spread has widened).
From a speculator standpoint, the trade is simply used to profit from a differential in price between crude and its by-products. The speculator does not have any business tied to refining crude oil, but simply wishes to make a play on the commodities in an effort to turn a profit.
The Bottom Line
A crack spread falls on the slightly more complex side, as it involves simultaneous short and long positions in the futures market. It is only appropriate for those with a firm understanding of the futures market as well as the energy space more specifically. In many cases, a crack spread probably won’t be the appropriate trade for your portfolio. For those wishing to learn more, the CME Group offers a crack spread calculator to help you better plan your trade.
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Disclosure: No positions at time of writing.
