Refining Crack Spread Overview: All You Ever Wanted to Know

The crack spread is a major component that drives refiners’ valuation. In this article, we’ll look at the metric’s different aspects like crack spread components, how they can differ across refinery locations, and how they impact refiners’ profit.

Investors who are thinking about buying refining stocks should know that refining cracks and oil spreads are the main indicators of refiners’ earnings.

Essentially, refiners take crude oil, which generally can’t be used in its raw form, and turn it into refined products like gasoline, diesel, and jet fuel. The refining crack 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 be volatile too.

The above chart is the US Gulf Coast WTI 3-2-1 crack spread or USGC WTI 3-2-1. The metric assumes that for every three barrels of crude oil, refiners produce two barrels of gasoline and one barrel of distillate fuel. Since the output varies across refineries, the metric is only used as a proxy. The metric uses posted prices closest to what Gulf Coast refineries would receive for finished products and pay for crude oil. Gasoline and distillates are fuels that refiners produce for end-use. Their chemical makeup is slightly different. Usually, gasoline is a lighter compound.

So, to calculate the USGC WTI 3-2-1 crack spread, you take the price for two barrels of Gulf Coast gasoline and the price of one barrel of Gulf Coast heating oil or gasoil and subtract the price of three barrels of crude oil.

We’ll show you how to calculate the crack spread.

• Crude oil – WTI – the closing price on September 25 of $56.38 per barrel
• Gasoline – RBOB (Gulf Coast) – the closing price on September 25 of $1.62 per gallon (multiply by 42 to get the price per barrel of $68.04)
• Heating oil or gasoil – the closing price on September 25 of $1.81 per gallon (multiply by 42 to get the price per barrel of $76.02)
• (Two barrels of gasoline + one barrel of heating oil or gasoil – three barrels of crude oil) / 3 = crack spread
• {(2 * $68.04 + $76.02) – (3 * $56.38)} / 3 = crack spread
• $42.96 / 3 = $14.32 per barrel

Note that the above chart and the example show the Gulf Coast 3-2-1 crack using WTI Cushing oil as the input price. However, not all of the Gulf Coast refineries use crude benchmarked to Cushing. Some of the refineries use crudes closer in price to LLS (Louisiana Light Sweet)—a Gulf Coast crude that’s waterborne. In the past, LLS traded significantly above WTI and closer to Brent. The significant crude oil production growth in inland regions like North Dakota and West Texas impact regional demand-supply dynamics. However, the price trend seems to be changing with new pipelines connecting oil supply across the US. We’ll also discuss regional differences in crack spreads later in this article.

Crude oil and refined product prices impact refining cracks. There are several parameters that impact these prices. Let’s start by looking at the parameters that impact oil prices.

Here are some important factors that impact crude oil prices.

Oil demand: The state of the global economy broadly impacts oil demand. More economic activity usually requires more energy. Recently, non-OECD (Organisation for Economic Cooperation and Development) nations have been consuming more oil as their economies grow and develop. Meanwhile, the oil demand from OECD nations has been flat or falling. Their economies are more mature. Also, they’re using other fuel sources like renewables, nuclear, and natural gas.

Oil supply: Worldwide production impacts the oil supply. In recent years, oil production in the US increased due to the shale boom, which added to the global oil supply. Also, OPEC plays a major role in setting the global oil supply. The member countries produce a significant portion of the world’s global oil. OPEC members also convene periodically to discuss optimal pricing and supply.

Speculation: Market participants’ speculation through instruments like crude oil futures also plays a role in setting oil prices. For example, oil price volatility was extreme in 2008. At times, prices hit almost $150 per barrel. Economist Thomas Palley said, “The actual behaviour 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.”

Refineries produce a wide range of finished products. We’ll discuss some of the major outputs.

Gasoline: Gasoline demand is one of the major drivers of gasoline prices. The demand is mainly driven by the miles that cars drive. More cars on the road and more driving create more demand for gasoline. Demand can be seasonal. For example, more driving occurs in the summer. Higher oil prices also push gasoline prices higher because crude oil is the main input for gasoline.

Distillates and others: There’s 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 of the products have their own unique demand drivers. For example, jet fuel is in higher demand during the summer when more flying occurs. Kerosene burns in portable space heaters, stoves, and water heaters. As a result, kerosene is in higher demand in the winter. Diesel is another common fuel used for vehicles. Like gasoline, diesel is in higher demand during the summer driving season. Home heating oil or light fuel oil is in higher demand during the winter.

More refining capacity online—more refineries running—can depress refining cracks. Higher refining capacity online results in more competition to supply the marketplace with finished fuels. During extended periods of low crack spreads, the least profitable refineries might be forced to shut down, which helps rationalize refining capacity and rebalance the market.

Also, events that impact refineries’ operations, like hurricanes, can take some refineries offline temporarily, which causes crack spreads to spike for short periods.

All of the refineries periodically perform “turnarounds.” Turnarounds are planned refinery shutdowns to perform maintenance, repairs, and testing. When a refinery undergoes a turnaround, it’s offline. The turnaround usually decreases the refined product supply, which increases the industry refining cracks.

Usually, commodities’ product prices depend on the demand-supply scenario, which causes volatility in the refining crack.

As we’ve seen, crack spreads can be extremely volatile. In the EIA’s 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 above graph, the Gulf Coast 3-2-1 crack has ranged from $6 per barrel to $35 per barrel in the past four years. The variation makes a huge difference in refiners’ profits.

Cracks and oil spreads help determine refinery earnings. Due to cracks and spreads’ volatile nature, refining companies’ earnings can also vary widely. Since refiners’ earnings can be volatile, refiners’ valuations can be volatile too. Refining stocks tend to be higher beta than other energy stocks.

The above chart shows refining stocks’ betas compared to some of the most prominent integrated energy stocks. Usually, refiners have higher betas than integrated energy companies. Among refiners, Marathon Petroleum (MPC) is the most volatile stock with a beta of 1.72. However, Phillips 66 (PSX), with its diversified earnings model, has a lower beta of 1.08.

The betas are still higher than integrated energy stocks’ beta. Integrated companies have an upstream and downstream asset base, which partially shields their earnings from volatile business conditions.

A typical refining company’s financial statement, through the operating income line, would read like this:

Revenues (generally the amount received from finished products depending on the price at which the finished products sell multiplied by the volume of finished products)

Minus the cost of products sold (generally the cost of the crude oil purchased)

Less direct operating expenses (like natural gas used for fuel, chemicals and catalysts, and utilities)

Minus SG&A expenses

Less depreciation and amortization

Equals earnings before interest and taxes

Investors can use refining cracks as a rough proxy for a refiner’s revenues less the cost of products sold. Directionally, where the crack trades should also indicate how strong earnings should be and where refiner stocks should trade.

Let’s look at Marathon Petroleum as an example. According to the company’s guidance, it expects its total throughput to be 3,050,000 barrels per day and refining operating expenses of $5.90 per barrel in the third quarter. Other guidance includes $1.300 billion of distribution costs, $155 million of refining planned turnaround costs, and $420 million of depreciation and amortization costs.

Marathon Petroleum publishes various factors, which make up the refining and marketing margin indicator, per month. The factors include a blended crack, sweet prompt differential, sour prompt differential, and market structure. Among the factors, the blended crack usually has a significant impact on Marathon Petroleum’s refining margins and earnings. According to the company, a dollar per barrel rise in the blended crack expands its annual net income by $900 million. A dollar per barrel change in the sour differential and the sweet differential changes the company’s yearly net income by $450 million and $370 million, respectively.

Reviewing the refining indicator trend can help you understand the current direction of the company’s refining margin. For example, in the third quarter, the blended crack has fallen by $0.5 per barrel YoY to $13.4 per barrel. The prompt sour differential and prompt sweet differential have narrowed by $5.4 per barrel YoY and $1.9 per barrel YoY, respectively, in the third quarter. So, falling cracks and spreads could have a negative impact on Marathon Petroleum’s refining margins and earnings in the third quarter.

Refiners’ earnings can be very volatile. Notably, earnings depend on various factors. A big change from one quarter to the next is possible due to cracks and oil spreads’ variant nature. There can be a significant difference in earnings. The refining segment is one of the most volatile segments in energy and the overall market.

Representative crack spreads can vary widely between locations. As a result, refiners’ margins also vary. The cost of crude oil can vary in different areas in addition to gasoline and distillates’ selling price. As we discussed earlier, some Gulf Coast refineries had to purchase crude oil closer in price to LLS instead of WTI Cushing. LLS traded at a premium to Cushing for many years.

At times, WTI Midland, which represents crude prices in the Permian Basin region in West Texas, traded at a significant discount to WTI Cushing. Refiners with access to West Texas crude had a profit advantage.

When differentials between various crudes become wide enough, refineries might look for ways to access the cheaper crude. They don’t want to be completely bound by geographical constraints. For example, Andeavor, now owned by Marathon Petroleum, announced a plan in mid-2012 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 seaborne West Coast bound crude. The differential between the two crudes had to be larger than the rail transportation cost for Andeavor to make the decision.

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. According to The Washington State Quarterly Gasoline Report website, “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 in other areas of the country.”

The report also said, “Unlike the rest of the United States, the West Coast has limited refineries and pipeline capacity. 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.”

Around the time of the 2008 financial crisis, crack spreads collapsed. The demand for products like gasoline suffered due to the weak economy. However, well-positioned refiners’ earnings started improving around early 2011. A major reason for the change was the divergence between WTI 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. They were still able to sell finished products at relatively higher prices, which broadly improved their earnings.

WTI Cushing traded significantly below Brent crude for most of 2014 through mid-2015. However, in early September 2015, the spread between WTI and Brent closed dramatically. The two crude benchmarks were nearly on par with each other. The WTI-Brent spread was at its widest point of ~$13 per barrel in February 2015. The spread remained rangebound in 2016 and 2017. However, the spread started widening in 2018. In mid-2018 and mid-2019, the spread hovered around $11–$12 per barrel. In September 2019, the spread is trading at around $6 per barrel.

Meanwhile, the movements helped many refiners earn handsomely from the spreads, which impacted refining stocks. In the past five years, Valero Energy (VLO) stock had a terrific run. The stock posted the highest returns of 78%. Marathon Petroleum, Phillips 66, and HollyFrontier (HFC) followed with 44%, 28%, and 23% returns in the past five years. PBF Energy (PBF) and Delek US Holdings (DK) had lower returns of 10% and 9% during the same period.

In the near future, one of the major trends to watch for in crack spreads is the WTI-Brent and WTI Cushing-WTI Midland spread. Also, broadly speaking, a refiner’s access to price-advantaged crude will improve its operating margin.

For instance, with Andeavor’s refineries, Marathon Petroleum has more flexibility to refine different sweet or sour crudes in its system. The company can utilize its pipeline network to refine cheaper Permian oil, Canadian crude oil, and Bakken oil in its refineries. The trend has been gaining traction due to growing production. Oil flows freely due to the expanding pipeline infrastructure.

Although Marathon Petroleum’s Washington refinery is on the West Coast, it doesn’t necessarily have to purchase all of its crude from West Coast sources. The West Coast crack might not be the best indicator of Marathon Petroleum’s profitability.

You should also watch the demand for refined products like gasoline and diesel. The demand depends on economic health. Higher refined product demand supports prices and improves crack spreads.

Investors with major holdings should watch refining cracks and oil spreads. Although refining cracks and oil spreads might not represent refiners’ gross margins perfectly, they’re a good indicator of where a refiners’ profits will go directionally.

Read What Is Crude Oil Refining and How Does It Work? to learn more about how refining works.