The Crack Spread Effect

Despite gasoline and other refined petroleum products reaching prices on par with the fallout of Hurricane Katrina in the fall of 2005, profit margins for the major refineries are well below historical levels. This surely comes as a surprise to motorists as they watch the price at the gasoline pumps continue to climb or to pensioners fretting over their ever-increasing heating oil bills. How is it possible that in the face of the record retail prices consumers are forced to pay, the refineries can claim to be suffering?

The answer – a narrowing of the crack spread.

Come now – all joking aside, this is a serious topic and I assure you that you won’t be laughing when you learn that given the current price of crude oil, many consumers – and North Americans in particular – are getting a bargain when compared to the profit margins the refineries routinely achieved in the past.

The term crack spread has two distinct but related meanings – the first consists of a hedging strategy that seeks to lock-in the cost to refineries of crude oil and at the same time, guarantee a certain level of revenue for the refined products. The second use of the term – and the one we are most concerned with here – is the difference in the price of crude oil and the revenue generated by the products refined from crude oil. To put it another way, crack spread is the profit margin that refineries earn when the cost of crude oil is subtracted from revenues generated in the wholesale / retail markets for their refined products.

In January of 2008, the crack spread earned by major U.S. refineries was about 15% of the price of a barrel of oil but it fell to less than 9% within a few weeks. By mid-April the crack spread had rebounded somewhat and is currently around 12%. In terms of dollar amounts, this equates to about $40 of profit on each barrel of crude refined.[1]

While this seems like a nice little profit for the refineries, consider that two years ago – when oil was trading at under $60 a barrel rather than over $125 as it is now – refiners were making nearly $70 profit on each barrel of oil they refined.[2] Yep – the oil companies are really taking one for the little guy right now!

But such generosity cannot be sustained forever and there are a couple of factors that will come into play in the next few weeks that will likely result in further increases in retail gasoline prices. First off, the warmer weather and the ending of the school year marks the beginning of the so-called “summer driving season”. Yes, that time of the year will soon be upon us when families load up the mini van or SUV and head off in quest of the great family vacation. Even if not going on a summer driving vacation, people tend to drive more when the warmer weather hits – picnics, little league games, recreational vehicles – it all adds up to make summertime in North America the peak demand time for gasoline. And as we all know, with greater demand, comes higher prices.

The other factor pointing to an inevitable increase in gas prices this summer is the time lag between the time when refineries purchase crude and the point at which the refined products are shipped to retailers. This lag can be anywhere from three to six months but the key is that the products you are buying today were most-likely refined from crude purchased several months ago.

And what was the price of crude then? Well, West Texas Intermediate (WTI) was priced around $90 a barrel during the first week of February this year – today, just over three months later, WTI is north of $125 – this represents an increase of over 30%!

That doesn’t look very encouraging does it? You can bet on a substantial increase to refined petroleum products that reflects the price jump in crude over the last three months. In fact, an increase of 30% is required to merely maintain the current profit margins which as we have already seen, are considerably below the historical margins.

Happy motoring!

About the Author

Scott Boyd has been working in and writing about the financial industry since the early 1990s. As a technical writer and project manager with several of Canada’s leading financial institutions, Scott has produced educational materials for investment system end-users including portfolio managers and traders. Scott now administers and contributes to OANDA FXPedia and regularly provides commentaries for the OANDA FXTrade website.

This article is for general information purposes only. It is not investment advice or a solicitation to buy or sell securities. Opinions are the author’s — not necessarily OANDA’s, its officers or directors. OANDA’s Terms of Use apply.