How to Profit: Oil and Gas Crack Spread

Oil and Gas Crack Spread: How to Profit from an unrealistic Spread.

Spread out of whack: Natural Gas Crack Spread

When you hear oil and gas futures traders talking about the crack spread what they really mean is the difference between the price of crude oil and petroleum products extracted from it. The ‘Crack’ can be though of as cracking raw oil into the various components that it will become when processed: gasoline, kerosene, diesel, heating oil, jet fuel, asphalt, etc.

Normally, futures traders will focus on the crack spread for gasoline and heating oil. During the winter the focus tends to be on the heating oil crack spread while the remainder of the years the focus tends to be on the gasoline crack spread.

Large Oil refiners and oil and gas companies may trade crack spreads to hedge price risks for the products that they offer while speculators will try and predict where the market is heading and profit from the change in oil vs gas/heating old differentials.

Speculating on the various crack spreads is for more sophisticated investors; however, it does not need to be a difficult thing. Many of the large commodities exchanges have simplified the trades needed to perform such strategies. The NYMEX for example offers virtual crack spread futures by combining a basket of underlying futures contracts that correspond to the various oil production outputs. With the basket futures you only need a single transaction to organize a trade as opposed to buying and selling a full basket of futures yourself to participate.

So what should I be looking for to make money?

When crude oil rises:

If other products appear to be flat or more up in price to a lessor degree then the crack spread will be diverging. These spreads tend to remain within a range that could be correspondent to actual costs associated with their production. A large jump in oil prices without a corresponding large jump in gasoline prices for example, throws the spread outside the comfort zone. As a speculator you are look to spot that divergence and profit from it.

How to profit: When there is a divergence as above, to profit you would shot sell the crude futures contract and buy the gasoline or heating oil futures contract with the same expiry to keep things simple.

When the price of oil falls and the crack spread narrows:

Under this scenario you would just do the opposite: sell the crude oil futures contract and buy the gasoline or heating oil futures contract. Again, keep things simply and just use the same expiry dates.

The Basic Rule of Thumb: Sell the overpriced product and Buy the under priced product.

If you do not understand futures they you can also perform these trades using options

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