The gross processing margin refers to the difference between the cost of a commodity in its raw form and the income generated by it once it is polished into its finished form. For example, such a margin would be the difference of the cost of oil and the positive return reached by selling gas. In investment circles, gross processing margin is used by investors as an opportunity to take advantage of the price differences between a commodity and the products it creates. This usually entails an investor buying long on the commodity and selling short on the refined form of it.
Commodities are raw materials from which other products are made, and their market price is determined by the laws of supply and demand. There can often be a discrepancy between the price of a commodity on the market and how much income is generated from the products that emanate from that commodity. The spread between the two is known as the gross processing margin, or GPM, and it is an important concept for both industries and investors alike to understand.
Most industries have their own specific formulas to determine the gross processing margin of their commodity. For example, the electricity industry has what’s known as the spark spread, which is the difference between the market price of electricity and what it costs to produce the electricity. The industry pays close attention to this spread in an effort to determine what is the best time to produce electricity. In similar fashion, the oil industry has the crack spread, and the soybean industry has the crush spread.
Investors may try to take advantage of gross processing margin by utilizing options contracts. The typical spread position in these cases would be to buy low, or take the long position, on the underlying commodity, hoping that the price will rise. In turn, the investor would then borrow options with the intent to sell high, also known as the short position, on the finished product created by the commodity, hoping that the price will fall.
This allows the investor to essentially set his or her own position on how much it costs to make a typical product. For example, an investor playing a crack spread on the oil industry is betting on the efforts of oil refineries to do their jobs well. By contrast, an investor can go against the grain on such options. In the case of the soybean trade, this would mean going long on soybean oil and feed and short on the soybean itself, which creates what is known as a reverse crush spread.