Crack Spread 'Yes' Futures 'No'

By Brad Zigler

This is not just any market. But you already knew that, right?

When oil falls on the prospect of throttled-down supply, the world must be topsy-turvy.

The Organization of Petroleum Exporting Countries [OPEC] hoped for a little "shock and awe" of its own by slashing its daily output by a record 2.2 million barrels a day. On that news, crude oil's barrel price paradoxically slipped lower to tease $40, a level not seen since 2004. Go figure.

Well, let's figure.

Oil's been going down since the Independence Day weekend. Down 72% to be exact. Prices for refined products such as gasoline and heating oil, however, haven't slumped as badly. Heating oil has been particularly strong in relation to crude and now gasoline's margin is improving. In fact, there's enough pricing strength in the products now to make crack spread purchases enticing.

"Buying the crack spread" entails selling short crude oil futures and simultaneously buying contracts on the refined products.

The case for a spread trade's made stronger by the crude market's expanding contango, now at $9.11 for the nearby quarter (more on oil's contango can be found in "Oil Demand Peaking Or Perking?"). Supplies, weighing heavily on front-month futures, inflate the storage premium in the back months.

Traditionally, a crack spread is built with futures. A classic "3-2-1" refining model balances two barrels of gasoline and one barrel of heating oil with three barrels of crude. Based on this model, the spread uses six contracts: three crude oil futures on one side, two gasoline contracts and a cargo of heating oil on the other.

The spread balances because each of the contracts calls for delivery of equal amounts of crude and fuel. Crude oil futures are priced for delivery of 1,000 barrels. The distillate contracts are the same size, but are denominated in gallons (there are 42,000 U.S. gallons in the fuel contracts; a barrel contains 42 gallons). Presently, a crack spread constructed with front-month crude and second-month products is worth $9.61 a barrel. With an oil price of $40.06, that represents a 24% gross profit margin.

The spread is determined by subtracting the crude oil cost from the combined value of the heating oil and gasoline contracts. At current levels, the spread looks like this:

[2 x (42 x $1.0425) + (42 x $1.4625)] - (3 x $40.06) = $28.82 ÷ 3 = $9.61/barrel

The green-eyeshade set, however, uses the "cost of goods sold" as a profit measure for the refining company's income statements. From that perspective, the refiner's profit is $28.82 on every $149 of product sales, or 19.3%.

Because of the price volatility of crude oil and cracked products, margin percentages are more reliable profit indicators than the dollar amount of the crack. Back on September 4, for example, the crack was $28.98. With crude priced at $108 a barrel, though, the refining margin was a relatively paltry 9%.

Right now, oil's being traded as if it were in glut. OPEC production cutbacks are yet to come (and could very well be cheated), while domestic refining operations are being throttled back for winter, keeping newly refined product outputs relatively modest. In other words, it's a good time to be short oil and long the products.

Why not just short oil? Volatility, for one thing. The risk of being margined for an outright short, even in a market as technically weak as crude oil, exposes a trader to a substantial risk given the 58% volatility in daily prices. Minimum margin for an outright NYMEX crude contract is now $10,463. A maintenance call awaits if crude rises just $27 a barrel from a short sale price. Spot crude recently covered that distance (granted, on the downside) in just 14 trading days.

Spreading reduces a trader's capital risk in a big way. Spreads tend to be less volatile and more predictable than outright trades. This year, for instance, the crack spread's been 25% less volatile than outright crude prices.

With a spread trade, the absolute price levels of the legs are of secondary importance. What's paramount is the relationship between the long side and the short. When you buy the crack, you want the difference between the prices of crude and the distillates to widen, through either cheapening of oil or increases in the value of the refined products. It doesn't matter which of those scenarios play out. There are two routes to profits in a spread trade; only one road leads to gains in an outright position.

NYMEX Spot Crude Oil

With the margin credits available for spreads, it's also possible for crack traders to make better returns than those speculating in outright futures. In the past trading week, for example, outright oil traders could have earned a 73% return on margin on a short crude position. Traders who bought the 3-2-1 crack (short crude, long the products) had an opportunity to make a contemporaneous 130% return.

NYMEX Implied Refining Margin

You shouldn't get the idea that spread trading eliminates risk, though. It doesn't. Sooner or later, a spread runs its course and eventually reverses. Margin calls can and do befall spread traders.

There is a way, however, for spread-minded investors to capture refining profits without the risk of margin calls. Crack trading can now be simulated with levered and short exchange-traded vehicles on petroleum products.

A 2-1-1 variant of the crack spread, for example, can be bought by purchasing equal lots of the ProShares UltraShort DJ-AIG Crude Oil ETF (NYSE Arca: SCO), the United States Gasoline Fund (NYSE Arca: UGA) and the United States Heating Oil Fund (NYSE Arca: UHN).

The returns may not be as dramatic as those obtainable through futures - the 2-1-1 combination, for example, earned only a 5% return last week - but then, neither will the drawdowns (the risk of drawdowns is illustrated in "Recovering Market Losses").

For the topsy-turvy oil market, the ETF crack spread could turn out to be a trader's 5% solution.

Comments

[Glen Bradford:]

Sounds like an interesting idea.

Here's a seasonal investing one. Disclaimer: THIS IS NOT MY USUAL INVESTING IDEA --- THIS IS SPECULATION. That said, I'll probably be doing it.

I'm skimming Thackray's 2009 investor's guide. February 25th to May 9th looks like a great time to buy XOI, the Amex Oil Index. Since 1984, this produced an average return of 8.6% and beat the S&P 500 by 6%, and was positive 92% of the time.

The author gloats that this is the best seasonal trade in the book. I think the ETFs to go bullish on are OIL, UCO.

Everyone is waiting on oil to bottom. I figure once oil bottoms, then russia, rsx can bottom as well as other emerging economies. But, I'm not going to be out there trying to catch the raining knives. I'm going to wait till the bottom has passed and then all-aboard.

Also, on your charts, you should have circled the point on the chart where oil was short squeezed back up to around $125. That kind of information is critical, since it crossed all your moving averages.

Out of my stocks, I own APA and NOV.

2008 Dec 23 04:45 PM

[wosg:]

Brad,
Which month's futures contracts did you use in establishing your crack spread. You're numbers do not reflect today's futures prices.

2008 Dec 23 11:02 PM

[NOWHEREMAN:]

Glen: that spike will not be the lone example. I expect Sabre Rattling to occur periodically as rumors are used to create similar occurances.

Can you imagine the kind of sustained spike that would occur if the Somalian pirates managed to sink a supertanker in the middle of the Strait of Hormuz?

2008 Dec 24 10:00 AM

[L Boyd:]

Brad,

Great article; a strategy that I was not aware of and makes perfect sense for the current state of things (refiners massively cutting back production; unrefined oil sitting in tankers idly at sea). I was wondering the same thing as wosg though; can you specifically tell us the contracts that you're quoting above?

2008 Dec 24 10:47 AM

[hovendic:]

you posted

"crack spread constructed with front-month crude and second-month products"

It looks like you have a little calender action going in which the oil short (front month) expires before the long products (second-month). Does this leave you naked the second month and expose you to more than you originally intended?

2008 Dec 24 11:36 AM

[Kunst:]

The Strait of Hormuz is a bit far from Somalia, don't you think? Also, I believe it is crawling with US and other naval forces.


On Dec 24 10:00 AM aitvaras wrote:

> Can you imagine the kind of sustained spike that would occur if the
> Somalian pirates managed to sink a supertanker in the middle of the
> Strait of Hormuz?

2008 Dec 24 07:26 PM

[Brad Zigler:]

The crack spread employs front-month crude oil (which, in December was the January delivery), along with the February product contracts to simulate a storage and processing cycle.

And, no, the spread doesn't "go naked." If the spread is to be held over an expiration, the entire position can be rolled forward.

2008 Dec 28 06:20 PM