THE CRACK SPREAD CASE STUDY
The crack spread is a comparative strength chart that tracks the performance of crude oil versus the two main derivative products, namely gasoline and heating oil. This is a recognized spread for traders, and as a result is granted a special margin requirement through the commodity exchange.
Typically one uses the 3-2-1 ratio because it mirrors the refinery output ratio required to produce the byproducts from crude oil. This commonly used formula represents the theoretical refining margin that two barrels of unleaded gasoline and one barrel of heating oil are derived from three barrels of crude oil.
The crack spread often creates attractive trading opportunities. For example, if you believe that crude oil is expensive relative to the products, then you would sell crude oil and buy the products. One other useful tool is to use the crack spread chart to uncover hidden strength in the energy complex. If crude oil begins to strengthen relative to the products, then the crack spread will become less positive and the trend of the crack spread will weaken.
Notice in the chart below how in October 2011, crude oil prices climbed while both hearting oil and gasoline moved sideways and the crack spread moved lower. This was an indication that crude was outperforming the byproducts. As traders, we might not trade specific markets, but knowing the tools other traders use to make trading decisions may help give us an edge, especially if the markets are entering a ...