Commodities · M4 · 8 min
Spreads: cracks, sparks and locations
Work out a refinery’s margin and a power plant’s margin, and say when moving oil from one place to another pays.
In the news: When diesel prices jump and crude doesn’t, refiners earn more on every barrel and run harder.
The essentials
- Spread
- One price minus another. A refinery, a power plant or a trader shipping cargoes earns a spread, so it cares about the gap between two prices more than about either price alone.
- Crack spread
- A refinery’s margin: the fuels it makes minus the crude it buys. The 3-2-1 assumes 3 barrels of crude make 2 of gasoline and 1 of diesel, with fuel prices converted at 42 gallons a barrel.
- Spark spread
- A gas-fired plant’s margin: power minus the gas it burns. Gas burned per MWh of power is the , 2 for a 50% efficient plant, so power at £90 and gas at £35 give a of £20.
- Calendar spread
- Buying one delivery month of a commodity and selling another. Buying the nearer month gains if prompt supply tightens; selling it gains if a glut builds.
- Location spread
- The price gap for one commodity at two places, such as over . When it is wider than the cost of moving the oil, traders ship it, and their buying narrows the gap.
The 3-2-1 crack spread
Crack = (2G + D − 3C) ÷ 3
- G
- gasoline, $ a barrel ($ a gallon × 42)
- D
- diesel, $ a barrel
- C
- crude, $ a barrel
How it works
1. Buying one thing to make another
A baker’s profit depends on the gap between the price of bread and the price of flour, not on either price alone. Many commodity businesses work the same way: refineries turn crude oil into fuels, and power plants turn gas into electricity. Their margin is a spread: one price minus another.
2. Barrels and gallons
Crude oil is dollars a barrel, but US petrol (gasoline) and diesel are priced in dollars a gallon. A barrel holds 42 gallons, so convert before comparing: gasoline at $2.50 a gallon is $2.50 × 42 = $105 a barrel.
3. The refinery’s margin
A typical US refinery turns 3 barrels of crude into about 2 of gasoline and 1 of diesel. Its margin per barrel of crude is (2 × gasoline + 1 × diesel − 3 × crude) ÷ 3, all in $ a barrel. This is the 3-2-1 : “cracking” is the refining process that breaks crude into fuels.
4. What the crack tells a refiner
A wide crack means fuels are scarce compared with crude, so refiners run harder and buy more crude. A narrow crack makes them cut back. Refiners often sell the crack forward, selling fuel futures and buying crude futures, to lock in their margin.
5. The power plant’s margin
A gas-fired power plant burns gas to make electricity, both measured in MWh (megawatt-hours, a unit of energy). A plant that is 50% efficient burns 2 MWh of gas for each MWh of power. Its margin, the , is power − 2 × gas: with power at £90 and gas at £35, £90 − £70 = £20.
6. Heat rate
The gas a plant burns per MWh of power is its : 2 for a 50% efficient plant. In the US gas is priced per MMBtu (a million British thermal units), and an efficient plant needs about 7 MMBtu per MWh. Either way, spark spread = power − heat rate × gas.
7. Spreads between months
A spread can also be between two delivery months of the same commodity: buy one month and sell another. Expect a shortage soon? Buy the nearer month and sell a later one, which gains if the near month rises against the later one. Expect a glut? Do the reverse. This is a .
8. Spreads between places
(North Sea crude) and (US crude) differ in price mainly by the cost of moving oil. If Brent is $5 above WTI and shipping US crude to Europe costs $3, traders buy WTI, ship it and sell it at Brent prices: $2 a barrel. Their buying narrows the gap until the trade stops paying.
Worked example
WTI is $72.00 a barrel, RBOB gasoline $2.25 a gallon and ULSD diesel $2.60 a gallon. What is the 3-2-1 crack spread?
- Convert products to barrels: gasoline $2.25 × 42 = $94.50; diesel $2.60 × 42 = $109.20.
- Products out: 2 × $94.50 + $109.20 = $298.20.
- Crude in: 3 × $72.00 = $216.00.
- Margin: ($298.20 − $216.00) ÷ 3 = $27.40 a barrel of crude.
$27.40 a barrel: before its operating costs, the refinery earns that on each barrel of crude it runs.
Check yourself
8 quick questions on the explanation above.
Practice
New numbers every set. Misses and guesses go into your review deck.
In the interview
Answer out loud in under a minute, then compare.
What’s a crack spread, and who trades it?
Why might the Brent–WTI spread widen?
Remember
3-2-1 crack = (2G + D − 3C) ÷ 3
Desks trade the gap between two prices; the spread tells you whether a refinery, a power plant or a cargo makes money.