Crack Spreads: 'Tis the Season

Real-time Monetary Inflation (last 12 months): 1.7%

We often mention spreads in Desktop articles as trading alternatives to outright positions or as indicators of market trends. Because these spreads pit futures contracts against one another, however, many readers can't make use of them as investments.

Take crack spreads for example. In a crack spread, crude oil contracts are sold short in ratio to the simultaneous purchase of gasoline and heating oil futures. The trade simulates the gross profit obtained by refiners.

The crack spread's seasonal: It tends to widen in the early part of the year, peaking just ahead of the summer driving season (background on the crack spread can be found in "Time For Crack Spreads?").

Refiners' profit margins ebb and flow along with crack spread movements from New Year's Day to May 31. Refiners' gross margins expand by an average 8 percentage points over the typical season, though there can be a lot of variance from one year to the next. Take the last four years, for example.

 

Refining Margins Implied By 3-2-1 Crack Spreads

Year	Jan 2	May 31	Change
2006	20.6%	27.8%	+7.2%
2007	15.5%	37.6%	+22.1%
2008	11.5%	13.9%	+2.4%
2009	15.1%	15.6%	+0.5%

 

The volatility in seasonal margins was largely due to spikes-upward and downward-in the price of crude. Through the 2007 season, product prices could be raised to keep pace with increases in crude input costs, but after that, refiners put a lid on distillates to avoid wholesale demand destruction.

This year - 2010 - is shaping up for recovery, all of which bodes well for refiners. Margins, now at 10.5 percent, look ripe for expansion, since year-over-year demand for gasoline finally turned up and distillate consumption bottomed.

 

Historic Product Cracks

 

That warms the hearts of spread traders of course, but leaves investors chary of the futures market out in the, um, cold.

Enter ETFs. Specifically, the ProShares UltraShort Dow Jones-UBS Crude Oil Fund (NYSE: SCO), the United States Gasoline Fund (NYSE: UGA) and the United States Heating Oil Fund (NYSE: UHN). Purchasing equal amounts of each portfolio simulates a crack spread variant that yields one barrel of heating oil and of gasoline from two barrels of crude oil.

Last year-when the ProShares fund was first launched-the spread made a 7.3 percent return for the entire season, though interim gains reached as high as 36.6 percent early on.

 

ETF Crack Spread

 

There's, of course, no guarantee that this year's spread will produce the same result as last year's. But if the spread doesn't flex its muscles now, it's not likely to expand at all this year.