Crack Spread 101 (Part 1: What’s a crack spread?

By Ingrid Pan, Sr Energy AnalystJuly 26, 2013 11:07 AM

Taking a look at crack spreads

A major component that drives refiner valuations is the crack spread. In this series, we look at
different aspects of this metric, such as components of crack spreads, how they can differ
across refinery locations, and how they affect refiner profits. Explore the parts of this series
below to learn more about crack spreads.

The crack spread and refiner stocks

Investors who are thinking of buying refiner stocks should know that one of the primary indicators
of refiners’ earnings is the crack spread.

Essentially, refiners take crude oil (which generally can’t be used in its raw form) and turn it into
refined products such as gasoline, diesel, and jet fuel. The crack spread represents the price
difference between the finished, refined products (which translate into refiner revenues) and the
price of crude oil (one of the primary factors in refiner costs). Because commodity prices can be
incredibly volatile, refiners’ margins can too.

The above chart is the “Gulf Coast 3-2-1 Crack Spread.” This metric assumes that for every three
barrels of crude oil, refiners produce two barrels of gasoline and one barrel of distillate fuel (but
note that output varies across refineries and this metric is used just as a proxy), using posted prices
 closest to what Gulf Coast refineries would receive for finished products and pay for crude oil. Both
gasoline and distillates are fuels refiners produce for end use—the only difference is that they’re of
slightly different chemical make-up, with gasoline generally being a lighter compound.

(Read more: Brent crude prices advanced along with WTI crude, but tighter spread)

Calculating the spread

So, to calculate the Gulf Coast 3-2-1 spread, you take the price for two barrels of Gulf Coast gasoline
plus the price of one barrel of Gulf Coast ultra-low sulfur diesel (ULSD) and subtract the price of
three barrels of crude oil.

We use the example of the “Bloomberg WTI Cushing Crude Oil 321 Crack Spread/Gulf Coast”
(Bloomberg ticker CRKS321 Index). Bloomberg notes that the inputs are the following:

 Crude oil – WTI at Cushing (USCRWTIC Index ) – closing price at July 19, 2013, of $108.05 per
barrel
 Gasoline – U.S. Gulf prompt 87 Octane gasoline (MOIGC87P Index) – closing price at July 19,
2013, of $2.92 per gallon (multiply by 42 to get price per barrel of $122.64)
 Heating oil or gasoil – U.S. Gulf No. 2 Oil (NO2IGCPR index) – closing price at July 19, 2013, of
$2.87 per gallon (multiply by 42 to get price per barrel of $120.54)
 (Two barrels of gasoline + one barrel of heating oil or gasoil – three barrels of crude oil) / 3 =
crack spread
 (2 * $122.64 + $120.54 – 3 * $108.05) / 3 = crack spread
 $41.67 / 3 = $13.89 per barrel

Differences in crack spreads

Note that the chart above and the example show the Gulf Coast 3-2-1 using WTI Cushing oil as the
input price, but not all Gulf Coast refineries use crude benchmarked to Cushing. Some use crudes
closer in price to Louisiana Light Sweet (LLS), a Gulf Coast crude that’s waterborne. For most of the
past two years, LLS traded significantly above WTI and has traded closer to Brent due to significant
growth in production of crude oil in inland regions such as North Dakota and West Texas. Please
see What happened to the WTI-Brent spread? for more information on why WTI and Brent diverged
in price. We’ll also discuss regional differences in crack spreads later in this series.

(Read more: Why ethane stopped trading like crude and started trading like nat gas (part II))
 3:2:1 Crack Spread

Source: U.S. Energy Information Administration, based on Thomson Reuters.

A crack spread measures the difference between the purchase price of crude oil and the selling price of finished
products, such as gasoline and distillate fuel, that a refinery produces from the crude oil. Crack spreads are an
indicator of the short-term profit margin of oil refineries because they compare the cost of the crude oil inputs to
the wholesale, or spot, prices of the outputs (although they do not include other variable costs or any fixed costs).
The 3:2:1 crack spread approximates the product yield at a typical U.S. refinery: for every three barrels of crude oil
the refinery processes, it makes two barrels of gasoline and one barrel of distillate fuel.

To calculate the 3:2:1 crack spread for a Gulf Coast refinery that processes Louisiana Light Sweet (LLS) crude oil,
add the spot price for two barrels of Gulf Coast conventional gasoline to the spot price for one barrel of Gulf Coast
ultra-low sulfur diesel. Since prices for petroleum products are typically quoted in dollars per gallon, they must be
multiplied by 42 gallons per barrel to convert to dollars per barrel. Then subtract the spot price for three barrels of
LLS crude oil. Finally, divide the result by 3 to produce a crack spread in dollars per barrel.

The figure illustrates the Gulf Coast (LLS) 3:2:1 crack spread during 2012. Because the 3:2:1 crack spread is a
product of the interplay of three commodity prices, each subject to different but interconnected supply and
demand balances, the range of values can vary widely. Product supply shortages resulting from serious disruptions
such as hurricanes or other refinery or pipeline outages can cause large spikes of short duration.

Crude oil prices

Here are some important factors that affect crude oil prices.

 Oil demand: Broadly affected by the state of the global economy, as more economic activity generally
requires more energy. Recently, non-OECD (Organisation for Economic Co-operation and Development)
nations have been consuming more and more oil as their economies grow and develop. Meanwhile, oil
demand from OECD nations has been flat or falling because their economies are more mature and they’re
further using other fuel sources such as renewables, nuclear, and natural gas.
 Oil supply: Affected by worldwide oil production. In recent years, oil production in the United States and
Canada has increased greatly, which has added stability to global oil supply because production from other
sources such as the North Sea has begun to decline. Additionally, OPEC (Organization of Petroleum
Exporting Countries) plays a major role in setting global oil supply, as the member countries produce a
significant portion of the world’s global oil. OPEC members also periodically convene to discuss optimal
pricing and supply.
 Speculation: Speculation by market participants through instruments such as crude oil futures also plays a
role in setting oil prices. For instance, regarding the extreme oil price volatility seen in 2008, when prices
hit almost $150 per barrel at points, economist Thomas Palley stated, “The actual behavior of oil prices is
consistent with speculation. In June, oil prices leapt by $11 in one day, and in July they fell back by $15 in
three days. Such volatility does not fit a fundamentals-driven market.”

Finished product prices

Refineries produce a wide range of different finished products, but in this series, we’ll cover
several of the major outputs, and we’ll discuss other refined products in a further series.

 Gasoline: One of the major drivers of gasoline prices is gasoline demand, driven primarily by miles driven
by cars. More cars on the road and more driving create more demand for gasoline. Demand can be
seasonal, as more driving occurs in the summer. Higher oil prices also push gasoline prices higher because
crude oil is the primary input for gasoline.
 Distillates: Includes a group of similar products used for jet fuel, gas turbine fuel, kerosene for heaters and
lamps, diesel fuel, home heating fuel oil, and industrial fuel. All have their own unique demand drivers. For
example, jet fuel is in higher demand in the summer when more flying occurs. Kerosene burns in portable
space heaters, stoves, and water heaters and is in higher demand in the winter. Diesel is another common
fuel used for vehicles, and like gasoline it’s in higher demand in the summer driving season. Home heating
oil (light fuel oil) is in higher demand during the winter.

Refinery capacity and operations

More refining capacity online (that is, more refineries running) can depress crack spreads
because that essentially results in more competition to supply the marketplace with finished
fuels. During extended periods of low crack spreads, the least profitable refineries may be
forced to shut down, which helps to rationalize refining capacity and rebalance the market.

Additionally, events that affect refinery operations (such as hurricanes) can take some
refineries temporarily offline, thereby causing crack spreads to spike for short periods.

Lastly, all refineries periodically perform “turnarounds.” Turnarounds are planned shutdowns of
a refinery in order to perform maintenance, repairs, and testing. When a refinery undergoes a
turnaround, it’s offline, and this also increases crack spreads.

Several commodity products depend on prices, which means crack spreads are extremely
volatile
As we’ve seen, crack spreads can be extremely volatile. In the U.S. Energy Information
Administration’s (EIA) own words, “Because the 3:2:1 crack spread is a product of the interplay
of three commodity prices, each subject to different but interconnected supply and demand
balances, the range of values can vary widely. Product supply shortages resulting from serious
disruptions such as hurricanes or other refinery or pipeline outages can cause large spikes of
short duration.”
As you can see in the graph above, the Gulf Coast 3-2-1 crack has ranged from below $0.00 per
barrel at points to over $40.00 per barrel in just the past five years. This variation makes a huge
difference for refiners’ profits. The table below shows various measures of crack spread levels,
showing the standard deviations, averages, minimums, and maximums of three benchmark 3-2-
1 crack spreads.

Note that one factor in crack spreads is a refinery’s location, and we’ll discuss this consideration
later in this series.

Because crack spreads are volatile, so are refining companies’ earnings

Crack spreads are a major determinant of refinery earnings. Due to the volatile nature of crack
spreads, earnings of refining companies can also vary widely from period to period. Because
refiners’ earnings can be volatile, refiner valuations can be too. Additionally, refining stocks
tend be higher beta than other energy stocks.

The chart above displays the betas of various pure-play refiner stocks versus some of the most
prominent master limited partnerships (MLPs) and upstream energy stocks as well as the AMLP
 (Alerian MLP ETF) and XLE (Energy Select SPDR Fund). Generally, pure play refiners are higher
beta than upstream energy companies and MLPs.

The effect of crack spreads on refiner margins

A typical refinery company’s financial statement (through the operating income line) would
read like this:

 Revenues (generally the amount received from finished products, and this depends on the price at which
the finished products sell multiplied by the volume of the finished products)
 Less the cost of products sold (generally the cost of the crude oil purchased)
 Less direct operating expenses (such as natural gas used for fuel, chemicals and catalysts, utilities)
 Less selling, general, and administrative expenses
 Less depreciation and amortization
 Equals operating income
Investors can use crack spreads as a rough proxy for a refiner’s revenues less cost of products
sold. Directionally, where crack spreads trade should also indicate how strong earnings should
be and therefore where refiner stocks should trade.

Examples: Using crack spreads as a rough proxy for refiner revenues

Let’s take the example of Western Refining (WNR). The company gave guidance for its El Paso
Refinery of throughput of 133,000 to 138,000 barrels per day in 2Q13, and direct operating
expenses of $4.15 per barrel. It also gave guidance for its Gallup Refinery of 22,000 to 25,000
barrels per day in 2Q13, and direct operating expenses of $9.25 per barrel. Other guidance
includes $27 million to $28 million of costs for SG&A (selling, general, and administrative
expense), $15 million to $16 million for interest expense, and $25 million for depreciation and
amortization.
WNR stated for last quarter (1Q13), that its gross margin at El Paso was $34.57 per barrel and
at Gallup was $26.77 per barrel. Let’s assume that gross operating margins for 2Q13 will be the
same (but note that this is unlikely, given the volatility in crack spreads).

Using these assumptions, we show a simple calculation of EBITDA—or earnings before interest,
taxes, depreciation, and amortization (excluding other ancillary sales or costs). In Example A, El
Paso’s gross margin is calculated using midpoint of throughput guidance of 135,500 barrels per
day times 91 days in 2Q13 times $34.57 (1Q13’s gross margin). We use the same logic for the
Gallup refinery. In Example B, we look at how a $10 per barrel negative change in gross margin
affects EBITDA, so we use $24.57 per barrel.
This also shows how a refiner’s earnings can be very volatile. Because of the variant nature of
crack spreads, a change of $10 per barrel from one quarter to the next isn’t improbable, and
this results in a significant difference in earnings. This volatility makes pure-play refiners one of
the most volatile segments in energy—and the overall market.

Crack spreads and regional differences

Representative crack spreads can vary widely from location to location, and therefore so can
refiners’ margins. This is because the cost of crude oil can vary in different areas, as can the
selling price of gasoline and distillates. As we discussed earlier, some Gulf Coast refineries have
had to purchase crude oil closer in price to Louisiana Light Sweet (LLS) rather than WTI Cushing,
and LLS had traded at a premium to Cushing for much of the past two years. Additionally, at
some points, WTI Midland (which represents crude prices in the Permian Basin region in West
Texas) has traded at a significant discount to WTI Cushing, meaning refiners with access to the
West Texas crude had a profit advantage.

When differentials between various crudes become wide enough, refineries may look for ways
to access the cheaper crude so they’re not completely bound by geographical constraints. For
example, Tesoro Corp. (TSO) announced in mid-2012 a plan to move 50,000 barrels per day of
crude from the Bakken region in North Dakota to its refinery in Anacortes, Washington. Bakken
crude was trading significantly below where seaborne West Coast bound crude was trading,
and the differential between the two crudes had to be larger than the rail transportation cost
for TSO to make that decision.
Additionally, the prices of products like gasoline can vary from region to region. For example,
West Coast gasoline prices tend to be more expensive than other regions. The Washington
State Quarterly Gas Report dated April 1, 2013, stated, “The West Coast is a unique market in
the United States in terms of supply, demand, and production of gasoline. As a result, the
average price of gasoline tends to be higher than other areas of the country. Unlike the rest of
the United States, the West Coast has limited refineries and pipeline capability. The majority of
crude oil in the United States is delivered and refined in the Gulf States where it is efficiently
distributed via a network of pipelines. In contrast, the West Coast and Washington in particular
remain isolated with minimal pipelines. In addition, due to our geographical and social factors,
the West Coast exceeds the national average for gasoline consumption.”

Recent crack spread trends

Around the time of the 2008 financial crisis, crack spreads collapsed because demand for
products such as gasoline suffered due to the weak economy. However, since around early
2011, well-positioned refiners began to see improving earnings. A major reason for this change
has been the divergence between WTI (West Texas Intermediate) and Brent crudes. Refiners
that had access to WTI or similarly priced crudes saw increased gross refining margins due to
WTI’s relatively cheaper price, while they were still able to sell finished products at relatively
higher prices, which broadly improved earnings.

WTI Cushing traded significantly below Brent crude for much of 2011 through mid-2013.
However, throughout 1H13 and early July, the spread between WTI and Brent closed
dramatically so that the two crude benchmarks now trade close to par. The WTI-Brent spread
was at its widest point of ~$20 per barrel in mid-February, and it has closed in to roughly zero
since then. Meanwhile, many refiner stocks that had taken advantage of discounted WTI prices
have also seen their stocks fall. In mid-February, HollyFrontier Corp. (HFC) was trading at ~$55
per share, and the stock currently trades at $43 per share. Western Refining (WNR) traded as
high as ~$39 per share in early March, and now trades around $29 per share. Meanwhile, the
broader market has mostly appreciated. The S&P500 traded around 1500 in mid-February and
is currently near 1700.
What to watch for in crack spreads
For the near future, one of the major trends to watch for in crack spreads is the WTI-Brent
spread. Plus, broadly speaking, a refiner’s access to price-advantaged crude will improve its
operating margin. For instance, Tesoro Corp. (TSO) has a refinery in Washington, but the
company began replacing some seaborne West Coast barrels with much cheaper crude railed
from North Dakota. This trend has been gaining traction because significant production growth
in the inland United States has caused price differentials between crudes of different
geographies to vary more than in the past. So, although TSO’s Washington refinery is on the
West Coast, TSO doesn’t necessarily have to purchase all of its crude from West Coast sources
and the West Coast crack may not be the best indicator of profitability.
Other factors to watch for include demand for refined products, such as gasoline and diesel,
and these depend on economic health. Higher refined product demand supports prices and
improves crack spreads.

Investors with major holdings should watch crack spreads. Though the spreads may not
perfectly represent refiners’ gross margins, they’re a good indicator of where a refiner’s profits
will go directionally.