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The Crack Spread’s Cyclicality and Correlation to WTI Spot Prices

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Cyclicality of the crack spread

The crack spread moves in a cycle. Normally it picks up for the first two quarters of a year, saturates, then bottoms out. Between September to December of every year, the spread bottoms out relative to its movement at the start of the year. The crack spread is the difference between the market cost of the crude derivative product and crude oil and is an important indicator of the profitability of downstream companies. Revenue and EPS (earnings per share) growth also follow the same pattern.

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The revenue and EPS growth on a quarter-over-quarter basis for downstream companies such as Tesoro (TSO), Phillips 66 (PSX), Valero Energy (VLO), Marathon Petroleum (MPC), and other refiners follow the same pattern on an average basis. Refiners comprise ~11.6% of the Energy Select Sector SPDR Fund (XLE).

Quarterly correlation between the crack spread, WTI spot prices

A simple correlation analysis of the downstream sector’s main driver versus crude can be helpful in illustrating how investors can take advantage of allocating toward refiners. The third quarter of 2015 saw a correlation between the 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.

One main reason for an elevated correlation during the fourth quarter of 2014 was the cyclical nature of the 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 near zero. The crack spread moved up by around 121% in 1Q15 over 4Q14.

In the next part, we’ll analyze the moving average and analysts estimate for midstream companies.

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