Each week, we comment on the U.S. Department of Energy reports of crude oil and fuel inventories (see our last commentary, "Oil Report Stumps Analysts," and each week, we’re asked why we include the "crack spread" in our remarks.
Why bother depicting some obscure trading strategy, the queries usually run, when all we really want to know is whether oil's headed up or down?
The crack spread, in case you haven't encountered it before, depicts the potential profit that an oil refiner can obtain by "cracking" crude oil into its major tradeable distillates, namely gasoline and heating oil. It doesn’t represent the profit margin earned by all refiners, or any one refiner, in fact, but it is important as an indicator of refiners’ intentions. Together with other indicators, such as crude oil inventories and refinery utilization rates, shifts in crack spreads or refining margins can help investors get a better sense of where some companies, and the oil market, may be headed in the near term.
To get at the margin, you first have to rationalize crude oil and distillate prices. Crude oil is priced in dollars per barrels, but gasoline and heating oil prices are denominated in gallons. Then, you’ve got find prices. The most transparent marketplace is a futures bourse where trades are made publicly. You could have for example, seen nearby futures contract for NYMEX crude recently trading at $134.86 per barrel while unleaded gasoline changed hands at $3.4516 per gallon and a heating oil for $3.8633. To better simulate real world conditions, use the distillate prices a month out from the crude delivery to allow for a storage, refining and marketing cycle. A crude oil futures contract calls for delivery of 1,000 barrels. So too, do the distillate contracts, albeit indirectly. Heating oil and gasoline contracts specify delivery of 42,000 gallons, but with a barrel holding 42 U.S. gallons, it’s really 1,000 barrels. Just multiply the distillate prices by 42 to get the barrel prices. Your gasoline, then, fetches $144.97 a barrel and a barrel of heating fuel, $162.26.
OUTPUT INPUT
Gasoline Heating Heating Oil Crude Oil
[(2 x $144.97) + (1 x $162.26)] – (3 x $134.86) = $47.62 per 3 barrels = $15.87/barrel of crude
$452.20 – $404.58
If $15.87 represents the gross profit on a barrel of oil that nominally costs $134.86, the gross refining margin appears to be 11.8% ($15.87/$134.86). From a “cost of goods sold” basis, however, the refiner’s potential profit is $47.62 on every $452.20 of product sales, or 10.5%. This is the number stock analysts watch when evaluating a publicly traded refining company. It’s useful to know both numbers because one running significantly ahead of the other often signals windfalls. We’ll come back to this later.
Because the prices of the crack spread components vary, crack spreads and refining margins themselves ebb and flow, sometimes dramatically. Last summer, for example, the nearby one-month NYMEX crack spread collapsed from $27.71 to just $4.92.
NYMEX Crack Spread
At this time of year, experienced futures traders might “sell the spread” in expectation of the seasonal narrowing in refining margins. This “reverse” crack spread entails selling short three futures contracts while simultaneously holding two gasoline contracts and one heating oil contract long.
More commonly, though, futures-savvy investors wait for the fall, when spreads have contracted, to “buy the spread.” Holding three crude oil futures long against the sale of two gasoline contracts and one heating oil futures through the winter is a more reliable, and generally more profitable, trade.
Either way, traders buying or selling 3:2:1 NYMEX spreads take advantage of 75% margin credits which make the trades particularly attractive. Alternative ratios—5:3:2 and 2:1:1—are also recognized for spread margin treatment.
Investors without a futures account can utilize exchange-traded funds in their securities accounts to trade seasonal margin variances. The crack spread can be simulated by buying the United States Oil Fund (AMEX: USO) while selling short the United States Gasoline Fund (AMEX: UGA) and the United States Heating Oil Fund (AMEX: UHN). Without a margin break, however, the ETF version of the trade isn’t as attractive as futures.
There’s a margin-timing trade, however, that entails only the outright purchase of an independent oil refiner such as Valero Energy Corp. (NYSE: VLO), Tesoro Corp. (NYSE: TSO) or Holly Corp. (NYSE: HOC).
Integrated oil companies such as ExxonMobil (NYSE: XOM) and Chevron Corp. (AMEX: CHV) have a natural hedge against adverse price movements of the refining spread components because they control their entire supply chain. It’s really the independent oil refiners that are obliged use crack spreads to hedge their operational risks.
We noted previously a distinction between apparent refining margins and profit spreads measured by the “cost of goods sold” method. Long positions in the independents are favored as longsoon as soon as the differential between the two margins tips over 5%.
A picture speaks louder than words. Profits speak even louder. Does tracking the crack spread make more sense now?
www.hardassetsinvestor.com
