November 29, 2016
A Dynamic Commodities Exclusive
Crack spreads are refining or processing margins that reflect the profitability of turning a barrel of crude oil into oil products like gasoline, heating oil, jet fuel or many of the other processed products of the energy commodity.
These spreads often go by the name “crack spreads” because the crude oil processing occurs via a catalytic cracking process at an oil refinery. When it comes to investing in companies within the crude oil sector, there are three distinct types of investments. Each has a different level of risk. Oil exploration and production companies are at risk for the discovery and price of oil. The success of an investment in an oil exploration and production company depends on the ability to locate crude oil reserves. Then, it must produce the energy commodity at a price that is lower than the market price. Oil services provide infrastructure to the exploration and production companies such as drilling rigs and other equipment. They also support personnel necessary when it comes to finding and producing crude oil. Oil refining presents a different set of risks for investors.
An oil refinery is not at risk for the price of crude oil. Nor does it risk the ultimate prices of the products it processes through its refinery. The profitability of refining companies is a function of the spread between the two prices. These entities buy raw crude oil at market prices and then sell the products at market prices. Therefore, it is a refining margin that determines if the refinery makes a profit or loses money. The wider the crack spread, the more profitable for refineries. A narrower crack often means that profit margins shrink causing the loss of revenue. Sometimes a crack spread falls so low that turning a barrel of crude oil into oil products becomes a losing proposition for refineries.
For those who own shares of companies involved in the refining of oil, understanding and monitoring crack spreads is an important consideration. After all, volatile crack spreads are a real-time indicator of the profitability of these companies. Additionally, crack spreads also offer clues about the demand for the raw crude oil as well. The CME offers contracts on gasoline and heating oil cracks spreads on their website free of charge. Anyone who invests in or trades shares of oil refining companies should pay close attention to the movements of these spreads. They can provide crucial information on earnings and losses. Crack spreads can help you crack the code of investing in this sector of the market.
Nothing on this site should ever be considered to be advice, research or an invitation to buy or sell any securities