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What is the Crack Spread Chart Telling Us?

Imagine you ran a bakery. A cupcake bakery to be exact. How do you make money? It's fairly simple:

  1. Buy Sugar, Flour, Eggs and other goodness
  2. Cook the cupcakes
  3. Sell cupcakes for a profit

Pretty simple business, right? Well how can you increase your margins? You can try and keep the price low on your raw materials (sugar, flour) and keep the price high on your cupakes.

Refiners work about the same way. They take the raw materials (crude) and process it into stuff that people use (heating oil, gas). If the price for crude goes down but the price for gas stays up, they make a higher margin. This spread is known as the crack spread.

There are fancy ways to determine this, but the quick and dirty way is to look at the current price of /CL and compare it to /HO and /RB. If you use thinkorswim as your broker, you can use this formula:

28*/RB+14*/HO-/CL

I don't know about the precision of the coefficients, but I'm sure it's related to the actual amount of commodity as defined by the futures contract specs. This chart shows the current spread:

This is the chart that gives us an approximation of the crack spread. It goes back to the 2007 levels, when the move started to go parabolic.

If we see continued improvements in the spread going into the summer, look for the margins to improve for the refiners. Many of these names are already setting up on a technical basis.

by Steven Place

Steven Place is the founder and head trader at investingwithoptions.com/