This article is the third in our series covering multi leg complex spreads fundamentals. Previous two articles focused on intra commodity spreads and inter commodity Crush spreads
In the petroleum industry, refineries are most concerned about hedging the difference between their input costs and output prices. Their profits are tied directly to the spread between the price of crude oil and the prices of refined products, gasoline and distillates (diesel and jet fuel). This spread is called Crack spread. It is referenced as Crack spread because of the refining process that “cracks” crude oil into its major refined products.
Refineries, like other processors, are caught between two markets. Raw materials they need to purchase and the finished products they offer for sale. The prices are often independently subject to variables of supply, demand, production economics, environmental regulations and other factors. Therefore refineries can be at enormous risk when the price of crude oil rises while the prices of the refined products remain stable or even decline. Such a situation can severely narrow the crack spread, which represents the profit margin. Because refiners are on both sides of the market at once, their exposure to market risk can be greater than that incurred by companies who simply sell crude oil, or sell products to the wholesale and retail markets.
In a typical refinery, gasoline output is approximately double of distillate fuel oil (the cut of the barrel that contains diesel and jet fuel). This refining ratio translates to 3:2:1 Crack spreads - three crude oil (CL) contracts versus two gasoline (RB) contracts and one heating oil (HO) contract.
Crack spread calculation needs conversion, because the quantities are given in different units. Crude oil is quoted in dollars per barrel, but gasoline and heating oil are both quoted in dollars per gallon and must be multiplied by 42 gallons per barrel to convert to dollars per barrel. Together with 3:2:1 ratio, we can define gross cracking margin (GCM):
Rationale behind the speculation on Crack spread is again very similar as on the other processing margin spreads. Going short Crack spread is called synthetic refining, transaction hedges an actual operating refinery. On the other hand, reverse Crack spread replicates a theoretical refinery.
The combined value of gasoline and heating oil must cover crude oil price and refining production costs. Crack spread can be affected by the seasons. For example, during the summer months, gasoline is in greater demand than heating oil. During the winter months, the demand will move to heating oil. If spread is too narrow to make a refining profit, we can expect that product prices should rise to meet crude oil prices and so we can favor heating oil and gasoline contracts over crude oil. On the other hand, if spread between product and crude prices is large, we can expect refineries will push production and selling of unleaded gasoline and heating oil to take advantage of the profit. This selloff should push product prices lower and we can favor the crude oil over heating oil and gasoline.
Let’s end up with summary of pros and cons of multi leg spreads.
The information presented in this site is for general information purposes only. Although every effort attempt has been made to assure accuracy, we assume no responsibility for errors or omissions. Everything is provided for illustrative purposes only and should not be construed as investment advice or strategy. This site disclaims any responsibility for losses incurred for market positions taken by visitors or registered users, or for any misunderstanding on the part of any users of this website. This site shall not be liable for any indirect incidental, special or consequential damages, and in no event will this site be held liable for any of the products or services offered through this website.
The risk of loss in trading commodities can be substantial. You should therefore carefully consider whether such trading is suitable for you in light of your financial condition. The high degree of leverage that is often obtainable in commodity trading can work against you as well for you. The use of leverage can lead to large losses as well as gains. Past results are not indicative of future results. Hypothetical performance results have many inherent limitations, some of which are described below. No representation is being made that any account will or is likely to achieve profits or losses similar to those shown. In fact, there are sharp differences between hypothetical performance results and the actual results subsequently achieved by any particular trading program. One of the limitations of hypothetical performance results is that they are generally prepared with the benefit of hindsight.
© 2013, SeasonAlgo.com, Algotronix Inc.