Crack Spread

8/17/2019 Crack Spread

1/21

How can refineries hedge?

Crudeoil

Refinery

Input Process

Naphtha

Jet Kero

Gasoil

Fuel Oil

Gasoline

Output


2/21

Crack Spread & Refining! Is simply the wholesale cost of the refined

product less the cost of the raw material

!

If the spread it too low to yield a profit = refinerieswill cut back until product price increases

! Refiners face substantial price risk between thetime the refinery buys crude and when they can

sell the finished product


3/21

Crack Spread! Therefore they must attempt to ‘lock in profit’ by

agreeing a sale price ahead of time

! They can do this by agreeing the sale of thereproducts (most important) now

! They can do this by ‘hedging’ using the crackspread


4/21

Crack Spread! Buy Crude – input

! And sell the output

! Most common crack trades are to buy in thefollowing ratio

3 – Crude

2 – gasoline

1 - heating oil

Known as a 3.2.1 crack-spread trade


5/21

Raw data from CME

!"#$%&'$ )*+ ,-$-%./ 0%1 2&/"313#. 21 4.&5#6 731 21

8&%9:; ?; @>A?B @>?C?@ @>?FA@ @>=A=@C= @>?


6/21

How might you conduct a

3.2.1 trade! Step 1 convert gallons into barrels

! For a 3.2.1 crack spread trade for the above

data.

! 3* WTI (CL)

! 2 * Gasoline (RB)

!

1 * Heating (HO)

! Crack spread = ( 2*RB) + (1*HO) – (3*CL)


7/21

Answer

)*L M B 2&/"13#. M @ 4.&5#6 731 M: !%&'N IE%.&O

8&%9:; @C@ @@C>B=@ :@C>=A;A@

DE%9:; @B:CA :@B>;? =:>?BCA

8&G9:; @?@;F? :@@>B=C; =@>=C; @BC>=@F? :@@>:F@; =@>@?B@

D-69:; @?B>:: @B@>A@:@ :@:>???@ =:>B=A@@ =F>F::

7'$9:; @=?>;A @:A>;:=A :@:>A@BA CC?:@

J"K9:; @=A>;? @:@>A?? :@:>A@BA C=>?B:A


8/21

Crack spread profit! The crack spread ‘profit’ should cover all costs

and for refiners is not pure profit

50

55

60

65

70

75

Mar-14 Apr-14 May-14 Jun-14 Jul-14 Aug-14 Sep-14 Oct-14 Nov-14

Crack Spread

Crack Spread


9/21

Exercise

!"#$%&'$

)*+

,-$-%./ 01 2&/"13#. 21

4.&5#6 731

21

8&%9:; ?; @>A?B @>?C?@ @>


10/21

Answer

!%&'N IE%.&O

;@>?FF@

;?>


11/21

Jet Fuel Oil – Cross HedgeAirline industry may wish to hedge its ‘exposure’ tochanges in Jet Fuel oil prices (costs) using futures.

! Problem is – there is no jet fuel oil futures contract.

! The airline may wish to buy an OTC contract i.eoptions, swap or forward

! Or the airline can cross hedge


12/21

Jet Fuel – Hedging! Hedgers( buyers) at the airline company can

choose to cross – hedge.

!

Take a position in a contract where the price iscorrelated with jet fuel prices.

! A common correlation correct is normallyHeating oil , Crude or Gasoline


13/21

Minimum variance hedge

ratio

MV (or hedge ratio) = Correlation between two prices( Stand deviation of percentage change Jet

Fuel / Standard Deviation of the percentagechange Heating oil)


14/21

How can I use my ratio?

As the airline you will purchase 500,000 gallons of jet fuel.

Key question - How many correlation contractsshould I buy?

Number of contracts = (500,000 * hedge ratio )/ 42000 Gallons


15/21

Example

Correlation Co. 87.52%

Require Vol(gallons)

500,000

!"#$%&'$

)*%'*#$&+*

',+* -*&.#+ /01

21

)*%'*#$&+*

',+* "3 4*$ 56*1

5"%7&%8 !6%9*

:&%;?%;


16/21

Hedge Ratio

Correlation Co *( Std Dev JF/STd HO)

= 87.52 * 3.42/2.79

= 1.0731

How Many Contracts

!

(Vol Required * hedgeratio )/42000 Gallons

= 500,000*1.0731/42000

= 12.77 Contracts

= or 13 Contracts

We can not buy 12.77contracts and the correlationis not 100% therefore its an

‘imperfect hedge’


17/21

Jet Fuel Price Increase $1 (per

gal)! Corresponding increase in

HO should the correlationhold should be

! = 1/87.52

! = Increase of 1.1426 (p/g)

! Increase cost in purchase of

JF = 500,000* 1 = $500000

! Long position in HO beforethe increase

! 13 * 1.1426 * 42000 =$623,881

!

Gain of $123,881


18/21

EX.

Correlation Co. 80.87%

Require Vol(gallons)

1,000,000

What is the gain

if Spot P of JFincrease by

$1

!"#$%&'$ OPQ4*$ 56*1 5"%7&%8!6%9*

:&%;?%;


19/21

Answer

Hedge Ratio

= 80.87% * 3.80/4.86

= 0.6319

How Many Contracts

! (Vol Required * hedgeratio )/42000 Gallons

= 1,00,000*0.6319/42000

= 15.04 Contracts

= or 15 Contracts

We can not buy 12.77contracts and the correlationis not 100% therefore its an‘imperfect hedge’


20/21

Jet Fuel Price Increase $1 (per

gal)! Corresponding increase in

HO should the correlationhold should be

! = 1/80.87

! = Increase of 1.2366 (p/g)

! Increase cost in purchase of

JF = 1,000,000* 1 =$1,000,000

! Long position in HO beforethe increase

! 15 * 1.2366* 42000 = $779045

! Imperfect hedge – ( cashflow did not cover the fullmovement


21/21

Intended Learning

Outcomes

! Be clear and the meaning and purpose of

hedging & risk mitigation

! Understand Basis trades

! Understand and be able to construct complexhedges

- Crack spread

- Cross hedge

Crack Spread

Documents

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