Jan 5, 2009

Refiners' stock prices and the crack spread

The crack spread is a rough measure of an oil refiner's gross profit margin. It measures the difference between the cost of inputs (crude oil) and outputs (gasoline, fuel oil, diesel, etc.). Normally this ratio is expressed as 3-2-1, where 3 barrels of crude yield 2 barrels of gasoline and one of heating oil, although other ratios are also possible. The term "crack" refers to the process of breaking the hydrocarbon molecules in crude oil through the application of either a catalyst (cat cracking) or hydrogen (hydrocracking). Another interest fact: a high complexity refinery can actually output 5-10% more material by volume than it consumes as inputs due to volumetric expansion as lighter molecules are produced.

Since the crack spread is a measure of profitability, one might expect that refiners' stock prices are highly correlated with it. The strange thing in 2008 was that refiners were much more highly correlated with the overall stock market (represented by the S&P 500) than the crack spread. The crack spread even became negative at one point in the year - why would refiners continue to operate only to lose money on every barrel they refine? The answer is that they had hedges which locked in input or output prices at levels other than the currently observed spot prices.

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