Definition: A crack spread is an options strategy employed in the oil and energy sector named after the ability of oil producers to generate residual income by cracking oil products in gasoline and heating oil.
What Does Crack Spread Mean?
What is the definition of crack spread? A crack spread is a strategy that allows the oil refiner to purchase crude oil futures or swaps and sell the refined products futures or swaps, such as gasoline, diesel fuel, jet fuel, etc. In doing so, the oil refiner locks a profit on the difference between the crude oil and the refined products, and hedges against exposure to volatile oil prices.
Let’s look at an example.
An oil refiner is interested in hedging WTI-NY Harbor ultra-low sulfur diesel (ULSD) in October by selling heating oil and gasoline. Therefore, he enters a futures contract for the WTI crude oil to purchase 800 barrels of WTI crude oil at $62.28 per barrel and sell 21,000 gallons of heating oil and 22,240 gallons of gasoline at $1.92 and $2.08 per gallon, respectively.
The details of the futures contract are the following:
The tick value is what the refiner will earn if the price of crude oil increases by 1 tick or if the price of heating oil and gasoline decrease by 1 tick.
The oil refiner needs to convert the price per gallon to the price per barrel so that the prices are comparable. Each barrel contains 42 gallons of oil. Therefore, the heating oil is 7,000 / 42 = 167 barrels, and the gasoline is 8,000 / 42 = 190 barrels. Hence, the per barrel price of the heating oil is 167 / 1.92 = $86.81, and the per barrel price of the gasoline is 190 / 2.08 = $90.27.
Hence, the 1:1 spread for heating oil is $86.81 – $62.28 = $24.53 and for gasoline is $90.27 – $62.28 = $27.99.
Since the 1:1 spread is positive, the oil refiner will realize a profit. If the spread was negative, the oil refiner would realize a loss.
Define Crack Spreads: Crack spread means an investment strategy in the oil and gas industry.