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By Stanley Dash, VP, Applied Technical Analysis
with Erik Skyba, CMT, Sr. Quantitative Analyst
Crude oil and its distilled products are essential parts of our modern world. From transportation and agriculture to heating and cooling, petroleum fuels industry and so much of the way we live. Of course, crude oil and its products are produced and consumed around the world and so they are also a major part of modern financial markets.
The NYMEX division of CME Group hosts trading in futures on crude oil, gasoline and heating oil. This presents opportunities for tracking and trading relative valuations among these closely related markets.
In the futures markets, such value relationships are known as spreads. Futures spreads are an integral part of the markets and are actively traded by many participants, both speculators and hedgers. Spread valuations not only offer spread traders insights into economic and industry conditions, but also may be a useful indicator to those trading crude oil or one of its products on an outright basis.
This Analysis Concepts paper examines the general idea of tracking oil spreads and using the values to trade crude oil futures.
Crude oil is a raw material. When distilled, or “cracked,” crude oil yields a range of useful products including gasoline, heating oil and other products known collectively as distillates. It is these products that are consumed in the industrial and consumer markets. Gasoline and heating oil account for the lion’s share of product from a barrel of crude oil, as well as the lion’s share of its value. In fact, these two so dominate the valuation metrics that other products are often disregarded in the financial markets.
Manufacturers in any industry closely monitor the cost of their raw materials and the prices of their products. Oil refiners are no exception; crude oil is their raw material and gasoline and heating oil are their finished products. The difference between the raw materials cost and the product selling prices, known as the gross cracking margin, is also the refiner’s gross profit margin. Energy futures markets provide us with these valuations every day and in real time.
As defined above, futures traders refer to inter-market valuations as spreads. In the oil futures markets, these are known as crack spreads, as in the nickname of the refining process. The term crack spread is used in reference to a variety of possible spread trades in the energy futures markets.
A crack spread in futures always involves crude oil futures and one or more of the product futures: gasoline and/or heating oil. The nomenclature for a crack spread refers to the number of futures contracts in the position: crude oil, gasoline and heating oil in that order. Common crack spreads are
1:1 1 crude oil vs. 1 gasoline or 1 heating oil
2:1:1 2 crude oil vs. 1 gasoline and 1 heating oil
3:2:1 3 crude oil vs. 2 gasoline and 1 heating oil
5:3:2 5 crude oil vs. 3 gasoline and 2 heating oil
A position long crude oil and short products is known as “short the crack”; short crude oil and long products would be “long the crack” or a reverse crack. In any case, a crack spread always involves taking opposing positions in crude oil futures and product futures.
The necessity for using the contract ratios noted above is most often the province of hedgers. The yield from a barrel of crude oil depends on many factors, including the type of crude oil, environmental regulations and the method of processing. Oil refiners often hedge by taking crack spread positions that mimic the product yield of their refining operations. Hence the ratios listed above.
Speculators interested strictly in trading price relationships and movements often focus on the 1:1 crack. In this case, a trader may try to identify which of the products is driving the price action and focus on spreading only that product against the crude oil. This is also done to minimize commissions and slippage in trading.
This paper uses the 3:2:1 crack spread as an example of tracking the spread as an indicator of oil market direction.
NYMEX crude oil futures are 1,000-barrel contracts, and prices are expressed in dollars and cents per barrel. NYMEX gasoline and heating oil futures are 42,000-gallon contracts, and prices are expressed in dollars and cents per gallon.
It may seem unusual that these contracts are 1,000 barrels and 42,000 gallons, respectively, but they are actually the same volume since 1 barrel = 42 gallons. Crack spreads are expressed in dollars and cents per barrel, as are crude oil prices. Therefore, calculating the spread requires converting the gasoline and heating oil prices per gallon to prices per barrel. The product prices are multiplied by 42 to express them per barrel.
Figure 1 contains the formula for a 3:2:1 crack spread. The spread is calculated by taking 2 (for 2 contracts) times the gasoline price (expressed per gallon) multiplied by 42 to express the price per barrel. Then 1 (for 1 contract) times the heating oil price (expressed per gallon) multiplied by 42 to express the price per barrel. The sum of those is the product value of the crack. Finally, we subtract 3 times the crude oil price, already expressed in barrels, and then divide the result by 3 to get the crack spread value for 1 barrel.
Figure 1 – Calculating Crack Spreads
In Figure 2 are the charts of the 3:2:1 crack spread, along with the three NYMEX unadjusted custom continuous futures contracts that make up the spread – crude oil, gasoline and heating oil – in the top three sub-graphs.
Note: you can learn more about TradeStation’s custom futures symbols by checking the TradeStation Platform Help topic “Custom Continuous Futures Symbology” or emailing us at TSLabs@TradeStation.com.
Figure 2 – 3:2:1 Crack Spread Indicator
The crack spread indicator shown above is not smoothed in any way. It can be helpful to smooth this to create a clearer picture of the trend of the spread. Figure 3 shows the 10-bar simple average of the same spread. This average will also be used in the strategy to follow.
Figure 3 – 10-Bar Average of the 3:2:1 Crack Spread
Table 1 shows the inputs that are used in the crack spread indicator and in the strategy that follows later in this paper. The first three input values (CrudeOilCts, GasolineCts and HeatingOilCts) are multipliers used to create the desired contract ratio for the crack spread. These values can be changed to create a 5:3:2 or 2:1:1 or 1:1 spread. The AverageLength input sets the number of bars to use in calculating the moving average of the crack spread. The last input, MomentumLength, appears only in the strategy; it sets the number of bars to be used in calculating the momentum of the crack spread. The indicator and strategy may be downloaded using the link associated with this paper.
Trading the crack spread involves some combination of simultaneous long and short positions in crude oil and the products. This paper suggests that there may also be analytical value in tracking the spread for someone trading the oil markets outright – that is, in non-spread positions. Our sample strategy idea uses the 3:2:1 crack spread to generate trading signals in crude oil. The rules for this strategy are shown in Table 2.
The strategy is predicated on the idea that rising (falling) crack spread values may presage rising (falling) crude oil prices. A moving average of the crack spread is used to achieve a smoother picture of the trend; using momentum of the average of the crack spread is intended to refine the definition of the trend even further.
For this demonstration, there are no exit rules such as stops, trailing stops or profit targets, nor are there any rules for scaling in or out of positions or dynamic position sizing. Such rules for money and trade management are very important and their exclusion here is not meant to suggest that they be ignored in actual trading. The rules here have been kept as simple as possible to encourage an understanding of inter-market relationships and how they may be used in outright trading.
Figure 5 below shows the Performance Summary tab of the Strategy Performance Report for the five-year period ending October 31, 2011. When examining metrics such as Drawdowns and Time in the Market, recall that there are no protective orders and that the strategy simply reverses position on each new signal.
Figure 4 – Trading Example
Figure 5 – Crack spread strategy performance report
Many traders, usually hedgers and other institutions, will participate in complex multi-leg transactions. This is often done out of necessity as much as in pursuit of trading profits. Yet understanding the dynamics and the related inter-market forces that are unique to a market may provide perspectives even to the outright trader. In this case, the crack spread may be a window into the forces at work in the oil industry and the economy, and may provide a guide to general oil-complex price movement.
For additional information, you may want to read this publication: CME Group Crack Spread Handbook.
To use the files provided with this issue of Analysis Concepts:
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