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To protect itself from increasing product prices and decreasing crude oil prices, the refinery uses a short hedge against crude oil and a long hedge against refined products, which is the same as “purchasing” the crack spread. If the refiner’s supply and sales commitments are substantial and if it is forced to make an unplanned entry into the spot market, it is possible that prices might move against it. Furthermore, lacking adequate storage space for incoming supplies of crude oil, the refiner must sell the excess crude oil on the spot market. Unable to produce enough products to meet term supply obligations, the refiner must buy products at spot prices for resale to his term customers. When refiners are forced to shut down for repairs or seasonal turnaround, they often have to enter the crude oil and refined product markets to honor existing purchase and supply contracts. It entails selling crude oil futures and buying refined products futures. The purchase of a crack spread is the opposite of the crack spread hedge or “selling” the crack spread.
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Whether a hedger is “selling” the crack or “buying” the crack reflects what is done on the product side of the spread, traditionally, the premium side of the spread.Īt times, however, refiners do the opposite: they buy refined products and sell crude oil, and thus find “buying” a crack spread a useful strategy. If refiners expect crude oil prices to hold steady, or rise somewhat, while products prices fall (a declining crack spread), the refiners would “sell” the crack that is, they would sell gasoline or diesel (ULSD) futures and buy crude oil futures. When refiners look to hedge their crack spread risk, they typically are naturally long the crack spread as they continuously buy crude oil and sell refined products. Conversely, if the refined product value is less than that of crude oil, then the gross cracking margin is negative. If the refined product value is higher than the price of the crude oil, the cracking margin is positive. The crack spread is quoted in dollars per barrel since crude oil is quoted in dollars per barrel and the refined products are quoted in cents per gallon, diesel and gasoline prices must be converted to dollars per barrel by multiplying the centsper-gallon price by 42 (there are 42 gallons in a barrel). The crack spread - the theoretical refining margin - is executed by selling the refined products futures (i.e., gasoline or diesel) and buying crude oil futures, thereby locking in the differential between the refined products and crude oil. The most common type of crack spread is the simple 1:1 crack spread, which represents the refinery profit margin between the refined products (gasoline or diesel) and crude oil. Because refiners can reliably predict their costs, other than crude oil, an uncertain crack spread can considerably cloud understanding of their true financial exposure. In addition to covering the operational and fixed costs of operating the refinery, refiners desire to achieve a rate of return on invested assets. Because refiners are on both sides of the market at once, their exposure to market risk can be greater than that incurred by companies who simply sell crude oil, or sell products to the wholesale and retail markets. Such a situation can severely narrow the crack spread, which represents the profit margin a refiner realizes when he procures crude oil while simultaneously selling the refined products into a competitive market. As such, refiners and non-integrated marketers can be at enormous risk when the price of crude oil rises while the prices of the refined products remain stable, or even decline.
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The price of crude oil and its principal refined products are often independently subject to variables of supply, demand, production economics, environmental regulations and other factors. It is referenced as a crack spread due to the refining process that “cracks” crude oil into its major refined products.Ī petroleum refiner, like most manufacturers, is caught between two markets: the raw materials he needs to purchase and the finished products he offers for sale. This spread is referred to as a crack spread. Refiners’ profits are tied directly to the spread, or difference, between the price of crude oil and the prices of refined products - gasoline and distillates (diesel and jet fuel). In the petroleum industry, refinery executives are most concerned about hedging the difference between their input costs and output prices.