Can You Profit from the Cyclicality of Crack Spread?



Should investors rebalance their energy holdings?

In terms of performance, there is quite a stark contrast between downstream energy and the upstream subsector. In the midst of the ongoing energy price collapse, downstream companies Valero Energy Corporation (VLO), Tesoro Corporation (TSO), and Marathon Petroleum Corporation (MPC) have provided investors with returns of approximately 32%, 59%, and 12%, respectively, since 4Q14. In other words, not all energy companies are a proxy for crude prices. Even Phillips 66 Company (PSX), which has lost about 9% since 4Q14, has outperformed crude prices by more than 30%. The equal-weighted price return of these stocks since 4Q14 to 3Q15 was approximately 23%. The Energy Sector Select SPDR ETF (XLE) has about a 12% exposure to these stocks. The ETF lost 31% from 4Q14 to 3Q15.

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The graph above illustrates the return of the stocks and the ETF. Investors should understand the different drivers of the companies aggregated in XLE. Given the cyclical nature of crack spread, distillates have outperformed crude prices. Therefore, downstream energy firms have outperformed upstream firms. During periods of oversupplied crude markets relative to distillates, investors should seek to balance their energy portfolios between refiners and producers.

The correlation between crack spread and WTI spot prices

To illustrate how investors can take advantage of allocating towards refiners, a simple correlation analysis of the downstream sector’s main driver versus crude can be helpful. 3Q15 saw a correlation between crack spread and WTI (West Texas Intermediate) spot prices at 0.3. The average correlation factor per quarter since 4Q14 is ~0.4. In 4Q14, the correlation between the crack spread and WTI crude oil was higher, at 0.8x.

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One main reason for an elevated correlation during the fourth quarter of 2014 was the cyclical nature of crack spread. Generally, the fourth quarter sees a higher correlation between these commodities and can serve as a good pivot point for portfolio rebalancing. As an example, the very next quarter, 1Q15, saw correlations fall back down to ~-.001, or near zero. Crack spread moved up by ~121% in 1Q15 over 4Q14.

The chart above illustrates the correlation and sensitivity of crack spread with crude oil. Crack spread measures the difference between the cost of crude oil and the cost of products extracted from it. The 3:2:1 crack spread measures the difference between the cost of three barrels of crude oil minus the cost of two barrels of gasoline and one barrel of diesel extracted from it. Crack spread is an indicator of refineries’ profit margins.


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