### The Crack Spread

The crack spread is probably the most important financial strategy within the energy industry. The price of the crack spread is so crucial that it is closely monitored by commercials, hedge funds, banks, energy companies and governments. The value of the crack spread summarizes and combines, in 1 strategy, the price of crude oil and its two most important derivatives: diesel and gasoline. The entire oil industry, which still plays a very significant role as far as energy production is concerned, is strongly and inevitably linked to the performance of the crack spread. The present research investigates the structure of the aforementioned strategy and the quantitative relationships of and among its components.

Commodity traders and portfolio managers are no strangers to the concept of spread trading. In fact, many commodities are powerfully linked by common factors such as fundamentals, demand/supply dynamics, extraction/production procedures, import/export processes, shipping/transportation routes, geographical availability, geopolitical variables and so forth. There are many types of spreads within the commodity sector (natural gas vs power, copper vs aluminium, gold vs silver, platinum vs palladium) and all of them are based on some of the above mentioned common factors. The crack spread, the focus of the present research, is built using WTI Crude oil, RBOB gasoline and diesel prices. Nevertheless, it is worth mentioning that the term “crack spread” can also refer to another spread combination which involves WTI, RBOB and heating oil or to the less popular, but still frequently traded, European crack spread (Brent Crude vs European Gasoil).

The crack spread provides a fairly good approximation of the margin earned by refiners and this is precisely why this strategy is at the core of the oil industry. In fact, it simply expresses the relative value of the cost of crude oil with respect to refined products (gasoline and diesel). Refiners can enter a simple 1:1 crack spread (crude oil vs gasoline or crude oil vs diesel), however, in a typical refinery the gasoline output is usually two times larger than that of distillate fuel oils (diesel, heating oil, jet fuel oil, bunker oil, etc). Consequentially, it would be more appropriate to trade diversified crack spread constructions like a 3:2:1 spread or a 5:3:2 spread. The present analysis will focus on the 3:2:1 crack spread which is the most popular and useful construction because it meets the needs of many refiners. The formula for calculating the price of a crack spread is the following:

[(2 * RBOB $/bb + 1 * ULSD $/bb) – (3 * WTI $/bb)] / 3

The calculation is simple. However, RBOB and ULSD prices (or RBOB and heating oil prices) are expressed in $ per gallon and not in $ per barrel. Hence, they have to be multiplied by 42 (1 barrel contains 42 gallons) in order to express them in barrel terms. For example, on the 9^{th} of June 2014, RBOB and NY Harbor Diesel closed at $3.049 and $2.886 per gallon respectively, hence, their “per–barrel prices” would automatically be ($3.049 *42) = $128.058 for RBOB and ($2.886*42) = $121.21 for ULSD.

Refiners are naturally long the crack because they have to purchase crude oil, refine it and then sell the products. Hence, the profit margin comes from the relation between crude prices and product prices while the biggest concerns for refiners come from any unwanted changes in such relation. Refiners predominantly fear increases in crude oil prices and drops in product prices because in this case their profit margin would shrink. The refiner, in order to lock in the price, will therefore cover its physical position on the financial market. Let’s assume a refiner decides to lock in the current margin because he fears an increase in the price of crude oil with respect to product prices. The best strategy he can implement involves selling a crack spread so that the long crude position will offset potential augments in oil prices while the short positions on products will counterbalance losses coming from potential plunges in diesel and/or gasoline prices. WTI is trading at $100.52, RBOB gasoline trades at $2.905 per gallon while NY Harbor diesel is at $2.927 per gallon. Consequently, RBOB gasoline and NY Harbor diesel in barrel terms are priced at ($2.905*42) =$122.01 and ($2.927*42) = $122.93. The 3:2:1 crack spread can now be constructed, so the refiner will purchase 3 WTI crude contracts at $100.52 and simultaneously sell 2 gasoline futures at $122.01 and 1 diesel futures at $122.93. The margin from the financial crack spread is equivalent to:

[(2 * $122.01 + 1 * $122.93) – (3 * $100.52)] / 3 = $21.79

The refiner has now locked in a $21.79 margin and it has secured its transaction. In fact, any potential rises in crude oil prices will be counterbalanced by a larger profit on the long WTI futures position while any potential plunges in gasoline or diesel prices will be offset by the gains on the financial short positions. Clearly, refiners tend to hedge looking forward so the contracts that will be used can expire in 1, 2 or 3 months from the implementation time depending on the delivery date. On the other hand, there are times where refiners are forced to sell crude oil and buy products. Consequentially, in order to hedge such exposure, they need to implement a reverse crack spread (also known as crack spread hedge). The reverse crack spread is just the opposite of a regular crack, in fact, it involves taking a short futures position on WTI crude oil and long positions on gasoline and diesel futures. Why would a refiner sell crude and buy products? Isn’t that counterproductive? Refineries work at full capacity to satisfy the demand for oil derivatives, however, forced shutdowns, due to machine breakdowns or unexpected technical problems, can happen. Contractual agreements must always be honoured, therefore, in the unfortunate event of a technical breakdown, refiners have to purchase products from someone else and deliver it to their clients as per contract. Furthermore, refiners tend to buy crude oil 2–3 months in advance so a breakdown would obligate them to sell the amount already delivered, or about to be delivered, because a technical “crash” would not allow them to refine it. These situations can easily happen, not that frequently, but they do happen. Hence, the best way to protect the business is to enter a reverse crack spread where crude oil is shorted and products are bought. The final margin is the difference between the operations on the physical market (selling WTI barrels and purchasing barrels of products) and the ones on the financial market (selling WTI futures while purchasing gasoline and diesel futures). Let’s assume that on the physical market the refiner faces a loss of $22.52 because he is forced to buy many thousands of barrels of products at a higher price due to the unexpected breakdown. On the other hand, thanks to the reverse crack strategy, he manages to lock in a $23.46 profit. The final margin would be $23.46 – $22.52 = $0.94.

Again, refiners do not usually buy products and sell crude unless obligated to do so, hence, the crack spread hedge is implemented only in particular occasions.

It is also worth mentioning that many refiners may want to enter different types of crack spread in order to cover the so–called energy basis risk. The basis risk is the difference in price between the same product delivered or traded in 2 different locations. The price difference between US Gulf Coast Ultra Low Sulphur Diesel and New York Harbor Ultra Low Sulphur Diesel is an example of basis risk. A refiner that uses only NY Harbour diesel will build a crack spread using NY Harbor ULSD futures while another one may want to take simultaneous positions on Gulf Coast and NY Harbor diesel because he refines them both.

The following section of the present research will quantitatively analyze the crack spread and it will separate each component of the strategy to study its behaviour and fluctuations. The first chart displays the price oscillations of the 3:2:1 crack spread that has been synthetically replicated using WTI crude, RBOB gasoline and NY Harbor diesel futures prices ranging from June 2006 to June 2014:

It is evident that the margin earned by refiners has remarkably fluctuated over the past years and it is safe to say that geopolitical factors have strongly impacted its performance. The chart shows that the price of the crack spread has predominantly oscillated within $10 and $40 with occasional deviations from such channel. The price drop in 2008 and the violent spike in 2012 are clear examples of what happens to the margin when crude oil and products prices diverge in relative terms: crude oil goes up while products prices plunge or vice versa. The following graph summarizes the performance of the crack spread on a yearly basis:

The figures reported in each bubble represent the average price for the crack spread in that year. The graph shows rather eloquently that, in the time interval 2006–2010, the price action moved between $13.3 and $17.3. However, the trend observed during the aforementioned 5 years was clearly bearish and the refiners’ margins decreased by $2–$3. The second part of the chart, instead, displays a diametrically opposite scenario. In fact, the data for the interval 2011–2014 show a violent explosion of the price action and a consequential widening of the margins. The highest average price was achieved in 2012 ($34.05) while 2013 and the first half of 2014 registered lower average prices ($25.55 and $23.77 respectively). It is interesting to notice that the price gap between 2010 and 2011 is as high as $15.94. Once again, the price jump was due to a divergence between the price of WTI, which at the beginning of 2011 dropped below $90 in several occasions, and the price of gasoline and diesel that, contrarily, remained constant. The initial imbalance between crude oil and products, however, persisted throughout the rest of the year even if the WTI recovered and moved back in the $100 area. It is important to point out that in November 2011 the Seaway pipeline project, which reversed the flow of crude oil, allowing its transportation from the Cushing to Houston’s vast refining area, got started. This project, which was completed on May 2012, has without a doubt contributed to increase the margin for refiners.

The next chart displays the fluctuations of the realized volatility for each component of the crack spread: WTI Crude Oil, RBOB gasoline and Ultra Low Sulphur diesel:

At a first glance, it is clear that the most volatile component is RBOB gasoline because the spikes in volatility are usually more violent in this market than in all the others. The second component, as far as volatility fluctuations are concerned, is WTI Crude Oil because its realized volatility is rather close to the RBOB one but slightly lower. The least volatile component of the entire crack spread is the diesel. In fact, it is evident that diesel realized volatility is well below the RBOB one and it is lower than the volatility curve observed for crude prices. The next graph, in order to provide a more accurate and quantitative approach, plots the distribution of the realized volatilities for each component and it ranks them:

The above reported chart eloquently confirms that RBOB is the asset class with the highest average volatility (37.73%), followed by WTI (27.97%) and ULSD (26.32%). It is important to point out that we are dealing with commodities and therefore it is not surprising to observe average volatilities well higher than the ones usually obtained by filtering equity indices data. The RBOB market is so volatile that its Low range values oscillate around 30.28% while WTI and diesel experience Low values fluctuating around 21.16% and 19.76% respectively. The same scenario can be easily noticed in the High segment of the distribution because, even in this case, the RBOB has the highest figure (46.61%) while WTI (35.76%) and ULSD (34.07%) rank lower. The examination of the extreme values, Minimum and Maximum, shows rather similar results. In particular, the Minimum segment has the identical ranking seen so far: RBOB is still the most volatile (16.68%), WTI is the second most volatile (11.15%) while diesel remains the third most volatile component (8.55%). The analysis of the Maximum segment, instead, provides some interesting evidence. Firstly, realized volatility spikes within energy markets can be rather violent and aggressive, therefore, it is not surprising to see values well beyond 100% for both RBOB gasoline (125.46%) and WTI Crude Oil (122.63%) while ULSD ranks again 3^{rd} (81.26%).Secondly, it is very interesting to notice that in the Maximum segment, WTI values are very close to RBOB ones implying that extreme realized volatility explosions in the American crude oil market can be tremendously violent. Numerically speaking, a realized volatility explosion, that would cause the volatility to shift from the Medium segment to the High segment, would mean a 232.5% increase for RBOB gasoline but, in the case of WTI, it would imply an increment of 365.9%. It means that WTI extreme volatility explosions can be up to 57.3% more aggressive than the ones on RBOB which is, on average, the most volatile component of the crack.

So far, the concepts that have been discussed and expanded are:

1) The fundamental reasons behind the crack spread

2) How to construct a crack spread

3) Utilization of the crack spread for hedging purposes

4) Analysis of the crack spread price

5) Volatility analysis of the components

The last section of the present research will conclude the investigation on the components of the crack spread. The previous study showed that RBOB gasoline is the most volatile component of the strategy but, in order to quantitatively define which of the 3 asset classes influence crack spread prices the most, it is necessary to run a correlation analysis:

The correlation matrix is divided into 2 groups. The first group consists of 3 sets of bars containing the distribution of the correlation coefficients calculated by running the analysis between one component against the other: RBOB vs ULSD, WTI vs RBOB and WTI vs ULSD. The second group, instead, presents the distribution of the overall numerical relationships between each component and the crack spread itself: WTI vs Crack Spread, RBOB vs Crack Spread and ULSD vs Crack Spread. Medium correlation bars will be used as a proxy for long term correlation because they provide an assessment of the average connection among the variables under examination. The chart suggests that all components are well linked to each other, in fact, the RBOB/ULSD correlation is +0.70 while the WTI/RBOB rapport is +0.67. The strongest coefficient is observed for the WTI/ULSD pair and in this case the figure is as high as +0.86. The crack spread strategy, instead, displays a robust relationship with RBOB gasoline (+0.78), a very weak one with respect to diesel (+0.30) and an almost non–existent link to WTI (–0.09). The high correlation coefficient between gasoline and crack spread is due to the high volatile nature of the RBOB market. The high volatility in gasoline prices, in fact, is likely to produce sudden and more frequent changes to the price of the crack spread. It is important to mention that the strong linear relationship detected by the correlation analysis, between RBOB and crack spread , has been confirmed also by the regression analysis. In fact, the adjusted–R squared values obtained by regressing every single component against the crack spread concluded that RBOB gasoline is indeed the asset class that influences the price of the crack the most. Numerically speaking, the computed adjusted–R squared for the WTI/Crack Spread regression was 6.75% and it confirms the extremely low linear relationship between WTI and crack prices. The adjusted–R squared for the ULSD/Crack Spread regression was 24.65% and, even in this case, the weak connection is confirmed. The adjusted–R squared for the RBOB/Crack Spread regression was 45.5% and it robustly confirms the relevant linear relationship between gasoline prices and the price of the crack spread.