Crack Spreads

One common form of basis risk in the crude oil sector is the so-called "crack spread."²⁴ This represents the price differential between refined and unrefined products. While banks' virtual absence in the physical markets means that their activity in this sector is extremely limited, a thumbnail sketch of the activity in the crack spread may be beneficial.

The NYMEX launched options contracts on two crack spreads (crude oil vs. either gasoline or heating oil) in October 1994. Exercising these options results in a spread position (one long, one short) in two futures contracts. Crack spreads can also be traded with the futures contracts outright, allowing for different ratios than the one-to-one ratio implicit in the option contract.

Refiners comprise the bulk of the participation in the crack spread markets. OTC, crack swaps are another popular hedging vehicle. Hedging the crack spread allows refiners to exercise some control over the refining margin which fluctuates with supply and demand factors, seasonal pressures, inventory levels and other market factors.